International Financial Reporting Standard (IFRS®) 16, Leases was issued in January 2016 and has been effective for periods beginning on or after 1 January 2019. Early adoption was also permitted for entities that applied IFRS 15, Revenue from Contracts with Customers at or before the date of initial application of IFRS 16. The purpose of this article is to summarise some of the key issues related to IFRS 16 from the perspective of the lessee and how these impact on financial reporting.
IFRS 16 replaced International Accounting Standard (IAS®) 17. The approach of IAS 17 was to distinguish between two types of lease. Leases that transfer substantially all the risks and rewards of ownership of an asset were classified as finance leases. All other leases were classified as operating leases. The lease classification set out in IAS 17 was subjective and there was a clear incentive for the preparers of lessee’s financial statements to ‘argue’ that leases should be classified as operating leases rather than finance leases in order to enable leased assets and liabilities to be left off the statement of financial position.
It was for this reason that IFRS 16 was introduced. Although the concept of operating leases and finance leases still exists from the perspective of the lessor, they do not relate to the accounting of the lessee and lessor accounting is beyond the scope of this article.
At the inception of a contract, an entity must assess whether the contract is, or contains, a lease. This will be the case if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
To assess whether a contract conveys the right to control the use of an identified asset for a period of time, the lessee must have both of the following:
2.1 An ‘identified asset’
One essential feature of a lease is that the underlying asset (ie the asset that is the subject of the lease) is ‘identified’. This normally takes place through the asset being specified in a contract, or part of a contract. For the asset to be identified, the supplier of the asset must not have the right to substitute the asset for an alternative asset throughout its period of use. The fact that the supplier of the asset has the right or the obligation to substitute the asset when a repair is necessary does not preclude the asset from being an ‘identified asset’.
Example – identified assets
Under a contract between a local government authority (L) and a private sector provider (P), P provides L with 20 trucks to be used for refuse collection on behalf of L for a six-year period. The trucks, which are owned by P, are specified in the contract. L determines how they are used in the refuse collection process. When the trucks are not in use, they are kept at L’s premises. L can use the trucks for another purpose if it so chooses. If a particular truck needs to be serviced or repaired, P is required to substitute a truck of the same type. Otherwise, and other than on default by L, P cannot retrieve the trucks during the six-year period.
Conclusion: The contract is a lease. L has the right to use the 20 trucks for six years which are identified and explicitly specified in the contract. Once delivered to L, the trucks can be substituted only when they need to be serviced or repaired.
2.2 The right to direct the use of the asset
IFRS 16 states that a customer has the right to direct the use of an identified asset if either:
Example – the right to direct the use of an asset
A customer (C) enters into a contract with a road haulier (H) for the transportation of goods from London to Edinburgh on a specified truck. The truck is explicitly specified in the contract and H does not have substitution rights. The goods will occupy substantially all of the capacity of the truck. The contract specifies the goods to be transported on the truck and the dates of pickup and delivery.
H operates and maintains the truck and is responsible for the safe delivery of the goods. C is prohibited from hiring another haulier to transport the goods or operating the truck itself.
Conclusion: This contract does not contain a lease.
There is an identified asset. The truck is explicitly specified in the contract and H does not have the right to substitute that specified truck.
C does have the right to obtain substantially all of the economic benefits from use of the truck over the contract period. Its goods will occupy substantially all of the capacity of the truck, thereby preventing other parties from obtaining economic benefits from use of the truck.
However, C does not have the right to control the use of the truck because C does not have the right to direct its use. C does not have the right to direct how and for what purpose the truck is used. How and for what purpose the truck will be used (ie the transportation of specified goods from London to Edinburgh within a specified timeframe) is predetermined in the contract. Although it is possible for rights to be predetermined in a contract, in this contract C does not have any decision-making rights relating to the use of the asset.
Therefore, C has the same rights regarding the use of the truck as if it were one of many customers transporting goods using the truck. In other words, C is simply paying for haulage services rather than leasing a truck.
With very few exceptions (see section 3.4 for further details), lessees recognise a ‘right-of-use-asset’ (ie an asset in the statement of financial position representing the right to use an underlying asset) and an associated liability at the commencement date of the lease (ie the date that the lessor makes the underlying asset available for use by the lessee).
IFRS 16 requires that the lease liability should initially be measured at the present value of the lease payments that are not paid at the commencement date. The discount rate used to determine present value should be the rate of interest implicit in the lease.
3.1 Recording the asset
The right-of-use-asset would include the following amounts, where relevant:
The right-of-use-asset is subsequently depreciated. Depreciation is over the shorter of the useful life of the asset and the lease term, unless the title to the asset transfers at the end of the lease term, in which case depreciation is over the useful life.
3.3 Lease liability
The lease liability is effectively treated as a financial liability which is measured at amortised cost, using the rate of interest implicit in the lease as the effective interest rate.
Example – accounting for leases
A lessee enters into a 20-year lease of one floor of a building, with an option to extend for a further five years. Lease payments are $80,000 per year during the initial term and $100,000 per year during the optional period, all payable at the end of each year. To obtain the lease, the lessee incurred initial direct costs at the commencement date of $25,000.
At the commencement date, the lessee concluded that it is not reasonably certain to exercise the option to extend the lease and, therefore, determined that the lease term is 20 years. The interest rate implicit in the lease is 6% per annum which is equivalent to a 20-year cumulative discount factor of 11.470. The present value of the 20 years of lease payments is $917,600 ($80,000 x 11.470).
The carrying amount of the right-of-use-asset at the commencement date is $942,600 ($917,600 + $25,000 initial direct costs) and consequently the annual depreciation charge will be $47,130 ($942,600 x 1/20).
The lease liability will be measured using amortised cost principles. In order to help us with the example in the following section, we will measure the lease liability up to and including the end of year two. This is done in the following table:
|Finance cost (6%)|
At the end of year one, the carrying amount of the right-of-use-asset will be $895,470 ($942,600 less $47,130 depreciation).
The interest cost of $55,056 will be taken to the statement of profit or loss as a finance cost.
The total lease liability at the end of year one will be $892,656. As the lease is being paid off over 20 years, some of this liability will be paid off within a year and should therefore be classed as a current liability.
To find this figure, we look at the remaining balance following the payment in year two. Here, we can see that the remaining balance is $866,215. This will represent the non-current liability, being the amount of the $892,656 which will still be outstanding in 12 months’ time. The current liability element is therefore $26,441. This represents the $80,000 paid in year two less year two’s finance costs of $53,559 (or $892,656 – $866,215).
Therefore, where payments are being made in arrears as is the case here, the non-current liability is the balance carried forward at the end of year two. The current liability is the difference between the total liability at the end of year one and the non-current liability (ie the total liability remaining at the end of year two).
However, this is not the case where payments are made in advance.
The following table could be used to calculate the relevant figures if payments were to be made in advance instead of in arrears. You should note the different placement of the payment column and the inclusion of a ‘subtotal’ column. For simplicity, we have used the same effective interest rate of 6%:
As payments are made in advance, this is equivalent to a 19-year cumulative discount factor of 11.158 since the first payment of $80,000 is incurred on the commencement of the lease. Therefore, the first payment is not discounted and the subtotal in year one of $892,640 ($80,000 x 11.158) would be the lease liability that should initially be recognised on commencement of the lease.
The initial lease payment of $80,000 would actually be included as part of the cost of the right-of-use asset rather than the lease liability. This is because, as noted earlier in section 3.1, the cost of the right-of-use asset should include the initial measurement of the lease liability plus any lease payments made at or before the commencement date.
Where payments are made in advance, the non-current liability would be the subtotal for year two ($866,198) and not the total liability carried forward at the end of year two as is the case with payments in arrears. This is because, with payments in advance, the balance carried forward at the end of year two includes the finance cost for year two.
In the case of both payments in arrears and payments in advance, the non-current liability is represented by the balance outstanding immediately after the payment in year two. In both cases, the current liability is the difference between the total liability at the end of year one (ie the end of the current year) and the non-current liability. This means that for payments in advance, the current liability would simply be $80,000 in this example.
3.4 A simplified approach for short-term or low-value leases
A short-term lease is a lease that, at the commencement date, has a term of 12 months or less. A lease that contains a purchase option cannot be a short-term lease. Lessees can elect to treat short-term leases by recognising the lease rentals as an expense over the lease term rather than recognising a right-of-use-asset and a lease liability. The election needs to be made for relevant leased assets on a ‘class-by-class’ basis. A similar election – on a lease-by-lease basis – can be made in respect of leases for which the underlying asset is of low value (ie ‘low-value leases’).
The assessment of whether an underlying asset is of low value is performed on an absolute basis. Leases of low-value assets qualify for the simplified accounting treatment explained above regardless of whether those leases are material to the lessee. The assessment is not affected by the size, nature or circumstances of the lessee. Accordingly, different lessees are expected to reach the same conclusions about whether a particular underlying asset is of low value.
An underlying asset can be of low value only if:
(a) The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee; and
(b) The underlying asset is not highly dependent on, or highly interrelated with, other assets.
A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value.
Examples of low-value underlying assets can include tablets and personal computers, small items of office furniture and telephones.
The treatment of sale and leaseback transactions depends on whether or not the ‘sale’ constitutes the satisfaction of a relevant performance obligation under IFRS 15. The relevant performance obligation would be the effective ‘transfer’ of the asset to the lessor by the previous owner (now the lessee).
4.2 Transaction constituting a sale
If the transaction does constitute a sale under IFRS 15 then the treatment is as follows:
If the fair value of the consideration for the sale of an asset does not equal the fair value of the asset, or if the payments for the lease are not at market rates, an entity shall make the following adjustments to measure the sale proceeds at fair value:
Example – sale and leaseback
Entity X sells a building to entity Y for cash of $4.5 million, which is the fair value of the building. Immediately before the transaction, the carrying amount of the building in the financial statements of entity X was $3.5 million. At the same time, X enters into a contract with Y for the right to use the building for 20 years, with annual payments of $200,000 payable at the end of each year. The terms and conditions of the transaction are such that the transfer of the building by X satisfies the requirements for determining when a performance obligation is satisfied in IFRS 15. Accordingly, X and Y account for the transaction as a sale and leaseback.
The annual interest rate implicit in the lease is 5%. The cumulative discount factor for 5% for 20 years is 12.462. The present value of the annual payments (20 payments of $200,000, discounted at 5%) amounts to $2,492,400.
X would recognise a right-of-use-asset arising from the leaseback of the building. This would be measured as the proportion of the previous carrying amount that relates to the right of use retained by X. On this basis, the right of use asset would be $1,938,533 ($3,500,000 carrying amount of the building ÷ $4,500,000 fair value of the building x $2,492,400 present value of the expected lease payments). Similarly, this could be calculated as the proportion of the equivalent asset retained by X.
The total gain on the sale of the building is $1,000,000 ($4,500,000 fair value – $3,500,000 carrying amount). However, X can only recognise $446,133 as this is the amount of the gain that relates to the rights transferred to Y ($1,000,000 total gain ÷ $4,500,000 fair value x ($4,500,000 fair value – $2,492,400 present value of annual payments)).
|Dr Right-of-use asset||1,939|
|Cr Lease liability||2,492|
|Cr Gain on rights transferred||447*|
4.3 – Transaction not constituting a ‘sale’
If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS 15, although a legal transfer of the asset has taken place, the seller does not ‘transfer’ the asset for accounting purposes. Instead, the seller continues to recognise it in the statement of financial position without adjustment. The ‘sales proceeds’ are recognised as a financial liability and accounted for by applying IFRS 9, Financial Instruments. In the same circumstances, the buyer recognises a financial asset equal to the ‘sales proceeds’.
Under IFRS 16, most lease contracts result in the recognition of right-of-use-assets and lease liabilities in the statement of financial position. Therefore, leasing assets under IFRS 16 without using the exemptions related to short-term or low value leases has significant impacts on key accounting ratios of lessees – they will reduce return on capital employed and increase gearing. Similarly, when compared to the exemptions for short-term and low-value leases, entering into a lease where these exemptions do not apply will reduce measures of profit. This is because, in the early years of a lease, the combination of depreciation of the right-of-use-asset and the finance charge associated with the lease liability will exceed the lease expense applicable with short-term and low-value leases (normally charged on a straight-line basis).
Written by a member of the Financial Reporting examining team