IFRS 16 Leases Overview Vcprod FG

IFRS 16 Leases Overview [Write a description of this document here.] This document is formatted for A4 paper. IFRS 16 Leases Overview

IFRS 16 Leases Overview

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15-30 Producer Go through producer min pre- checklist and handle the session check-in logistics. Recording the session:  5 minutes before live session begins, START and then immediately PAUSE recording. As soon as the facilitators are ready, RESUME recording.

00:00 Facilitator SESSION START SESSION START Pause for a few seconds before speaking.  Change layout to Welcome participants to the IFRS 16 Leases Overview. presentation upon cue from facilitators. Check that participants can hear the speaker. Ask participants to click the green checkmark icon to indicate “Agree” or “Yes”.  RESUME recording.

IFRS 16 Leases Overview / VC Facilitation and Production Guide | 3 IFRS 16 Leases Overview Visual Time Who Facilitation Notes Production Notes Stamp

Introduce yourself, your background and experience with the topic.

Explain why we are discussing this topic. Emphasise the impact on the engagement team and ‘hook’ them into the purpose of this module and how it impacts them and their clients.

Review the agenda.

Indicate that this session will take approximately 35 minutes.

Introduce next topic.

At the simplest level, the accounting treatment of leases by lessees will change fundamentally. Bringing operating leases on balance sheet for lessees results in recognising a new asset – the right to use the underlying asset – and a new liability – the obligation to make lease payments. Bringing operating leases on-balance sheet also changes the profit and loss account (P&L) of lessees. Currently, operating lease expenses are typically charged to the P&L as an operating expense on a straight-line basis over the term of a lease. From 2019, leases will be accounted for as if the company had borrowed funds to purchase an interest in the leased asset. This typically results in higher interest expense in the early years than in the later years, similar to any other amortising debt. In turn, this means that total lease expense in the P&L will typically be higher in the early than in the later years of a lease – even if a lease has fixed periodic cash rental payments.

The following two slides illustrate the impact – on both the balance sheet and the P&L – of applying the new standard. The slides illustrate a five-year lease that is currently classified as an operating lease, with fixed regular rental payments – e.g. a five-year lease of an aircraft or an office building. If there are no prepaid rentals or initial direct costs, then the asset and liability are equal on day one. Over the course of the five-year lease, the carrying amounts of the asset and the liability decrease. Crucially, the carrying amount of the asset decreases more quickly than the carrying amount of the liability. This means that the lease represents a net liability on the balance sheet from day two onwards.

Lease expense features in two P&L categories: 1) Depreciation expense, which is likely to be straight-line (“SL”) over the lease term, 2) Interest on the lease liability, which will decrease year by year. Therefore total lease expense at the beginning of the lease is higher than the cash rental payment, and decreases over the lease term. This is why this new accounting model result in a net liability on the balance sheet.

In the early years of a lease, when total lease expense is higher, profits decrease compared to current operating lease accounting. As a result, companies will record lower earnings per share. However, since the lease expense is now presented as interest and depreciation expense, rather than as operating expense, the lessee’s EBITDA will be higher. The lease creates an on-balance sheet liability that attracts interest, together with a new asset on the other side of the balance sheet. In other words, lessees will appear to become more asset-rich but also more heavily indebted. Note that the front-loaded pattern of total lease expense may average out across a portfolio of leases in a large, stable business. However, the front-loading effect could be significant in aggregate for a growing business, or a business that is undertaking a major refresh of its portfolio of leased assets – e.g. an airline that is introducing a new model of aircraft across its fleet. Many financial agreements – e.g. loan agreements – feature covenants that are applied on a ‘frozen GAAP’ basis, meaning that a change in accounting policy won’t affect the covenant test. But this isn’t true in all cases.

Highlight that assessing whether an arrangement is, or contains, a lease will be one of the biggest practical issues when applying the new standard. In effect, lease definition becomes the test that determines whether an arrangement is on- or off- balance sheet for a customer / lessee.

Under the new standard a lease will continue to be a contract that conveys the right to use an identified asset for a period of time in exchange for consideration. However, the new standard increases the focus on which party controls the use of the identified asset. Highlight there may be some arrangements currently accounted for as leases that may fall outside the new definition. For example, a power purchase arrangement in which the customer obtains all of the output but does not control the power plant. Applying the new definition is likely to be one of the biggest practice issues under IFRS 16. However, two significant practical expedients could ease the pressure on application of the lease definition and reduce the compliance costs for IFRS preparers.

Short-term leases This exemption applies to leases with a term of 12 months or less. If elected, the exemption is applied to all leases within that class of underlying asset.

Leases of low-value items

IFRS 16 Leases Overview / VC Facilitation and Production Guide | 7 IFRS 16 Leases Overview Visual Time Who Facilitation Notes Production Notes Stamp This exemption is intended to capture leases that are high in volume but low in value – e.g. leases of small IT equipment (laptops, mobile phones, basic printers) or office furniture. The exemption can be applied even if the effect is material in aggregate.

IFRS 16 does not define ‘low-value’ though the IASB has indicated that it had in mind assets with a value of USD 5,000 or less when new. This election can be made on a lease-by-lease basis. Lease liability comprises the present value of periodic fixed rental payments + the present value of any payments the lessee expects to make at the end of the lease – e.g. a payment under a residual value guarantee. This is similar but not identical to current finance lease accounting. For example, under IAS 17 if a lessee provides a residual value guarantee, the lessee includes its total exposure under the residual value guarantee in the lease liability. Under IFRS 16, the amount included is the amount the lessee expects to pay under the residual value guarantee.

Variable lease payments that depend on an index or a rate are included in the lease liability, initially measured using the index or rate as at the commencement date of the lease. The lease liability is subsequently remeasured if the variable lease payments change as a result of a change in the relevant index or rate. Other variable lease payments are excluded from the lease liability – e.g. payments based on revenue or usage of the underlying asset. Instead, such payments are recognised in profit or loss in the period in which the event or condition that triggers those payments occurs.

The IASB has sought to minimise changes to lessor accounting. Lessors continue to apply a lease classification test and the current finance lease and operating lease accounting models. This leads to an inconsistency between the accounting models for lessors and lessees. For example, in the case of a lease currently classified as an operating lease, the lessee will recognise a financial liability for its obligation to make fixed lease payments, but the lessor will not recognise a financial asset for its right to receive those lease payments.

All sale-and-leaseback transactions will be on-balance sheet for the seller-lessee. Companies entering into a sale-and-leaseback transaction need to assess whether the sale leg meets the criteria to recognise a sale in accordance with the requirements of IFRS 15 Revenue from Contracts with Customers.  If there is a sale, the company accounts for the leaseback in accordance with the IFRS 16.  If there is not a sale, then the company accounts for the arrangement as a financing in the scope of IFRS 9. Note that this applies to both the lessee and the lessor, i.e. the lessor’s accounting depends on the assessment of whether the sale meets the criteria in IFRS 15.

IFRS 16 Leases Overview / VC Facilitation and Production Guide | 9 IFRS 16 Leases Overview Visual Time Who Facilitation Notes Production Notes Stamp The IASB has sought to simplify transition to the new standard by including important option and practical expedients on transition.

Firstly, on initial application of the new leases standard, lessors and lessees can choose to:  Apply the new lease definition to all contracts; or  Grandfather the assessment of which existing contracts are, or contain, leases under IAS 17 and IFRIC 4 Determining Whether an Arrangement Contains a Lease, and to apply the new lease definition only to new contracts.

The option to grandfather existing contracts is a practical expedient that will decrease the cost and time required for first-time application. The downside is that a lack of comparability between transactions entered into before and after the date of initial application of the standard.

On initial application, a lessee applies IFRS 16 by either:  Retrospectively adjusting all prior reporting periods presented in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors – i.e. using the full retrospective approach; or  Without adjusting comparative information – i.e. using the modified retrospective approach. A lessee would apply the election consistently to all of its leases. The full retrospective approach will enhance comparability between the different periods presented, but it will also increase the cost of initial application. In contrast, the modified retrospective approach will reduce cost and comparability. If lessees decide to follow the modified retrospective approach, then they recognise the cumulative effect of initially applying IFRS 16 to operating leases as an adjustment to the opening balance of equity at the date of initial application (a ‘big bang’). The previous carrying amounts of finance leases (assets and liabilities) are

carried forward under this option. IFRS 16 contains additional practical expedients to bring current operating leases on the balance sheet.

IFRS 16 applies for annual reporting periods beginning on or after 1 January 2019. Early adoption is permitted provided that an entity also adopts IFRS 15.

Although the IASB and FASB worked together when developing their new leases standards, they have not always arrived at the same conclusions.

IFRS and US GAAP are converged regarding:  Lease definition;  On-balance sheet accounting for lessees; and  Lessor accounting.

However, there are differences between the IFRS and US GAAP versions of the standard, the most significant are:

1) The lessee accounting model.

IFRS 16 Leases Overview / VC Facilitation and Production Guide | 11 IFRS 16 Leases Overview Visual Time Who Facilitation Notes Production Notes Stamp While IFRS 16 contains a single lessee accounting model, US GAAP will feature a dual model for lessee accounting – i.e. finance vs. operating leases. Under US GAAP, finance leases will be accounted for in the same way as under the IASB’s model. Operating leases will also be presented on the balance sheet with a right-of-use asset and a lease liability. However, for operating leases, lease expense will typically be recognised on a straight-line basis – i.e. not front-loaded – and presented as a single amount within operating expenses. In order to achieve this profile of lease expense, the lessee will measure the right- of-use asset as a balancing figure – i.e. a plug. In addition, lease payments for operating leases will be presented within operating activities in the statement of cash flows.

2) Detailed measurement and transition requirements. US GAAP does not require a reassessment of variable lease payments that depend on an index or a rate. Moreover, while IFRS 16 limits the gain or loss that is recognised in a sale-and-leaseback transaction to the portion that is not retained, US GAAP does not contain such a requirement but refers to the general guidance on asset sales.

3) The exemption for low value items. Unlike IFRS, US GAAP does not provide a recognition exemption for leases for which the underlying asset is of low value.

Highlight the initial discussion points to consider in Audit Committee meetings.

Highlight the audit considerations for engagement teams to consider.

Highlight the publications and training resources issued and/or planned.

Summarise the Key Points to Remember.

SESSION ENDS SESSION ENDS Facilitator turns it back to producer to introduce course evaluation survey. Upon cue from facilitator, producer switches to course evaluation layout. Push the MTM survey link to learners. Leave on screen for about 3 minutes. Give learners an alert before ending the meeting.

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