Need to Know IASB Issues IFRS 16 – Leases

GAAP clear vision

Need to know IASB issues IFRS 16 – Leases

In a nutshell and liabilities recognised in respect Observation of all leases (subject to limited •• The new Standard provides exceptions for short-term leases and The project’s original aim was the a comprehensive model for the leases of low value assets). production of a converged IFRS and identification of lease arrangements U.S. GAAP standard. However, the and their treatment in the financial •• In contrast, the Standard does not IASB and FASB reached different statements of both lessees and include significant changes to the conclusions on a number of lessors. It supersedes IAS 17 Leases requirements for accounting by issues including the recognition and its associated interpretative lessors. and presentation of expenses by guidance. •• Entities will need to consider the lessees. As a result, the FASB’s •• IFRS 16 applies a control model to the impact of the changes introduced leasing standard (issued in February identification of leases, distinguishing by the Standard on, for example, IT 2016) differs from IFRS 16 in several between leases and service contracts systems and internal controls. respects. on the basis of whether there is an •• Subject to EU endorsement, the identified asset controlled by the Standard is effective for annual customer. periods beginning on or after 1 •• Significant changes to lessee January 2019 with earlier application For more information please see accounting are introduced, with the permitted for entities that have the following websites: distinction between operating and also adopted IFRS 15 Revenue from www.iasplus.com finance leases removed and assets Contracts with Customers. www.deloitte.ie

Introduction comparability between financial statements decided to develop a new approach to IFRS 16 is the result of the joint project due to the very different accounting lessee accounting that requires a lessee to initiated by the IASB together with the U.S. applied to operating and finance leases and recognise assets and liabilities for the rights national standard‑setter, the Financial limitations in the information provided on and obligations created by leases (with Accounting Standards Board (FASB), to operating leases and on entities’ exposure some limited exceptions) and to enhance address concerns raised by users of to risks arising from lease arrangements. the required disclosures on leases. financial statements in respect of reduced To address those concerns, the two boards 1 GAAP clear vision

Scope allowing short‑term leases and leases of The exception for leases of low value assets The new Lease Standard applies to all low value assets to be accounted for by can, on the other hand, be applied on leases, including leases of right of use simply recognising an expense, typically a lease by lease basis. assets in a sublease, with the exception of straight‑line, over the lease term (so, in specific items covered by other standards, a manner consistent with the current namely: accounting for operating leases). Observation •• leases to explore for or use minerals, oil, A ‘short term lease’ is defined as one that The ‘low value’ exception is unusual natural gas and similar non‑regenerative does not include a purchase option and in that it applies in absolute terms resources; has a lease term at commencement date rather than by reference to the size •• contracts within the scope of IFRIC 12 of 12 months or less. Lessees must apply, of the reporting entity (i.e. it is not Service Concession Arrangements; or not apply, the exception for short-term a measure of the lease’s leases consistently for each class of materiality). •• for lessors, licences of intellectual underlying leased asset. property within the scope of IFRS 15 The Standard does not provide Revenue from Contracts with Customers; a monetary value that should be and for lessees, leases of biological considered ‘low’ for these purposes, assets within the scope of IAS 41 Lease term but does state that the assessment Agriculture and rights held under licensing should be made based on the agreements within the scope of IAS 38 The lease term is defined as the asset’s value when new (even if Intangible Assets for items such as motion non‑cancellable period of the lease, a used asset is leased) and the Basis picture films, video recordings, plays, including: for Conclusions notes that, at the manuscripts, patents and copyrights. time of reaching its decision to 01. periods covered by an option to provide an exception, the IASB had Lessees are permitted, but not required, to extend the lease if the lessee is in mind leases of underlying assets apply IFRS 16 to leases of other intangible reasonably certain to exercise with a value, when new, in the order assets. that option; and of magnitude of US$5,000 or less. 02. periods covered by an option to It should also be noted that the ‘low Short-term leases and leases of low value terminate the lease if the lessee is value’ exception only applies to assets reasonably certain not to exercise leased assets that are not highly that option. dependent on, or highly interrelated In response to concerns raised over the with, other assets. cost of applying the requirements of the An entity is required to revise the new Standard, the IASB decided to provide lease term if there is a change in the a recognition exemption for preparers by non‑cancellable period of a lease.

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Definition of a lease The Standard aims to distinguish a lease Observation Consolidated Financial Statements and from a service contract on the basis of IFRS 15 Revenue from Contracts with whether a customer is able to control the The definition emphasises the notion of Customers, and with the IASB’s asset being leased. control because the IASB decided that proposals regarding control in the to control the use of an asset, Conceptual Framework Exposure Draft. A contract is, or contains, a lease if the a customer is required to have not only contract provides a customer with the the right to obtain substantially all of The Standard provides detailed right to control the use of the identified the economic benefits from use of an guidance to determine whether those asset for a period of time in exchange for asset throughout the period of use (a conditions are met. It is expected that consideration. Control is considered to ‘benefits’ element) but also the ability significant judgement will be required exist if the customer has: to direct the use of that asset (a ‘power’ to make this assessment in some cases. element). This guidance is consistent A summary of the detailed guidance is (a) the right to obtain substantially all of the with the concept of control in IFRS 10 provided below. economic benefits from use of an identified asset; and (b) the right to direct the use of that asset. inception and it will only reassess whether the earlier of the date of a lease agreement the contract is or contains a lease in case of and the date of commitment by the parties An entity is required to identify whether a modification to the terms and conditions to the principal terms and conditions of a contract is, or contains, a lease at of the contract. The inception of a lease is the lease.

Concept Definition Observation Use of an identified An asset is typically identified if it is The requirement is similar to the guidance set out in IFRIC 4 asset explicitly specified in a contract or Determining whether an Arrangement contains a Lease. An entity does implicitly specified at the time the not need to be able to identify the particular asset (for example, asset is made available for use by the a specific serial number). Instead, an entity needs to determine customer. However, if the supplier has whether an identified asset is needed to fulfil the contract. substantive rights to substitute the One area that will involve significant judgement will be the asset throughout the period of use distinction between a lease and a capacity contract. The Standard then the asset is not considered to be clarifies that a capacity portion of an asset is an identified asset if ‘identified’. it is physically distinct (for example, a floor of a building). By way of illustrating this concept, the Standard contrasts a contract for exclusive use of specific fibres within a larger cable used to transmit data with one for use of an equivalent portion of the capacity of the cable as a whole – concluding that the former contract includes the right to use an identified asset but the latter does not. Substantive A supplier’s right to substitute an The IASB decided to include this requirement because it considered substitution rights asset is substantive only if both of that if a supplier has a substantive right to substitute the asset the following conditions exist: (a) throughout the period of use, then it is the supplier who controls the the supplier has the practical ability use of the asset and not the customer. to substitute alternative assets The concept of economic benefit from substitution rights is throughout the period of use; illustrated by an example of a contract to use a specified type of rail and (b) the supplier would benefit car to transport goods. In this example, the supplier is deemed to economically from the exercise of its benefit from exercise of its right to substitute as this allows them to right to substitute the asset. utilise its pool of available rolling stock in the most efficient manner.

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Concept Definition Observation Right to obtain To control the use of an identified This assessment is made within the boundaries of the economic benefits asset, a customer is required to have scope of the contract. For example in a lease of a motor vehicle from use of the the right to obtain substantially all of which includes a limit for mileage use, that limit is the scope of identified asset the economic benefits from use of the contract and the customer will assess the economic benefits the asset throughout the period of obtained within this limit. use. The economic benefits from use of an asset include its primary output and by‑products, and other economic benefits from using the asset that could be realised from a commercial transaction with a third party. Right to direct the use A customer has the right to direct the The relevant decision rights to be considered are those that of the identified asset use of an identified asset throughout affect the economic benefits derived from the use of the asset. the period of use only if either: Some examples of customer’s rights that meet the definition are: (i) (a) the customer has the right to direct rights to change the type of output produced by the asset; (ii) rights how and for what purpose the asset is to change when the output is produced; or (iii) rights to change used throughout the period of use; or where the output is produced. On the other hand, rights that are (b) the relevant decisions about how limited to maintaining or operating the asset do not grant on its own and for what purpose the asset is a right to direct how and for what purpose the asset is used. used are predetermined and: (i) the customer has the right to operate the The concept of directing use through design of the asset is explored asset throughout the period of use; or in an example of a contract to purchase all of the output of a solar (ii) the customer designed the asset in farm, concluding that although the customer makes no decisions a way that predetermines how and for during the life of the farm it has the right to direct its use as a result what purpose the asset will be used. of having designed the asset before it was constructed.

Observation

The Standard does not provide a definition of services; however, the Basis for Conclusions provides some considerations made by the IASB to distinguish leases from services. For example, it indicates that leases create rights and obligations that are different from those that arise from service contracts. This is because the lessee obtains and controls the right‑of‑use asset at the time that the underlying asset is made available for use by the lessee, on the other hand, in a service contract, the customer does not obtain an asset that it controls at commencement of the contract.

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To help entities determine whether a contract is, or contains, a lease, the Standard provides the following flowchart:

No Is there an identified asset?

Yes

Does the customer have the right to obtain No substantially all of the economic benefits of the asset throughout the period of use?

Yes

Customer Does the customer, the supplier, or neither Supplier party, have the right to direct how and for what purpose the asset is used throughout the period of use?

Neither, how and for what purpose the asset will be used is predetermined

Yes Does the customer have the right to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions?

Did the customer design the asset in a No way that predetermines how and for what purpose the asset will be used throughout the period of use?

Yes

The The contract contract does not contains a contain lease a lease

5 GAAP clear vision

Accounting for leases in the financial Measurement Lease liability statements of lessees Right‑of‑use asset An entity will measure the lease liability Recognition A lessee is required to include the at the present value of lease payments A lessee will recognise at lease following items as part of the costs of the discounted using the rate implicit in commencement a right‑of‑use asset and right‑of‑use assets: the lease if that rate can be readily a lease liability. The commencement date determined. If an entity is unable to •• the amount of the initial measurement of of a lease is defined in the Standard as the estimate the rate implicit in the lease, the lease liability (see below); date on which a lessor makes an underlying then the lessee should use its incremental asset available for use by a lessee. •• any lease payments made to the lessor at borrowing rate. or before the commencement date, less any lease incentives; Observation Observation •• any initial direct costs incurred by the lessee; and The IASB decided to require a single The rate implicit in the lease is accounting model for leases in •• an estimate of costs to be incurred by defined in the Standard as the rate which a lease will be recognised in the lessee in dismantling and removing of interest that at commencement the statement of financial position the underlying asset, restoring the date causes the aggregate present (unless any of IFRS 16’s scope site on which it is located or restoring value of lease payments and the exceptions are available). The IASB the underlying asset to the condition residual value of the asset at the concluded that a lessee’s right to required by the terms and conditions of end of the lease term to equal the use an underlying asset meets the the lease, unless those costs are incurred sum of the fair value of the definition of an asset for the to produce inventories. The lessee underlying asset and any initial following reasons: incurs the obligation for those costs direct cost of the lessor. either at the commencement date or i. the lessee controls the right as a consequence of having used the The IASB indicates that the interest to use the underlying asset underlying asset during a particular rate implicit in the lease is likely to throughout the lease term; period. be similar to the lessee’s ii. the lessee has the ability to incremental borrowing rate in determine how to use the Subsequently, an entity will measure the many cases. This is because both underlying asset and, thus, how right‑of‑use asset using either the cost rates take into account the credit it generates future economic or revaluation model of IAS 16 Property, standing of the lessee, the length of benefits from that right of use; Plant and Equipment (thus, recognising the lease, the nature and quality of and depreciation and impairment expenses in the collateral provided and the iii. the right to control and use profit or loss and, if that model is applied, economic environment in which the the asset exists even when revaluations in other comprehensive transaction occurs. a lessee’s right to use an asset income). However, the Standard requires includes some restrictions the right‑of‑use asset of leased investment on its use; and the lessee’s property to be measured at fair value if control of the right of use arises the entity uses the fair value model under from past events – not only IAS 40 Investment Property to its other the commitment to the lease investment properties. contract but also the underlying asset being made available As noted below, right‑of‑use assets for use by the lessee for the are also adjusted as a result of certain duration of the non‑cancellable changes in the lease liability subsequent to period of the lease. commencement of the lease.

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The lease payments should include the •• amounts expected to be payable by the •• a change in future lease payments to following items: lessee under residual value guarantees; reflect a change in an index or rate used to determine those payments (including, •• fixed payments (including in‑substance •• the exercise price of a purchase option for example, a market rent review); fixed payments), less any lease incentives if the lessee is reasonably certain to receivable from the lessor; exercise that option; and •• a change in the lease term resulting from a change in the non‑cancellable period •• payments of penalties for terminating of the lease (for example, the lessee not the lease, if the lease term reflects the Observation exercising an option previously included lessee exercising an option to terminate in the determination of the lease term); or the lease. Lease payments should include •• a change in the assessment of an option fixed payments regardless of the Subsequently, a lessee will increase the to purchase the underlying asset. form in which they were structured lease liability to reflect interest accrued in the contract. For this reason, the (and recognised in profit or loss), deduct Changes resulting from revisions to residual IASB included the concept of lease payments made from the liability and value guarantees and changes in an index ‘in‑substance fixed payments’ which remeasure the carrying amount to reflect or rate are calculated using the interest intend to capture payments that any reassessment, lease modification, or rate determined at commencement of the could, according to the contract, be revision to in‑substance fixed payments. lease, whilst changes to the lease term or variable but are in reality in the assessment of a purchase option unavoidable. require calculation of a revised interest rate at the date of the change. Observation

•• variable lease payments that depend on A lessee is required to recognise the The differing treatment of the an index or a rate (such as the Consumer amount of the remeasurement of the lease right‑of‑use asset (depreciation Price Index or a benchmark interest liability as an adjustment to the right‑of‑use typically recognised on a rate), using the index or rate as at the asset unless the carrying amount of the straight‑line basis) and the lease commencement date; right‑of‑use asset is reduced to zero, in liability (interest calculated using that situation, a lessee will recognise any a constant rate of return method) remaining amount in profit or loss. results in probably the most Observation significant impact of the new Standard on a lessee’s net profit as A lease may include variable the total expense recognised will be payments related to future weighted towards the start of the performance. The Standard lease term (due to the higher requires that any variable lease interest cost arising at that time) payment not related to an index or whereas under IAS 17 the cost of an a rate will be recognised in profit or operating lease is usually loss as incurred. recognised on a straight‑line basis across the lease term. The IASB decided to exclude those variable payments from the initial measurement of the lease liability primarily for cost and benefits reasons. There was no specific Reassessment of the lease liability conclusion as to whether variable A lessee is required to remeasure the lease payments related to future liability in the following circumstances: performance meet the definition of •• a change in the amount expected to be a liability. payable under a residual value guarantee;

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Presentation The main presentation requirements are summarised below:

Statement of profit or loss Statement of financial position and other comprehensive income Statement of cash flows •• Right‑of‑use assets •• Interest expense on the lease liability (a •• Cash payments for the principal portion of component of finance costs) the lease liability within financing activities. •• Lease liabilities Distinguished from other assets and •• Depreciation charge from the •• Cash payments for the interest portion of liabilities either by separate presentation right‑of‑use asset the lease liability presented consistently in the statement of financial position or with other interest payments. by disclosure of the line item that they are •• Short‑term lease payments, payments for included in. leases of low‑value assets and variable lease payments not included in the measurement of the lease liability within operating activities.

Disclosure The disclosure objective of the Standard The Standard significantly expands the is that an entity is required to provide current disclosure requirements about information to enable users of financial leases. The required quantitative disclosure statements to assess the effect that leases requirements include: have on the financial position, financial •• depreciation charge for right‑of‑use performance and cash flows of the lessee. assets by class of underlying asset;

•• interest expense on lease liabilities;

Observation •• the expense relating to short‑term leases;

•• the expense relating to leases of Consistently with the requirements low‑value assets; being discussed under the IASB’s Disclosure Initiative, the Standard •• the expense relating to variable indicates that a lessee should lease payments not included in the provide additional quantitative and measurement of lease liabilities; qualitative information if it is •• income from subleasing right‑of‑use necessary to meet the disclosure assets; objective. •• total cash outflow for leases; The Standard indicates that the •• additions to right‑of‑use assets; information provided must be relevant for the users of the entity’s •• gains or losses arising from sale and financial statements and should leaseback transactions; and help users to understand the most •• the carrying amount of right‑of‑use relevant implications derived from assets at the end of the reporting period, its leases, including for example, by class of underlying asset. the flexibility provided by leases; restrictions imposed by leases; In addition, a lessee is required to disclose sensitivity on key variables; a maturity analysis of lease liabilities exposure to additional risks and (separately from other financial liabilities) deviations from industry practices. in accordance with IFRS 7 Financial Instruments: Disclosures. 8 GAAP clear vision

Accounting for leases in the financial a constant periodic rate of return on the of IFRS 15 Revenue from Contracts with statements of lessors lessor’s net investment in the lease. Customers for recognition as a sale. The Standard maintains substantially the lessor accounting requirements in IAS 17 Operating Leases If these criteria are met: Leases. Recognition and measurement •• the seller‑lessee recognises a right‑of‑use A lessor is required to recognise lease asset calculated as the proportion of Classification payments from operating leases as income the asset’s previous carrying amount The Standard requires a lessor to classify on either a straight‑line basis or another relating to the right‑of‑use it has retained a lease either as an operating lease or systematic basis. Another systematic basis (as a result, a gain or loss on disposal a finance lease. should be applied if that basis is more is recognised only to the extent that representative of the pattern in which rights of use have transferred to the A finance lease is a lease that transfers benefit from the use of the underlying buyer‑lessor); and substantially all the risks and rewards asset is diminished. incidental to ownership. The Standard •• the buyer‑lessor accounts for the includes examples of situations that Presentation purchase of the underlying asset under will lead a lease to be considered A lessor is required to present underlying applicable Standards (for example, IAS 16 a finance lease. assets subject to operating leases in its for a purchase of property, plant and statement of financial position according to equipment) and the lease under IFRS 16’s Finance leases the nature of the underlying asset. lessor accounting model. Recognition A lessor is required to recognise at the Disclosure If the sale proceeds do not reflect the fair commencement date assets held under Similarly to the requirements for lessees, value of the asset, or if the lease payments a finance lease in its Statement of financial the Standard includes a disclosure are not at a market rate, adjustments are position and present them as a receivable objective for lessors. The objective is to made to reflect a prepayment of lease at an amount equal to the net investment disclose information in the notes that, payments or additional financing provided in the lease. together with the information provided by the buyer‑lessor. in the statement of financial position, Measurement statement of profit or loss and statement If the criteria are not met: The net investment in the lease will be of cash flows, gives a basis for users of •• the seller‑lessee continues to recognise measured as the sum of both of the financial statements to assess the effect the underlying asset and recognises following: that leases have on the financial position, a financial liability in respect of the sales financial performance and cash flows of the proceeds received; and A. the lease receivable measured lessor. at the present value of the lease •• the buyer‑lessor recognises a financial payments; and Sale and leaseback transactions asset in respect of the payment made. B. the residual asset, measured at the The Standard includes guidance on sale present value of any residual value and leaseback transactions applicable to Both parties then account for the financial accruing to the lessor. both the seller‑lessee and buyer‑lessor. instrument in accordance with IFRS 9 The treatment of such transactions Financial Instruments (or, if that standard Subsequently, a lessor is required to depends on whether the transfer of has not yet been applied, IAS 39 Financial recognise finance income over the lease the asset in question meets the criteria Instruments: Recognition and Measurement). term, based on a pattern reflecting

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Effective date and transition A lessee can apply this Standard either Subject to EU endorsement, the Standard by a full retrospective approach or is applicable for annual reporting periods a modified retrospective approach. If the beginning on or after 1 January 2019. latter approach is selected, an entity is Earlier application is permitted for entities not required to restate the comparative that apply IFRS 15 Revenue from Contracts information and the cumulative effect of with Customers at or before the date of initially applying this Standard must be initial application of this Standard. presented as an adjustment to the opening The Standard provides specific transition balance of retained earnings requirements to: (or other component of equity as appropriate). •• the definition of a lease (permitting the conclusion reached under IAS 17 Implementing the new Lease Standard and IFRIC 4 Determining whether an The IASB set the effective date on 1 January Arrangement contains a Lease to be carried 2019 with the consideration of the time and forward in respect of contracts entered cost that will be involved in implementing into prior to the date of initial application the new Standard. This time allows entities of IFRS 16); to consider the effects of IFRS 16 for •• the measurement of right‑of‑use assets example in respect of: and lease liabilities (providing relief from •• changes needed to its systems and full retrospective calculation of these processes; for example to track leases balances); individually or at portfolio level and to •• sale and leaseback transactions before perform calculations; the date of the initial application •• judgements required particularly in (requiring accounting based on the respect of the definition of a lease and in conclusion on whether the transaction the assessment of the lease term; was a sale and operating leaseback or a sale and finance leaseback reached •• any potential tax impacts if the treatment under IAS 17); and of a lease for tax purposes is based on its treatment in financial statements; •• amounts previously recognised in relation to business combinations •• the impact of the Standard on (requiring any asset or liability in relation key metrics, debt covenants and to favourable or unfavourable terms of management compensation; and operating leases to be derecognised •• additional information that entities may and the carrying amount of the need to gather to make the required associated right‑of‑use asset adjusted by disclosures. a corresponding amount).

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