IFRS 16 Leases

Krina Shah

IFRS 16 Leases

IFRS 16 was issued in January 2016 and applies to annual reporting periods beginning on or after 1 January 2019. Under IFRS 16, there is no classification of operating leases and capital leases. There is only one umbrella for all leases – finance leases. Per the new rules, all leases must be accounted for on your balance sheet. Because your leases are no longer classified, you no longer need to use separate calculations – straight-lined vs. an outline of your interest and depreciation expense. Under IFRS 16, all leases will be calculated using your interest expense and depreciation expense. Instead all recognised leases are treated in a similar way to finance leases applying IAS 17.

Following are the criteria for identification of Lease

• The fact that a contract is labeled a lease does not necessarily mean it is or contains a lease.
• One of the key considerations is to evaluate whether the customer has the right to control the use of the identified asset. The control assessment is focused on decision-making rights.     
• Does the entity have the right to obtain substantially all the economic benefits from the use of the identified asset?
• Does the entity have the right to direct the use of the identified asset?

An identified asset is an asset that is either explicitly identified in the contract or is implicitly specified by being identified at the time that the asset is made available for use by the customer. Even if an asset is explicitly specified, a customer does not have the right to use an identified asset if the supplier has a substantive substitution right throughout the period of use.

Can a portion of an asset be an identified asset?

Yes, a portion of an asset is an identified asset if it is physically distinct (example: a single floor of an apartment building). Where a portion of an asset is not physically distinct (example: 20% of the capacity of an oil pipeline), the portion of the asset is not an identified asset unless it represents substantially all of the capacity of the asset. If neither of these situations exist, the customer is not provided with the right to obtain substantially all the economic benefits from use of the asset and an identified asset does not exist.

For better understanding of the identification of lease we shall use following example:

Example 1 – Rail cars

In a contract between a customer and a supplier, the supplier needs to transport goods using a particular type of rail car in line with a specified timetable over a three-year period. The timetable and quantity of goods stipulated are equivalent to the customer having the use of six rail cars for three years. The supplier makes available the cars, driver and engines as part of the arrangement. The supplier has a large supply of similar cars and engines that are available to fulfil the obligations of the arrangement. The rail cars and engines are kept at the supplier’s premises when they are not being used to transport the goods.

Analysis of the above example

The contract does not contain a lease of either rail cars or engines. The rail cars and engines used to transport the customer’s goods are not identified assets. The supplier has a substantive substitution right to replace the rail cars and engines as a result of:

1. supplier having the practical ability to substitute each car and engine throughout the period of use. Alternative cars and engines are readily available to the supplier and these can be substituted without the customer’s approval, and the supplier being able to economically benefit from substituting each car and engine. There would be very little cost associated

2. substituting these assets as the cars and engines are stored at the supplier’s premises and the supplier has a large pool of similar cars and engines. Therefore, the customer does not have the right to obtain substantially all of the economic benefits from the use of an identified rail car or an engine or directs their use. The supplier chooses which rail cars and engines are used for each delivery and therefore directs them. It has substantially all of the economic benefits from use of the rail cars and engines.

As per the above example the use of the understand whether the contract is a lease or not?

Now let’s understand what a lease term is, the lease term is defined as “the non-cancellable period for which a leasee has the right to use an underlying asset, together with both:

 

1. periods covered by an option to extent the lease if the lessee is reasonably certain to exercise that option; and

2. periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option”.

A lease is no longer enforceable when the lessee and the lessor each has the right to terminate the lease without permission from the other party with no more than an insignificant penalty.

 

IFRS 16 has an exemption for leases that meet the definition of a short-term lease. Short-term lease defined as leases that, at the commencement date, have a lease term of 12 months or less. A lease that contains a purchase option cannot be a short-term lease.

 

As we move forward, let’s understand what we really mean by Lease payments, following are the categories of lease payments:

1. They are Fixed payments, including in-substance fixed payments, less any lease incentives

2. Exercise price of a purchase option (if reasonably certain of exercise)

3. Payments for penalties for terminating the lease (unless reasonably certain not to exercise)

4. Variable lease payments that depend on an index or rate

5. Residual value guarantees (lessees: expected payment/lessors: all guarantees

 

*If the lessee is reasonably certain to exercise a purchase option, the exercise price is included as a lease payment.

Lease payments also includes residual value guarantees.

For Example: Lessee Z has entered into a lease contract with Lessor L to lease a car. The lease

term is five years. In addition, Z and L agree on a residual value guarantee – if the fair value of the car at the end of the lease term is below 400, then Z will pay to L an amount equal to the difference between 400 and the fair value of the car. At commencement of the lease, Z expects the fair value of the car at the end of the lease term to be 400. Z therefore includes an amount of zero in the lease payments when calculating its lease liability. Subsequently, Z monitors the expected fair value of the car at the end of the lease term. If the expected fair value of the car falls below 400, then Z will remeasure the lease liability to include the amount expected to be payable under the residual value guarantee, using an unchanged discount rate.

Incremental Borrowing Rate:

The incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow with a similar security over a similar term an amount equal to the lease payments in a similar economic environment. This definition implies that the incremental borrowing rate is not only a specific for the lessee, but also for the underlying asset and that’s the reason why you cannot use the same incremental borrowing rate for all of your leases.

Let me give a few illustrations:

1. Imagine you want to lease the valuable land in a high-level area – that’s really a great value  collateral and it affects your incremental borrowing rate. But, if you would like to lease a car, that’s not so valuable collateral as the land. In other words, the security is not the same and you would need to apply different incremental borrowing rate when leasing a car and when leasing a land.

2. Imagine you want to lease a land for 1 mil. CU and a car for 20 000 CU – not the same level of risk for the bank as not the same amount of funds necessary to borrow.

3. Imagine your car leases are for 3 years, but the office lease is for 10 years. I am quite sure that the  interest rate offered by the bank for 3-year loans would be different from the rate offered for 10 year loans.

4. Imagine you want to lease an office space in the capital city centre and a warehouse in a cheap area of your country. Again, not the same value, strength and environment.

 

So, how to determine the incremental borrowing rate

There are 2 basic steps:

1. Take some observable rate: Observable rates can be for example the rate on your past similar borrowings, or the actual offers from your bank for the loans with similar amount, security and term. Or, if you are renting the property, then the property yields could be a great start.

2. Make adjustments: Adjustment might be needed exactly because your observable rates might not precisely reflect the lease.

For example, when you take the rates for unsecured loans, then you need to adjust the rates for the collateral which is your underlying asset.

Or, maybe you took the rates offered to companies with low credit risk, but your credit profile is worse then you need to adjust.

Finally, let me point out the materiality.

It can happen that you have just a few leases and thus the impact of these adjustments to observable rates would not be material. In this case, just take the observable rates and don’t bother with adjustments – they would be costly, judgmental and immaterial. But, you need to make absolutely sure that you are below your materiality level.

lessee initial recognition and measurement

• Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as right-of-use assets or together with property, plant and equipment.

• At commencement of the lease, record a right of use asset and a lease liability.

• The lease liability is measured at the present value of the future lease payments (less incentives receivable).

• A lessee would also record a right of use asset at the amount of the lease liability, adjusted for:

o     any initial direct costs (incurred by the lessee in arranging the lease)

o     prepayments made by the lessee to the lessor

o     any lease incentives received from the lessor

o     and finally, if applicable, an estimate of costs to be incurred by the lessee to dismantle or remove or restore an asset (or the site on which the asset is located) at the end of the lease term

*IFRS 16 has two optional recognition exemptions – one for short term leases and one for leases of low value assets.

For Example: Year One – Beginning of Lease

Lessee enters into a 10-year lease of property with annual lease payments of $ 50,000 payable at the beginning of each year. The contract specifies that lease payments will increase every two years in line with the increase in the Consumer Price Index for the preceding 24 months. The Consumer Price Index (CPI) at the commencement date is 125.

The lessee has determined the appropriate rate to discount lease payments is 5%. At the commencement date, the lessee makes the lease payment for the first year and measures the lease liability at the present value of the remaining nine payments of $ 50,000, discounted at the interest rate of 5% per annum, which is $ 355,391.

Lessee initially recognises assets and liabilities in relation to the lease as follows:

Dr Right-of-use asset $ 405,391

Cr Lease liability $ 355,391

Cr Cash $ 50,000 (lease payment for the first year)

In measuring the lease liability, the lessee does not make any estimate of how future changes in CPI will impact future lease payments. Rather it assumes the initial lease payment will remain constant during the lease term.

Disclosure:

The standard notes that more information may be necessary on:

1. the nature of the lessee’s leasing activities;

        b. future cash outflows to which the lessee is potentially exposed that are not reflected in the

            measurement of lease liabilities

        c. restrictions or covenants imposed by leases;

        d. sale and leaseback transactions.