IFRS 16 Leases
IFRS 16 Leases replaces IAS 17 Leases, the earlier lease accounting standard. IFRS 16 is effective for annual period beginning on or after 1 January 2019.
IAS 17 required both lessees and lessors to classify leases into finance leases and operating leases depending on whether there is transfer of risks and rewards and recognize liabilities only in case of finance leases. Many companies used operating leases as a means of off-balance-sheet-financing. Analysts would adjust financial statements by capitalizing operating leases to better reflect a company's leverage. The new standard is aimed at providing a fuller picture of a company's lease liabilities. IFRS 16 does this by eliminating the lease classifications for lessees but retains it for lessors. A lessee is required to recognize right of use (ROU) assets and associated lease liabilities in the statement of financial position for most leases.
IFRS 16 applies to all leases except leases of natural resources, biological assets, service concession arrangements, and intangible assets. However, there is an exemption available for:
- Short-term leases, leases with a lease term of 12 months or less, and
- Leases in which the underlying assets are of low value when new.
Identifying a lease, its components and term
A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time. A contract conveys the right to control the use of an asset if:
- The customer can obtain substantially all the economic benefits, and
- It has the right to direct the use of the asset.
A customer has no right to control an identified asset when the lessor has substantive substitution rights, i.e. through out the contact period, it can practically substitute the asset, and this would economically benefit him.
When a contract has one or more lease component(s) and a non-lease component, the total consideration must be allocated based on the stand-alone selling prices.
A lessee (but not a lessor) can elect not to separate any non-lease components from the lease components.
A entity determines the lease term as the non-cancelable period of a lease, together with:
- Periods covered by an option to extend the lease (the extension option) if the lessee is reasonably certain to exercise it, and
- Periods covered by an option to terminate the lease (the termination option) if the lessee is reasonably certain not to exercise it.
Lease term is discussed in detail here.
At the commencement date (the date the lessor makes the underlying asset available for use) a lessee shall recognize a right of use asset and a lease liability.
Initial measurement by a lessee
The right of use asset shall be recognized at cost which shall comprise of:
- Lease liability,
- Lease payments made before the commencement date,
- Initial direct costs, and
- Estimated cost of dismantling.
The lease liability shall be initially measured at the present value of the future lease payments determined at the rate of interest implicit in the lease if such a rate is readily available, or the lessee’s incremental borrowing rate.
Lease payments shall include:
- Fixed payments (including in-substance fixed payments),
- Variable payments that depend on some index or rate,
- Payment for residual value guarantee, and
- Payment for purchase option or penalty of termination if the lessee is reasonably certain to exercise those options.
Subsequent measurement of right of use asset
Subsequently, a lessee shall account for the right of use asset using the cost model (of IAS 16 Property, Plant and Equipment), or the fair value model (if it is an investment property). However, a lessee can elect to apply the revaluation model to a class of right of use assets if it applies revaluation model to owned assets of similar nature.
If the ownership of the underlying asset transfers to the lessee or the purchase option is expected to be exercised, the lessee depreciates the asset based on its useful life, otherwise it is depreciated based on the shorter of the lease term or the useful life.
Subsequent measurement of lease liability
Subsequent to initial recognition, the carrying amount of the lease liability is:
- Increased by amount of interest expense recognized (at a constant periodic interest rate) and
- Decreased by lease payments made.
The interest expense and variable lease payment not included in lease liability are recognized in profit or loss unless they are eligible for capitalization under some other accounting standard.
Remeasurement of lease liability
When there is a change in future variable payments linked to some index/rate or change in expected payments on account of residual value guarantee, the lessee remeasures the lease liability by discounting the revised lease payments at an unchanged discount rate unless the change in cash flows results from change in the floating interest rate.
When there is a change in lease term or a change in an assessment of whether termination or extension options are exercised, a lessee remeasures lease liability using a revised discount rate.
Any changes arising from reassessment of lease liability are recognized in right of use asset or profit or loss if the carrying amount of the right of use asset is zero.
Presentation and disclosure
A lessee is required to present the right of use assets and associated liabilities either in the statement of financial position (SFP) or the notes. Any right of use assets which are part of investment property must be reported in the SFP. In the statement of cash flows, payments related to principal portion of lease liability are classified under financing activities and those related to interest are classified either under operating or financing activities.
A lessee discloses information about depreciation expense of right of use assets, expense on short-term leases, expenses on leases of low value assets, interest expense recognized on lease liabilities, lease cash flows, additions to right to use assets, etc. Additionally, a lessee provides information about the nature of its leasing activities, a maturity analysis of its lease liabilities, etc.
A lessor classifies its leases into operating leases and finance leases (which is changed only when there is a modification). A finance lease is one which transfers substantially all risks and rewards incidental to ownership of the underlying assets. An operating lease is a lease which is not a finance lease.
A lease is typically classified as a finance lease if any one or more of the following conditions are met:
- The lease transfers the ownership of the asset to the lessee at the end of the lease term;
- The lessee has an option to purchase the asset at a price significantly lower than its fair value;
- The lease is for a major part of the economic life of the underlying asset;
- At the lease inception, the present value of future lease payments substantially equals the fair value of the underlying asset;
- The underlying asset is so specialized in nature that only the lessee can use it.
Initial recognition of a finance lease
At the inception of a lease, the lessor recognizes assets under finance lease in its statement of financial position as a receivable at an amount equals to the net investment in lease. Net investment in lease equals the present value of the gross investment in lease (which is the sum of lease payments and any unguaranteed residual value) discounted at the rate of interest implicit in the lease.
Lease payments include fixed payments (including in-substance fixed payments), variable payments linked to an index or rate, and amount expected to be payable under residual value guarantee, extension option, and termination.
Manufacturer and dealer lessors recognize (a) revenue on their finance leases at the lower of the fair value of the underlying asset or the present value of lease payments, (b) cost of sale at its cost or carrying amount minus present value of unguaranteed residual value, and (c) selling profit or loss.
Subsequent measurement of finance lease
Subsequently, a lessor recognizes finance income on its net investment in lease at a constant periodic interest rate and applies any lease payments against the gross investment in lease to reduce both principal and unearned finance income.
A lessor recognizes lease payments on an operating lease on the straight-line or some other systematic basis.
A lessor depreciates the carrying amount of the underlying asset (plus the initial direct costs) in accordance with the requirements of IAS 16 Property, Plant and Equipment.
Presentation and disclosure
A lessor presents the underlying assets subject to operating lease in its statement of financial position and provides an overview of its leasing activities in the notes.
For finance leases, a lessor discloses selling profit or loss (if any), finance income earned on net investment in lease, and income arising from variable lease payments not included in measurement of net investment in lease. It provides information about significant changes in its net investment in lease and how he manages any associated risks. The lessor also discloses a maturity analysis of the lease payments (i.e. annually for five years and the sum for the remaining years) and reconciling these with its net investment in lease.
For operating leases, a lessor discloses lease income and income from variable lease payments.
Lease modification refers to a change in the scope of or the consideration for a lease, that was not part of the original terms and conditions of the lease.
Lease modifications from the perspective of a lessee
When a lease modification changes the scope of the lease by adding right to use one or more additional assets and the lease consideration changes by an amount commensurate with the standalone price of the additional asset, the modification is treated as a new lease, otherwise it is accounted for by remeasuring the lease liability at a revised discount rate.
For lease modification not recognized as a separate lease, the remeasurement of lease liability results in an adjustment to the right of use asset and any gain or loss is recognized in profit or loss.
Lease modifications from the perspective of a lessor
A modification in a finance lease is treated as a new lease if there is a change in the scope of the lease and a commensurate change in the consideration. If modification is not accounted for a separate lease and the modified lease would classify as an operating lease had the modification occurred at the inception date, the lease is treated as a new [operating] lease and the carrying amount of the asset equals the net investment in lease just before the effective date of the modification, otherwise it is accounted for under IFRS 9.
A modification in an operating lease is treated as a new lease from the effective date of the modification.
Sale and leaseback transactions
When a party sells an asset to another and leases it back, IFRS 15 is applied to the transaction to see whether a sale has occurred.
Transaction is a sale
If the transaction is a sale, the lessee shall recognize the right of use asset at the proportionate carrying amount of the asset sold and recognize profit or loss only to the extent of the portion of underlying asset not leased back to it. The lessor applies lessor accounting to the lease back.
If the fair value of the consideration transferred to the lessee does not equal the fair value of the asset, any below-market terms shall be treated as a lease prepayment, and any above-market terms shall be treated as additional financing provided by the buyer/lessor to the seller/lessee.
Transaction is not a sale
If the transaction is not a sale, both the lessee and the lessor shall not derecognize the transferred assets. Instead, a lessee would recognize a financial liability for the transfer proceeds and the lessor shall recognize a financial asset.