New leases standard requires virtually all leases to be capitalised on the balance sheet
On 13 January 2016, the International Accounting Standards Board (IASB) issued IFRS 16 Leases, which essentially does away with operating leases and, subject to limited exceptions, requires all leases to be capitalised on the balance sheet.
Given the sensitivity of the topic, this project was probably one of the longest in IASB history, with a Discussion Paper issued in 2009, two Exposure Drafts (2010 and 2013), and many roundtables and outreach with interested parties.
“One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.”
Sir David Tweedie, former Chair of IASB (speech to the Empire Club in Toronto, April 2008)
IFRS 16 includes a single accounting model for all leases by lessees.
The main implications of the new standard on current practice for lessees include:
- No more operating leases under IFRS 16 (subject to the exceptions described below)
- All leases (subject to the exceptions described below) will be capitalised on the balance sheet by recognising a ‘right-of-use’ asset and a lease liability for the present value of the obligation
- No rental expense! i.e. no more straight-line expenses for operating lease costs. All leases will incur a front-end loaded expense, comprising depreciation on the right-of-use asset, and interest on the lease liability
- When initially measuring the right-of-use asset and lease liability, non-cancellable lease payments (including inflation-linked payments), as well as payments for option periods which the entity is reasonably certain to exercise, must be included in the present value calculation.
Lessees of retail premises paying contingent (turnover) rentals, and others required to make significant contingent rental payments, will be relieved to know that these will not be capitalised into the right-of-use asset, but will continue to be expensed in profit or loss.
Industries and assets most impacted
IFRS 16 will result in higher debt levels and interest costs (particularly in the earlier years of a lease) for any entities operating in industries that currently have many operating leases of high value that are material to their balance sheets. For example:
- Retailers – their shops or mall space, particularly where leases include multiple renewal options (e.g. anchor tenants in a shopping mall)
- Mines and mining services companies, where there is a significant amount of expensive equipment held on operating leases
- Airlines – millions, and in some cases, billions of dollars will be required to be capitalised on balance sheet for aircraft
- Cruise ship operators – as for airlines above
- Businesses with large fleets of motor vehicles, including cars and trucks.
Lessees can choose not to apply the IFRS 16 requirements to the following types of leases:
- Short-term leases – leases for a period of 12 months or less from commencement date, including any extension options
- ‘Small ticket’ or low value items – items which, when new, have a low value, e.g. laptops, tablets, computers, small items of furniture and equipment.
This low value item is applied to an item, not to a group of items, and applies to the ‘as new’ value, not a second hand value, meaning that vehicles are unlikely to meet the requirements for a small ticket item.
“At the time of reaching decisions about the exemption in 2015, the IASB had in mind leases of underlying assets with a value, when new, in the order of magnitude of US$5,000 or less.”
Basis for Conclusions to IFRS 16, BC100
Lease payments for these assets will be recognised on a straight line basis over the lease term, or another systematic basis if more representative of the pattern of the lessee’s benefits.
Leases excluded from the scope of IFRS 16
The following types of leases (and subleases) are scoped out of the new IFRS 16 requirements:
- Exploration leases for minerals, oil, natural gas and similar non-regenerative resources (IFRS 6 Exploration for and the Evaluation of Mineral Resources)
- Biological assets (IAS 41 Agriculture)
- Service concession arrangements (IFRIC 12 Service Concession Arrangements)
- Licences of intellectual property of a lessor (IFRS 15 Revenue from Contracts with Customers)
- Rights held by a lessee under a licensing agreement (IAS 38 Intangible Assets).
No change to current practice - lessors
There have been no changes in the requirements for accounting by lessors required by IAS 17 Leases. This means that the distinction between operating and finance lease assets will remain.
Identifying a lease
Definition of a ‘lease’
‘…A contract, or a part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration…’
At inception of a lease, we need to assess whether a contract is, or contains, a lease.
Lessees will account for lease components under IFRS 16, and non-lease components by applying other relevant accounting standards (unless the practical expedient not to separate is applied).
Lessees will only reconsider the lease assessment if the terms and conditions of the contract are changed.
Per the definition of ‘lease above’, a contract is, or contains, a lease if it:
- Conveys the right to control the use
- Of an identified asset
- For a period of time.
Conveys right to control use
A contract only conveys the right for you to use an asset if you have the right to both:
- Obtain substantially all of the economic benefits of the identified asset, and
- Direct the use of the identified asset.
An identified asset is a specific item that, either implicitly or explicitly, is made available for use under the lease contract.
To circumvent the requirements of having to use an ‘identified asset’, lessees and lessors may be tempted to draft lease contracts so that the lessee does not have rights to use a specific asset throughout the lease period.
Note that this is only possible where the supplier has a substantive right to substitute the asset, i.e. the supplier:
- Has the practical ability to substitute alternate assets throughout the lease period, and
- Would benefit economically from substituting the asset.
In practice, suppliers could only have a substantive right to substitute assets that can be readily substituted such as movable items (e.g. motor vehicles or photocopiers). However it would still need to be demonstrated at inception that the supplier would benefit economically from substituting the asset, and in making this assessment, lessees would not be able to consider possible future contracts at above market rates, new technology that is yet to be developed, or the fact that the asset might be sold in future at a price higher than at inception.
Note that this assessment about substitution rights must be made by the lessee (not the lessor), who may have limited knowledge of the supplier’s operations.
We do not expect suppliers to have a substantive substitution right for specialised equipment installed at a customer’s premises because of the prohibitive costs of removing and replacing the asset.
Period of time
You can see from the above definition that as lessee, you must also have the right to use an identified asset for a set period of time. If you only have the right to use an asset for part of the contract term, the contract contains a lease only for that part of the lease term.
The lease term includes both of the following periods:
- Non-cancellable period of the lease, plus
- Options to extend and cancel the lease if the lessee is reasonably certain to exercise these options.
When considering whether it is reasonably certain for the lessee to exercise options, we need to consider all facts and circumstances that create an economic incentive for them to exercise.
This could have a massive impact for retailers currently expensing operating lease payments.
Example 1: Lease term
A lessee of premises containing a purpose built factory with an initial lease term of five years with six additional five year options to extend the lease could be argued to have an economic incentive to renew the lease because of the significant leasehold improvements undertaken, and the prohibitive cost of establishing equivalent premises in another location if the option to extend the lease is not exercised.
Reassessing lease term
The lease term would change if the non-cancellable period of the lease changes, for example when an option is exercised to extend the lease term, and this option was not previously included as part of the lease term.
The lessee also needs to reassess the lease term if there is a significant change, within the lessee’s control, that affects whether it is reasonably certain that the lessee will exercise options not previously included in the lease term, e.g. significant leasehold improvements made that would have benefit beyond the initial lease term, or subleases of the underlying asset beyond the initial lease term.
Initial recognition and measurement
When first entering into a lease (commencement date), as lessee, you will measure a right-of-use asset and a lease liability.
The right-of-use asset is measured at cost and includes:
- The initial measurement of the lease liability (present value of lease payments over the lease term, discounted using the interest rate implicit in the lease if it can be readily determined, otherwise at the lessee’s incremental borrowing rate)
- Lease payments made at or before commencement date, less any lease incentives received
- Initial direct costs of the lessee
- An estimate of dismantling /removal/restoration costs (these are only included in the cost of the right-of-use asset when it incurs an obligation for those costs).
The lease payments included in the initial measurement of the leased asset and lease liability include:
- Fixed payments, less any lease incentives receivable
- Variable lease payments that depend on an index or rate, initially measured using the index or rate at commencement date
- Amounts expected to be paid under residual value guarantees
- Exercise price of purchase options if reasonably certain to exercise
- Penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate early.
What about contingent lease payments?
Because of the difficulty modelling projected contingent lease payments, these are not included as ‘lease payments’ when determining the lease liability. Instead these payments are recognised in profit or loss in the period in which the event or condition triggers the payment.
Entity A leases a shop in Northfield shopping mall on 1 July 2015 for three years. Annual rental is stated at $500 per m2 plus turnover rental comprising five per cent of all sales revenue.
5% turnover rental
30 June 2016
30 June 2017
30 June 2018
In this example, Entity A does not include the $225,000 estimated contingent rentals in the initial calculation of the lease liability. Instead, they are expensed in profit or loss when they are due.
Example 3: Variable payments – rate increase
Entity B leases a shop in Northfield shopping mall on 1 July 2015 for three years.
Starting annual rental is $100,000 p.a. to increase each year by five percent.
This means that Entity B will use the following lease payments in its present value calculation:
| Year ended
30 June 2016
30 June 2017
30 June 2018
1: $100,000 X 1.05
2: $105,000 X 1.05
In this case, because the fixed rate increases are known at inception, the present value calculation of the lease liability (and right-of-use asset) will not change during the period of the lease.
After initial recognition, the lessee generally measures right-of-use assets classified as property, plant and equipment (PPE) or investment property using the depreciated cost model or the revaluation model.
If the right-of-use asset belongs to a class of PPE that is revalued under IAS 16 Property, Plant and Equipment, then the fair value model must be applied.
If right-of-use assets meet the definition of ‘investment property’ under IAS 40 Investment Property, and the lessee applies the fair value model to other investment property it holds, then the fair value model must be applied.
Right-of-use assets must be disclosed separately in the balance sheet or notes from other assets, and lease liabilities must be disclosed separately from other liabilities. However, right-of-use assets that meet the definition of ‘investment property’ must be disclosed as part of investment property.
The following expenses must be presented separately:
- Interest (component of finance costs)
Cash flow statement
Lessees must present lease payments as follows:
- Financing activities – payments of principal
- Operating activities – payment for short term leases and low value items expensed in profit or loss.
Interest payments should be classified as operating, financing or investing activities in accordance with IAS 7 Statement of Cash Flows, paragraph 33.
IFRS 16 also includes extensive new disclosure requirements.
What to do now?
We expect that IFRS 16 will result in many entities experiencing:
- Higher EBITDA (earnings before interest, depreciation, amortisation and tax) due to ‘operating’ lease costs being allocated to depreciation and interest, rather than to an ‘above the line’ expense
- Lower net profit in the early years of a lease due to front-end loaded expenses for interest
- Higher debt levels.
This means that triggers for bank covenants and bonus arrangements will need to be reworked to compensate for these accounting standard changes.
Extensive system changes will also be needed for assets previously recorded as operating leases:
- Creating asset registers to record ‘right-of-use’ assets and calculate amortisation charges
- Determining interest amortisation on lease liabilities.
IFRS 16 is operative for annual periods beginning on or after 1 January 2019 and can be adopted early if IFRS 15 Revenue from Contracts with Customers is adopted for the same accounting period. Note that early adoption is only permitted in Australia when the equivalent Australian standard, AASB 16 Leases, is approved by the Australian Accounting Standards Board.
Given the extent of system changes required, as well as potential impacts on bank covenants and bonus arrangements described above, we do not anticipate that there will be significant uptake on early adoption options.
Transition - Lessees
IFRS 16 must be applied from the ‘date of initial application’, which is the beginning of the annual reporting period in which an entity first applies this standard. If IFRS 16 is applied for the first time to the year ended 31 December 2019, the ‘date of initial application’ is 1 January 2019.
If you have identified contracts as leases under IAS 17 and IFRIC 4 Determining whether an Arrangement contains a Lease, on transition you can apply a practical expedient and account for these as leases under IFRS 16 (i.e. you do not need to reassess whether you have a lease at the date of initial application).
Also, if you have concluded that you do not have a lease under IAS 17 and IFRIC 4, you can also choose to apply the practical expedient and not apply IFRS 16 to those contracts.
Generally, the new requirements must be applied retrospectively, by either:
- Restating comparatives in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (full retrospective method), or
- Not restating comparatives, but rather showing the cumulative effect of initially applying the standard at the ‘date of initial application’ as an adjustment to opening retained earnings (modified retrospective method). For example, if IFRS 16 is initially applied for the year ended 31 December 2016, an adjustment is made to opening retained earnings on 1 January 2016 (date of initial application) for the retrospective effect of applying the new standard.
This election must be applied consistently to all leases.
Where the modified retrospective method is used, there are several additional practical expedients that can be applied.
Assets or liabilities recognised as part of a business combination for favourable/unfavourable operating leases must be derecognised and the carrying amount recognised as a right-of-use asset.
Transition – Lessors
Lessors are not required to make any adjustments on transition unless it is an intermediate lessor, in which case certain adjustments will need to be made as outlined in Appendix C, C15.
IFRS 16 will supersede the following pronouncements:
- IAS 17 Leases
- IFRIC 4 Determining whether an Arrangement contains a Lease
- SIC 15 Operating Leases – Incentives
- SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.
For more information, refer to IFRS at a Glance on IFRS 16.