In this article, we bring to you IFRS 16 Leases from the lessee perspective. IFRS 16 was issued by the International Accounting Standards Board (“IASB”) in January 2016. IFRS 16 replaces the previous lease standard, IAS 17 Leases with significant changes made on the accounting treatment for lease transactions for lessees. The accounting requirements for lease transactions of the lessors are very much carried forward or retained from IAS 17.
Previously, lease arrangement was a preferred financing arrangement for lessees particularly as a mechanism to manage the gearing of the company. This is because an operating lease transaction was not reflected in the book of the company (despite some information were required to be disclosed in the financial statements). Operating lease was treated as an off-balance sheet item of the lessees. However, because the substance of an operating lease arrangement is no different from the traditional financing or loans, IFRS 16 is issued to require lessees to record operating lease arrangements on-balance sheet. This allows for a better comparison between the companies which use lease arrangement to finance their asset acquisitions to companies which acquire assets through the traditional financing.
Here, we have prepared for you 10 quick facts for leases from the lessee perspective based on the requirements of IFRS 16.
#1: What is a lease?
A lease is an arrangement whereby the lessor grants or conveys the right to control the use of an identified asset to the lessee for a period of time in exchange for consideration. At the inception of a contract, entities must determine whether the contract is or contains a lease arrangement based on this definition. Both lessee and lessor need to assess whether a contract is or contains a lease arrangement using this definition.
From the definition of lease above, significant judgement and/or estimates are required to be exercised in:
- Separating lease and non-lease components for a contract that contains a lease arrangement.
- Determining whether customers have the right to control the use of an asset – customers’ right to obtain substantially all of the economic benefits and to direct the use of the identified asset.
- Determining the identified asset subject to the lease arrangement, including the assessment of the substantive substitution rights in the lease arrangement.
- Determining the period of time under the lease arrangement – i.e., determining how long is the lease term.
#2: How does the lessee determine the lease term?
IFRS 16 emphasises that in determining the lease term, lessees must consider the non-cancellable period of the lease, together with the periods covered by an extension option and/or termination option. They are explained as follows:
- Extension option –lessee includes the periods covered by an option to extend the lease in the determining the lease term when the lessee is reasonably certain to exercise that option.
- Termination option – lessee includes the periods covered by an option to terminate the lease in determining the lease term when the lessee is reasonably certain not to exercise this option.
Entities must consider all relevant facts and circumstances surrounding the lease arrangement which may create the incentive for lessees to exercise the extension option or not to exercise the termination option. Take note that lease term also includes rent-free periods provided to the lessees. The lease term shall only be changed when there is a change in the non-cancellable period of the lease.
#3: What is the difference between a finance lease and an operating lease for a lessee under IFRS 16?
Under the previous IAS 17, lessees only record the leased asset and lease liabilities arising from the finance lease arrangement. Leased asset and lease liabilities from operating lease arrangement were not taken up or recorded in the book of the lessee.
However, under IFRS 16, differentiation between a finance lease and an operating lease is no longer exist. All lease transactions are included and recorded in the book of the lessees. This is the fundamental change in lease accounting for lessees under IFRS 16.
#4: How and when do lessees recognise their lease arrangement?
On the commencement of the lease, lessees will need to recognise a right-of-use asset (also known as ROU asset) and a lease liability in their book. The commencement of the lease starts when the lessee gains access to the right of using the underlying asset. This is the date when the lessor makes the underlying asset or leased asset available for use by the lessee.
#5: How do lessees measure the ROU assets?
IFRS 16 requires a lessee to measure the ROU assets at cost on initial recognition. IFRS 16 further states that the cost of the ROU asset takes into consideration the following:
- The amount of lease liability – being the present value of the lease payments that are not paid at that date;
- Any lease payments made at or before the commencement date (less any lease incentives received);
- Initial direct costs incurred by the lessee relating to the lease arrangement; and
- The estimated costs to be incurred by the lessee in dismantling and removing the underlying assets, restoring the site on which the underlying asset is located or restoring the underlying asset to the condition required by the terms and conditions of the lease.
Subsequent to its initial recognition and measurement, ROU assets that do not meet the definition of investment property are measured either at the cost model or the revaluation model. ROU assets that meet the definition of investment property are measured either at cost or fair value model.
For the cost model, ROU assets are depreciated and subject to impairment loss similar to other assets such as property, plant and equipment. Lessee applies the depreciation requirements in IAS 16 Property, Plant and Equipment and impairment requirements in IAS 36 Impairment of Assets to the ROU.
In addition to depreciation and impairment, the carrying amount of ROU assets may also be changed to reflect adjustments in relation to any re-measurement of lease liabilities.
#6: How do lessees measure the lease liabilities?
Lease liabilities are initially recognised and measured based on the lease payments that are not paid at the commencement date. This amount is discounted based on either the lease implicit interest rate or the lessee’s incremental borrowing rate. Only the following lease payments be included in the lease liabilities:
- Fixed payments, including in-substance fixed payments (less any lease incentives receivables);
- Variable lease payments that depend on an index or a rate;
- The amount expected to be payable by the lessee under residual value guarantees; and
- The exercise price of a purchase option if the lessee is reasonably certain to exercise the option.
Subsequent to the initial recognition and measurement, the carrying amount of lease liabilities changes to reflect the interest on the lease liability and lease payments, similar to other loans and borrowings carried at amortised costs. However, the carrying amount of lease liabilities may also be changed due to the re-assessment or lease modifications.
#7: What is the re-assessment of lease liabilities?
A re-assessment of lease liability happens when there is a change in:
- The lease term due to the change in the assessment of extension and termination option;
- The assessment of an option to purchase the underlying assets;
- The amount expected to be payable under a residual value guarantee; and
- The future lease payments arising from a change in an index or a rate used to determine lease payments previously.
Under scenarios 1 and 2, a lessee will need to re-assess the lease liabilities based on the revised lease payments using a revised discount rate. In contrast, for scenario 3 and 4, a lessee will need to re-assess the lease liabilities based on the revised lease payments using an unchanged (or original) discount rate.
The corresponding adjustments relating to the re-assessment of lease liabilities will be reflected in the carrying amount of the ROU assets.
#8: What is a lease modification?
IFRS 16 defines lease modification as a change in the scope of the lease or the consideration for a lease that was not part of the original terms and conditions of the lease arrangement. This can happen, for example:
- When adding or terminating the ROU one or more underlying assets;
- Changes to the lease payments; or
- Extending or shortening the contractual lease term.
Importantly, a lease modification happens when changes made are not part of the original terms and conditions agreed by the lessee and lessor. Nevertheless, the International Accounting Standards Board (“IASB”) made a limited-time exception for rent concessions arising from the Covid-19 pandemic. In such a situation, a lessee has an option not to assess whether the rent concession given by the lessor is a lease modification. We have covered this in Top 5 Accounting Considerations for FY 2020 Financial Reporting. IASB has also recently extended the limited-time exception for rent concession given until 30 June 2022. The new extension is available on the IASB’s website – Covid-19 Related Rent Concessions beyond 30 June 2021.
The accounting treatment for lease modification depends on whether the lease modification is treated as a separate lease or not, and this is explained below.
#9: How do we know whether the lease modification is a separate lease?
A lease modification is treated as a separate lease only if both the following are satisfied:
- The modification increases the scope of the lease by adding the ROU to one or more underlying assets; and
- The consideration for the lease increases by the amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that stand-alone price.
If the above are not met, the lease modification is treated as not a separate lease.
#10: What is the accounting impact for a separate lease and not a separate lease?
In a situation where the lease modification is not accounted for as a separate lease, lessees account for the lease modification adjustments as follows:
- Allocate the consideration of the modified lease contract between a lease and non-lease component;
- Determine the lease term of the modified lease;
- Re-measure the lease liability using the revised lease payments and revised discount rate.
The re-measurement of the lease liability is accounted for:
- decreasing the amount of the ROU asset to reflect the partial or full termination, and
- recognising gain or loss on partial or full termination in profit or loss.
This is applicable for a lease modification that decreases the scope of the lease.
- For other lease modifications – corresponding adjustments are reflected in the carrying amount of the ROU assets.
Where the lease modification is a separate lease meeting the conditions in question #9 above, lessees shall account for the lease modification similar to a new lease arrangement.
The 10 quick facts above summarise the principles included in IFRS 16 for the lessees. See you again in our next article in the factsheet series. In the meantime, you can read various other related articles published in the Financial Accounting section.