Focus on IFRS 16 Leases – Best read

Focus on IFRS 16 Leases

 

(Source https://www.bdo.global/en-gb/services/audit-assurance/ifrs/ifrs-at-a-glance)

Focus on IFRS 16 Leases or in slightly more detail…..

Definition of a lease

A contract can be (or contain) a lease only if the underlying asset is ‘identified’. Having the right to control the use of an identified asset means having the right to direct, and obtain all of the economic benefits from, the use of that asset. These rights must be in place for a period of time, which may also
be determined by a specified amount of use.

Put simply, if the customer controls the use of an identified asset for a period of time, then the contract contains a lease. This will be the case if the customer can make the important decisions about the use of the asset in a similar way it makes decisions about the use of assets it owns outright.

In such cases, the customer (ie the lessee) is required to recognise these rights on its balance sheet as a ‘right-of-use’ asset. In contrast, in a service contract, the supplier controls the use of any assets used to deliver the service and so there is no right-of-use asset to recognise.

Applying the new definition involves three key evaluations, all of which must be met in order to conclude that a contract is or contains a lease. These evaluations are summarised in the following flowchart:

 

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.

What is a substantive substitution right?

A substantive substitution right exists if the supplier has the practical ability to substitute alternative assets throughout the period of use and the economic benefits of substituting the asset would exceed the cost (or in other words, the supplier would benefit economically from substituting the asset).

When the asset is located at the customer’s premises, the costs associated with substituting the asset are likely to be higher, making it less likely that the supplier would economically benefit from making a substitution.

The assessment of whether a supplier’s substitution right is substantive is based on facts and circumstances present at inception of the contract. This means that the customer ignores events that are not likely to occur in future such as:

• an agreement by a future customer to pay an above-market rate for use of the asset
• the introduction of new technology that is not substantially developed at inception of the contract
• a substantial difference between the performance or customer’s use of an asset, and the use or performance considered likely at inception of the contract, and
• a substantial difference between the actual market price of the asset during the period of use, and the market price
  considered likely at inception of the contract.

If the supplier has the right or obligation to substitute the asset for repair purposes or to provide routine maintenance services (eg, to allow it to install a technical upgrade that has become available), a customer is not precluded from having the right to use an identified asset.

A customer is also not required to perform an exhaustive search to determine if a supplier has a substantive substitution right. If a customer cannot readily determine whether a supplier has such a right, it may conclude that a right does not exist.

Lease term

Under IFRS 16 ‘Leases’, determining the correct ‘lease term’ is significant for a number of reasons. Firstly, the longer the lease term, the larger the lessee’s right-of-use asset and lease liability will be.

Secondly, the length of the lease term determines whether a lease qualifies for the short-term lease exemption. Finally, IFRS 16 contains additional application guidance on how to deal with periods covered by options to extend or terminate a lease. While this detailed guidance can be helpful, it also means there is more to consider when determining the lease term.

Ascertaining the correct lease term is one of the most challenging issues in applying IFRS 16 as it is likely to require a significant level of judgement.

‘Lease term’ is defined as the non-cancellable period for which a lessee has the right to use an underlying asset (including any periods covered by a lessor’s termination option), plus:

• periods covered by a lessee’s extension option if extension is reasonably certain; and
• periods covered by a lessee’s termination option if the lessee is reasonably certain not to terminate.

While the concept of ‘reasonably certain’ has not changed from IAS 17, the application of this concept in practice requires consideration of all the facts and circumstances that create a significant economic incentive for a lessee to extend the lease (where a lessee has an extension option) or not to terminate a lease (where the lessee has a termination option). This is ultimately a judgement considering factors specific to the asset, the entity and the wider market.

Example 1 – Extension option requiring approval by both lessee and lessor

ABC Ltd enters into a contract to lease a floor of a building for five years, with an option to extend for a further three-year period. Both ABC and the lessor must agree to extend the lease for a further three years. ABC is absolutely certain it will want to extend the lease.

Analysis

The non-cancellable portion is the five-year period, but is ABC’s right to extend the lease enforceable? No, because the lessor has the ability to refuse to extend. It is important that when assessing the lease term, an entity determines the period for which the contract is enforceable.

A lease is not enforceable when both the lessee and the lessor can exercise their right to terminate the lease without permission from the other party with no more than an insignificant penalty. In this case, ABC cannot force the lessor to lease to them for a further three-year period. Accordingly, the lease term is five years.

Initial assessment of the lease term

Entities are required to assess a lease’s term at the lease ‘commencement date’ which is the date on which a lessor makes an underlying asset available for use by a lessee.

It is important to contrast the lease commencement date with the lease ‘inception date’, which is the earlier of the date of a lease
agreement and the date of commitment by both parties to the terms and conditions of the lease. A lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.

When assessing whether a lessee is reasonably certain to exercise an option to extend the lease or not exercise an option to terminate the lease, the lessee considers all relevant facts and circumstances (both monetary and non-monetary) that create an economic incentive for them to exercise or not exercise that option.

It should include any expected changes in facts and circumstances from the commencement date until the exercise date of the option.

 

Worked example IFRS 16

As a simple example, a company taking out a 20 year lease at an annual rental of £1 million, with no break clauses, and an illustrative incremental borrowing rate of 6% will recognise a right to use asset (ignoring related costs) and a matching financial liability of £11.5 million, being the discounted value (at 6% pa) of future lease payments.

In the first year of the lease the company will recognise in its income statement expenses of:

• £573,000 for depreciation of the asset (on a straight line basis over 20 years)
• £688,000 of interest cost on the liability at 6%

It can be seen that this will result in a year one income statement cost of £1.26 million, an increase compared to the rental cost of only £1 million which would be recognised on a simple operating lease under current standards.

At the end of year one, there will also be a mismatch between the value of the lease asset and the associated liability, with the liability being higher and thus impacting on overall net assets.

The asset will be reduced from £11.5m to £10.9m (£11.5m less c.£0.6m depreciation), whilst the liability will decrease from £11.5m to £11.1m (£11.5m less c.£0.3m “loan repayment” (being the £1m real rent payment less c.£0.7m interest)).

Over the life of the lease, income statement expenses will generally be higher than under the current standards towards the start of the lease period, and lower towards the end, as shown in the graph below, based on the simple example above: