IFRS 16 Leases
IFRS 16 Leases requires lessees to put most leases on their balance sheets. Lessees will apply a single accounting model for all leases, with certain exemptions. For lessors, the accounting is substantially unchanged from today’s accounting under IAS 17 Leases.
Under IFRS 16, leases are accounted for based on a ‘right-of-use model’. The model reflects that, at the commencement date, a lessee has a financial obligation to make lease payments to the lessor for its right to use the underlying asset during the lease term. The lessor conveys that right to use the underlying asset at lease commencement, which is the time when it makes the underlying asset available for use by the lessee.
Entities will need to focus on whether an arrangement contains a lease or a service agreement because there are significant differences in the accounting. Although IFRS 16 changes how the definition of a lease is applied, the assessment of whether a contract contains a lease will be straightforward in most arrangements. However, judgement may be required in applying the definition of a lease to certain arrangements, particularly those that include significant services.
For lessees, the income statement presentation and expense recognition pattern is similar to finance leases under IAS 17 (i.e., separate interest and depreciation expense with higher periodic expense in the earlier periods of a lease).
Lessor accounting is substantially unchanged from current accounting. Lessors will classify all leases using the same classification principle as in IAS 17 and distinguish between operating and finance leases.
| When to use IFRS 16 Leases Lessee may use the practical exemptions | |
| Apply the lease accounting models | |
| Lessees Initial measurement lease liability Initial measurement right-of-use asset Subsequent measurement lease liability | Lessors |
| Special topics | |
Improved EBITDA
Changing from IAS 17 to IFRS 16 has one unexpected side-effect, EBITDA, a common key performance indicator used in directors’ reports improved, as shows this illustration.
1. Identify the lease / Lease definition
As all leases (except for the limited exceptions) will be recorded ‘on balance sheet’, a key consideration is whether a contract meets the definition of a lease in IFRS 16:
The definition:
‘A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.’
a period of time may also be described in terms of an amount of use of an asset (e.g. number of production units that a piece of machinery will produce).
An entity only reassesses whether a contract is, or contains, a lease subsequent to initial recognition if the terms and conditions of the contract are changed.
The key elements of the definition are therefore as follows.
However, a lessee is not required to apply the lessee accounting model to leases that qualify for certain practical expedients (see recognition exemptions for lessees).
1.1 Identified asset
A contract contains a lease only if it relates to an identified asset. [IFRS 16.B13–B20]
Q&A to get to the identified asset:
- Is the asset specified in the contract (explicitly or implicitly)? Yes, go to 2, No go to 4
- Is the asset physically distinct or does the customer have the right to receive substantially all of the capacity of that asset? Yes, go to 3, No go to 4
- Does the supplier have substantive substitution rights? Yes, go to 4, No go to 5
- Contract does not contain a lease. Apply the relevant (other) IFRS standard.
- There is an identified asset
Specified asset
An asset can be either explicitly specified in a contract (e.g. by a serial number or a specified floor of a building) or implicitly specified at the time it is made available for use by the customer. [IFRS 16.B13, IFRS 16.BC111]
| What does ‘implicitly specified’ mean? |
| An asset is implicitly specified if the facts and circumstances indicate that the supplier can fulfil its obligations only by using a specific asset. This may be the case if the supplier has only one asset that can fulfil the contract. For example, a power plant may be an implicitly specified asset in a power purchase contract if the customer’s facility is in a remote location with no access to the grid, such that the supplier cannot buy the required energy in the market or generate it from an alternative power plant. In other cases, an asset may be implicitly specified if the supplier owns a number of assets with the required functionality, but only one of those assets can realistically be supplied to the customer within the contracted time frame – i.e. the supplier does not have a substantive right to substitute an alternative asset to fulfil the contract – see Substantive supplier substitution rights below. For example, a supplier may own a fleet of vessels but only one vessel that is in the required geographic area and not already being used by other customers. |
Capacity portions
A capacity portion of an asset can be an identified asset if: [IFRS 16.B20]
- it is physically distinct (e.g. a floor of a building, a specified strand of a fibre-optic cable or a distinct segment of a pipeline); or
- it is not physically distinct, but the customer has the right to receive substantially all of the capacity of the asset (e.g. a capacity portion of a fibre-optic cable that is not physically distinct but represents substantially all of the capacity of the cable).
| Does ‘substantially all’ of the capacity of an asset mean 90 percent? |
| Not necessarily. IFRS 16 does not define what is meant by ‘substantially all’ in the context of the definition of a lease. IFRS 16 uses the same phrase in one of the criteria used by the lessor to determine lease classification: whether the present value of the lease payments (including the residual value guaranteed by the lessee or a third party) equals or exceeds substantially all of the fair value of the asset. US GAAP allows but does not require the use of a threshold of 90 percent for ‘substantially all’ when a lessor is determining classification. The common opinion is that, although the 90 percent threshold may provide a useful reference point, it does not represent a bright-line or automatic cut-off point under IFRS Standards. For the purpose of applying the lease definition, a company should develop an interpretation of ‘substantially all’ and apply it on a consistent basis. |
Substantive supplier substitution rights
Even if an asset is specified in a contract, a customer does not control the use of an identified asset if the supplier has a substantive right to substitute the asset for an alternative asset. Such a right exists if the supplier: [IFRS 16.B14]
- has the practical ability to substitute the asset throughout the period of use; and
- would benefit economically from exercising its right to substitute the asset.
A supplier’s right or obligation to substitute the asset for repairs and maintenance, because the asset is not working properly – i.e. a ‘warranty-type’ obligation – or because a technical upgrade becomes available, is not a substantive substitution right. [IFRS 16.B18]
A supplier has the practical ability to substitute alternative assets when the customer cannot prevent it from substituting the asset and the supplier has alternative assets either readily available or available within a reasonable period of time. [IFRS 16.B14(a)]
However, there is no practical ability to substitute the asset throughout the period of use (and therefore there is no substantive substitution right) if the substitution right applies, for example, only:
- – to a part of the period of use or at or after a specific date; or
- – on the occurrence of a particular event. [IFRS 16.B15]
The ‘period of use’ is a IFRS 16 Definition and is the total period of time that an asset is used to fulfil a contract with a customer (including any non-consecutive periods of time).
A supplier would benefit economically from the exercise of its right to substitute the asset when the economic benefits associated with substituting the asset are expected to exceed the related costs. [IFRS 16.B14(b)]
The costs associated with substitution are generally higher if the asset is not located at the supplier’s premises – i.e. when it is at the customer’s premises or elsewhere. In this situation, the costs are more likely to exceed the benefits associated with substituting the asset. [IFRS 16.B17]
| How do you evaluate whether the supplier would benefit economically from exercising its substitution rights and what should a customer do if it cannot assess whether a substitution right is substantive? |
| Judgement will be required to evaluate when the economic benefits associated with substituting the asset are expected to exceed the costs associated with doing so. Examples of factors to consider include:
Because the analysis is performed from the supplier’s perspective, it is more difficult for the customer to determine whether the supplier’s substitution right is substantive. Many of the factors that influence whether a substitution right is substantive are specific to the supplier – e.g. whether the supplier has access to alternative assets, the costs involved in substitution etc. The customer may not have access to this information. [IFRS 16.B19, IFRS 16.BC115] If a customer cannot readily determine whether a supplier has a substantive substitution right, then the customer should presume that any substitution right is not substantive. |
| When and how does a company assess whether substitution rights are substantive? |
| A company assesses whether substitution rights are substantive at inception of the contract. At that time, the company considers all of the facts and circumstances, but not future events that are not likely to occur. For example, it excludes the following future events: [IFRS 16.B16]
|
1.2 Economic benefits from using the asset
To determine whether a contract conveys the right to control the use of an identified asset, a company assesses whether the customer has the rights to:
- obtain substantially all of the economic benefits from use of the identified asset throughout the period of use; and
- direct the use of the identified asset throughout the period of use (see Right to direct the use below). [IFRS 16.B9]
The economic benefits from using an asset include its primary output, by-products and other economic benefits from using the asset that could be realised from a commercial transaction with a third party (e.g. sub-leasing the asset). The benefits derived from ownership of the asset (e.g. income tax credits) are excluded from the analysis. [IFRS 16.B21, IFRS 16.BC118]
A company considers the economic benefits that are in the defined scope of the right to use the asset – e.g. if a contract limits the use of a vehicle to only one particular territory during the period of use, then the company considers only the economic benefits from use of the vehicle within that territory, and not beyond. [IFRS 16.B22]
| How does a company evaluate whether a customer has the right to substantially all of the economic benefits from use of an asset? |
| Evaluating whether a customer has the right to obtain substantially all of the economic benefits from use of an asset throughout the period of use is straightforward in many situations, generally because the customer in a lease frequently has exclusive use of the asset. However, in some situations a contract may provide a party other than the customer the right to more than a minor amount of the economic benefits from use of the same asset. In evaluating whether the customer has the right to obtain substantially all of the economic benefits from use of an asset, a company considers the complete population of economic benefits that can be derived from the asset in the scope of the customer’s right to use. |
| Are tax credits and similar items ‘economic benefits’ for the purpose of applying the lease definition? |
| It depends on whether the benefits arise from ownership or use of the asset. [IFRS 16.BC118] A lease conveys a right to use the underlying asset. Accordingly, the benefits derived from ownership of the asset (e.g. income tax credits) are excluded when considering whether a customer has the right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use. Conversely, benefits such as renewable energy credits received from use of the asset are more akin to a by-product and so will be included in the analysis of economic benefits. IFRS 16 includes specific guidance in this area and has the potential to bring consistency in assessing whether an arrangement contains a lease. However, given the variety of arrangements seen in practice, and the complex structures sometimes used to allocate specific forms of benefits to different parties, judgemental issues still remain in practice. |
| Can a customer obtain substantially substantially all of the benefits from use even if lease payments are variable? |
| Yes. The existence of variable lease payments derived from the use of an asset – e.g. a percentage of sales from use of a retail space – does not prevent a customer from having the right to obtain substantially all of the economic benefits from use of the asset. In these cases, although the customer passes on certain benefits to the supplier, the customer receives the cash flows arising from use of the asset. For example, Customer D enters into a contract to use a retail store. The rent payments include a fixed amount per month plus 20 percent of the retail revenue generated from the store. D receives substantially all of the economic benefits: the gross proceeds accrue to D. Sharing a part of the revenues generated from the store (or, generally, usage-based rentals) does not prevent a contract from being a lease. |
1.3 Right to direct the use
A customer has the right to direct the use of an identified asset in either of the following situations: [IFRS 16.B24]
- the customer has the right to direct how and for what purpose the asset is used throughout the period of use (see determining who makes the how and for what purpose decisions); or
- the relevant decisions about how and for what purpose the asset is used are predetermined and either:
- the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
- the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use (see how and what purpose decisions are predetermined).
The following diagram summarises the assessment of the right to direct the use.
* if other criteria are met (see Identify the lease / Lease definition).
| How are decision-making rights evaluated? |
| IFRS 16 effectively requires a threefold classification of decision-making rights into the following categories, which feature in the analysis in different ways.
Assessing the categories into which decisions fall is a key area of judgement in practice. |
1.3.1 How and for what purpose decisions
In assessing who has the right to direct how and for what purpose the asset is used, a company considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used. Decision-making rights are ‘relevant’ when they affect the economic benefits derived from use. [IFRS 16.B25]
Examples of relevant decisions that, depending on the circumstances, grant the right to change how and for what purpose the asset is used include the following. [IFRS 16.B26]
- What: rights to change the type of output that is produced by the asset – e.g. deciding whether to use a shipping container to transport goods or for storage.
- When: rights to change when the output is produced – e.g. deciding when a power plant will generate power.
- Where: rights to change where the output is produced – e.g. deciding on the destination of a truck or a ship.
- Whether and how much: rights to change whether the output is produced, and the quantity of that output – e.g. deciding whether to produce energy from a power plant and how much energy.
Examples of decision-making rights that do not grant the right to change how and for what purpose the asset is used include: rights to operate an asset, rights to maintain an asset or rights to take output that has already been produced. [IFRS 16.B27, IFRS 16.B29]
However, rights to operate an asset drive the analysis if the relevant decisions about how and for what purpose the asset is used are predetermined (see How and for what purpose decisions are predetermined below).
| Consider this! |
| The guidance on determining who has the right to direct the use of the asset focuses on control. This is consistent with the IASB’s focus on control being a primary element in determining whether transactions qualify for recognition in other recently issued standards, such as IFRS 10 Consolidated Financial Statements and IFRS 15 Revenue from Transactions with Customers. However, it is slightly different from the current focus in IAS 17 on which party has the risks and rewards of the leased asset. |
| Case – Customer Directs Use |
| A customer enters into a 5-year contract with a supplier where the customer will purchase up to 100% of the energy produced by a bio-mass facility. The energy must be produced from this particular facility and the supplier does not have substantive substitution rights to provide energy from a separate facility. Alternative arrangements can only be made in extraordinary circumstances (for example, emergency situations rendering the facility inoperative). Under the contract the customer tells the supplier how much energy to produce and when to produce it and the supplier must stand ready to operate the facility to meet the customer’s needs. To the extent there is spare capacity, the supplier is not allowed to generate energy for sale to other customers. The supplier must therefore stand ready to provide all of the power output to the customer if needed. The supplier designed the facility when it was constructed some years before entering into the contract with the customer, who had no involvement in that original design. Assessment It is clear that the bio-mass facility is identified in the contract and the customer obtains substantially all of the economic output (it can take any amount up to 100% of the production capacity without anyone else being able to benefit from any spare capacity). The contract contains a lease for the bio mass facility because the customer also has the right to direct its use. That is, the customer makes the relevant decisions as to how and for what purpose the facility is used because it decides when and how much power is produced. The supplier’s staff simply follow the directions of the customer. The fact that the customer had no involvement in the design of the underlying asset is only relevant when decisions about how and for what purpose the asset will be used are predetermined, as illustrated in the case Pre-determined Functionality below. The customer therefore needs to determine how much of the total contractual payments to the supplier are for the leased asset as distinct from fees that may be charged for other services (such as operation and maintenance of the facility) and capitalise those lease payments on balance sheet. Alternatively, as a practical expedient, the customer can treat the entire contract as a lease, recognising an asset and liability for the present value of all payments to be made under the contract. |
| Cloud Computing |
| At its March 2019 meeting, the IFRS Interpretations Committee (the Committee) published an Agenda Decision in respect of a customer’s right to access a supplier’s application software hosted on the cloud, for a specified term. The request asked whether a customer receives a software asset at the contract commencement date or a service over the contract term (i.e. no asset or liability recognised)? The Committee observed that part of the definition of IFRS 16 is that the contract must convey the ‘right to use’ an asset. For a contract to convey the right to use an asset, the customer would need to have the right to obtain substantially all of the economic benefit from use of the asset and the right to direct use of the asset. Based on the fact pattern presented, the Committee observed that a right to receive future access to the supplier’s software on cloud infrastructure does not in itself give the customer any decision-making rights about how and for what purpose the software is used; it conveys a ‘right to access’, as opposed to a ‘right to use’. The Committee therefore concluded that if a contract conveys only the right to receive access to a software application over the contract term, the contract does not contain a lease. Note – ‘Right to access’ type cloud computing software arrangements are common since they typically do not require a large upfront investment and the software is maintained on hardware owned by the supplier (in the case of ‘public’ cloud structures). The Committee’s agenda decision means that many ‘software as a service’ (SaaS) arrangements will not be accounted for as leases in the scope of IFRS 16, however, entities must carefully analyse their facts and circumstances in light of the Committee’s decision. In cases where an entity accesses software hosted on the cloud using its own IT infrastructure, then these conclusions would not apply, as no customer-supplier relationship exists. |
1.3.2 Determining who makes the how and for what purpose decisions
A company has the right to direct how and for what purpose the asset is used if, in the scope of its rights of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use (see How and for what purpose decisions above). [IFRS 16.B25]
In assessing whether a company has the right to direct the use of an asset, only the rights to make decisions about the asset’s use during the period of use are considered. Decisions that are predetermined before the period of use – i.e. commencement date – are not considered. [IFRS 16.B29]
| How is an arrangement analysed when the customer and the supplier each make some of the how and for what purpose decisions? |
| A company does not have to take all of the how and for what purpose decisions in order to have the right to direct the use of the asset – the decisions can be allocated between the parties. Judgement is required to assess the individual significance of the different how and for what purpose decisions – i.e. their impact on the economic benefits. If some decisions have greater significance than others, then the party that makes the more significant decisions generally directs the right to use the asset. For example, Retailer T enters into a contract with Landlord L to use a specific retail unit for a five-year period. The unit is part of a larger retail space with many retail units. The contract requires T to use the unit to operate its well-known store brand to sell its goods during the hours when the larger retail space is open. L can make reasonable changes to the opening hours of the larger retail space. T decides on the mix of goods sold from the unit, their pricing and the quantity of inventory held. [IFRS 16.IE2 Example 4] In this example, there are a number of how and for what purpose decisions that are not predetermined. L can make reasonable changes to the opening hours. However, by deciding the mix of goods, their pricing and available quantities, T makes the decisions that will have a more significant impact on the economic benefits derived from the unit. Therefore, it is T that directs the right to use the unit. |
1.3.3 How and for what purpose decisions are predetermined
The decisions about how and for what purpose the asset is used can be predetermined in a number of different ways. They could, for example, be agreed between the customer and the supplier in negotiating the contract, with neither party being able to change them after the commencement date, or they could, in effect, be predetermined by the design of the asset. However, situations in which all how and for what purpose decisions are predetermined are likely to be rare. [IFRS 16.B24, IFRS 16.BC121]
As mentioned in Right to direct the use, when the relevant decisions about how and for what purpose the asset is used are predetermined, the customer has the right to control the use of an identified asset when either:
- The customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
- The customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
| Consider this! |
| Assets that may fall into this category include those that are:
|
An entity is only permitted to include in its analysis decision-making ability that will occur during the term of the lease, except in the situation described in (b) above where the customer designed the asset. In such a situation, an entity would identify which elements were pre-determined by the decisions made prior to the asset being completed.
| A customer enters into a contract with a supplier where the customer will purchase 100% of the energy produced by a bio-mass facility. The customer designed the bio-mass facility before it was constructed by hiring experts in the field to assist in determining the location of the facility and the engineering of the equipment to be used. The supplier is responsible for building the facility to the customer’s specifications, and then operating and maintaining it. There are no decisions to be made about whether, when or how much electricity will be produced because the design of the asset has predetermined those decisions. Assessment In assessing the ‘right to direct use of asset’ criterion, the functionality of the facility is predetermined based on its design, and those predeterminations were made by the customer. Therefore, the customer has the right to direct its use. |
| What happens if only some of the how and for what purpose decisions are predetermined? |
| In some cases, many, but not all, of the decisions about how and for what purpose an asset is used are predetermined in the contract. However, the customer has the right to make the remaining relevant decisions. In these cases, a question arises over whether the customer has the right to direct how and for what purpose the asset is used throughout the period of use. [IFRS 16.B24(a), IFRS 16.B29] The IFRS Interpretations Committee discussed this question in the context of a shipping contract and observed that because not all of the relevant decisions about how and for what purpose the ship is used are predetermined, the customer applies IFRS 16.B24(a) and assesses whether it has the right to direct how and for what purpose the asset is used. That is, when some but not all of the relevant decisions are predetermined, the assessment of whether the customer has the right to direct the use of the ship focuses on the relevant decisions that are not predetermined. |
1.3.4 Supplier’s protective rights
A contract may include certain terms and conditions designed to protect the supplier’s interest in the identified asset or other assets, to protect its personnel or to ensure the supplier’s compliance with laws or regulations. These protective rights typically define the scope of the right to use an asset but do not, in isolation, prevent the customer from having the right to direct the use of the asset within that scope. [IFRS 16.B30]
For example, a contract may:
- specify the maximum amount of use of an asset or where or when the customer can use the asset;
- require a customer to follow particular operating practices; or
- require a customer to inform the supplier of changes in how an asset will be used. [IFRS 16.B30]
2. Lessee may use the practical exemptions
A lessee can elect not to apply the lessee accounting model to: [IFRS 16.5]
- leases with a lease term of 12 months or less that do not contain a purchase option: i.e. short-term leases (see 2.1 below); and
- leases for which the underlying asset is of low value when it is new: even if the effect is material in aggregate (see 2.2 below).
If a lessee elects to apply either of these recognition exemptions, then it recognises the related lease payments as an expense on either a straight-line basis over the lease term, or another systematic basis if that basis is more representative of the pattern of the lessee’s benefit. [IFRS 16.6]
2.1 Short-term leases
The election for short-term leases is made by class of underlying asset. A ‘class of underlying asset’ is a grouping of underlying assets of a similar nature and use in the lessee’s operations. When electing the short-term lease exemption for a particular class of underlying asset, only underlying assets from leases that meet the definition of a short-term lease are considered. [IFRS 16.8]
IFRS 16.A The ‘lease term’ is determined in a manner consistent with that for all other leases (see Chapter 6). Consequently, the short-term lease exemption may be applied to renewable and cancellable leases (e.g. month-to-month, evergreen leases) if the lessee is not reasonably certain to renew (or to continue, in the case of a termination option) the lease beyond 12 months.
| What happens if the lessee applies the short-term lease exemption and there are changes in the lease term? |
| If a lessee elects to apply the short-term lease recognition exemption and there are any changes to the lease term – e.g. the lessee exercises an option that it had previously determined that it was not reasonably certain to exercise – or the lease is modified, then the lessee accounts for the lease as a new lease. [IFRS 16.7] |
2.2 Low-value items
A lessee is permitted not to apply the recognition and measurement requirements to leases of assets that, when they are new, are of low value. This exemption, unlike the short-term lease exemption, can be applied on a lease-by-lease basis. [IFRS 16.5(b), IFRS 16.8, IFRS 16.B3–B8]
A lessee does not apply the low-value exemption to a lease of an individual asset in either of the following scenarios:
- if the underlying asset is highly dependent on, or highly inter-related with, other assets; or
- if the lessee cannot benefit from the underlying asset on its own or together with other readily available resources, irrespective of the value of that underlying asset. [IFRS 16.B5]
The low-value exemption also does not apply to a head lease for an asset that is sub-leased or that is expected to be sub-leased. When a lessee neither enters into a sub-lease immediately nor expects to do so later, it may elect to apply the exemption. [IFRS 16.B7]
IFRS 16 does not specify a threshold for the low-value exemption, but the basis for conclusions states that the Board ‘had in mind’ assets with a value of approximately USD 5,000 or less when they are new, such as small IT equipment (e.g. some laptops, desktops, tablets, mobile phones, individual printers) and some office furniture – i.e. ‘inexpensive’ assets. The exemption is not intended to capture underlying assets such as cars and most photocopiers. [IFRS 16.B6, IFRS 16.B8, IFRS 16.BC98–BC104]
| What happens if the exemption is applied and the underlying asset is subsequently sub-leased? |
| If a lessee sub-leases, or expects to sub-lease, an asset, then the head lease does not qualify as a lease of a low-value item. When a lessee neither enters into a sub-lease immediately nor expects to do so later, it may elect to apply the exemption. [IFRS 16.7, IFRS 16.B7] However, if a lessee initially elects to use the low-value exemption – because it expects not to sub-lease the asset – but subsequently does enter into a sublease, then the lease would no longer qualify for the exemption. It appears that at the date of the change, the lessee should consider the lease to be a new lease. In these cases, the lessee also considers whether the reason for the change in intention provides evidence about whether other leases of low-value items do or do not qualify for the exemption. |
3. Separate lease and non-lease components
Many contracts contain multiple lease and non-lease components, which need to be identified and accounted for separately.
The key steps in accounting for the components of a contract are as follows.
3.1 Identify separate lease components
3.2 Identify separate non-lease components
3.3 Allocate the consideration
3.4 Allocate the variable consideration
3.1 Identify separate lease components
A company considers the right to use an underlying asset as a separate lease component if it meets the following criteria:
- the lessee can benefit from using that underlying asset either on its own or together with other resources that are readily available; and
- the asset is neither highly dependent on, nor highly inter-related with, the other assets in the contract. [IFRS 16.B32(a)–(b)]
Resources are considered to be readily available when they are sold or leased separately by the lessor or other suppliers, or when the lessee has already obtained them from the lessor or from other transactions or events. An asset is highly dependent on, or highly inter-related with, the other assets if the lessee could not lease the underlying asset without significantly affecting its rights to use other underlying assets in the contract. The separation guidance is broadly similar to the identification of performance obligations in a revenue contract under IFRS 15. [IFRS 16.B32(a)–(b), IFRS 16.BC134]
The general guidance on identifying separate lease components is the same for lessees and lessors. A lessor then classifies each lease component as a finance or an operating lease, based on the extent to which the lease transfers the risks and rewards incidental to ownership of the underlying assets (this guidance is not relevant to lessees) (see Section 3.2). [IFRS 16.12, IFRS 16.B53]
IFRS 16 applies to individual leases. However, as a practical expedient a company may apply the standard to a portfolio of lease contracts with similar characteristics if the company reasonably expects that the effects of accounting for the contracts as a portfolio would not be materially different from those of accounting for the individual leases within that portfolio. Once the portfolio approach has been selected, the company uses assumptions and estimates that reflect the size and composition of the portfolio. [IFRS 16.B1]
| If a lease of land and building is a single lease component, then does the lessor perform a single classification test? |
| Not necessarily. When a lease includes both land and building elements, the lessor assesses the classification of each element separately, unless the value of the land at inception of the lease is deemed immaterial. In this case, the lessor may treat the land and building as a single unit to classify it as either a finance or an operating lease, applying the criteria in the new standard. [IFRS 16.B55, IFRS 16.B57] If separating the land element would have no effect on the lease classification, then the lessor does not need to separate it because the accounting impact would be insignificant. However, if the land and building elements are classified differently – e.g. operating lease for the land and finance lease for the building – then the lessor accounts for the two elements separately. If the lease payments cannot be allocated reliably between the two elements, then the entire lease is classified as a finance lease, unless both elements are clearly operating leases. [IFRS 16.B56–B57] When a lease contract contains both land and building elements, a lessor considers the specific guidance described above, notwithstanding the fact that the land and building may not be separate components. [IFRS 16.B32, IFRS 16.B55–B57] |
3.2 Identify separate non-lease components
It is common for a lease contract to include non-lease components. For example, a real estate lease may include common area maintenance services provided by the lessor – e.g. cleaning services, maintenance of a central heating plant, common area repairs etc. IFRS 16 generally requires a company to separate the lease and non-lease components of a contract. The lease component is accounted for under IFRS 16 and the non-lease components are accounted for in accordance with other applicable standards. [IFRS 16.12]
As a practical expedient, a lessee may elect, by class of underlying asset, to combine each separate lease component and any associated non-lease components and account for them as a single lease component. This does not apply to embedded derivatives that are separated from the host contract in accordance with IFRS 9. [IFRS 16.15, IFRS 16.BC135]
The practical expedient is not available for a lessor. A lessor always accounts for non-lease components separately from the lease components. [IFRS 16.17, IFRS 16.BC135–BC136]
Only activities or costs that transfer a good or service to the lessee are identified as non-lease components. Amounts payable for activities and costs that do not transfer a good or service are part of the total consideration and are allocated to the lease and non-lease components identified in the contract. Common examples of activities (or costs of the lessor) that do not transfer a good or service to the lessee include the lessee’s payments for administrative tasks, insurance costs and property taxes. [IFRS 16.B33]
| What are the consequences for the lessee of applying the practical expedient? |
| Applying the practical expedient for lessees not to separate non-lease components from lease components has the potential to reduce cost and complexity in some cases. However, some lessees may find the accounting consequences unattractive. In effect, using this practical expedient may result in recognising a liability for the service component of the contract, which would otherwise remain off-balance sheet until the lessor performs. At the same time, using the practical expedient will impact the presentation in the statement of profit or loss, with consequential impacts on key ratios. For example, in a real estate lease the lessor may provide common area maintenance services to the tenants. If those services are accounted for as a non-lease component, then the tenant will typically recognise the consideration allocated to the common area maintenance as an operating expense as it is incurred. However, if the common area maintenance is fixed or varies depending on an index or rate and the tenant includes it in the lease payments, then it will not be an operating expense. Instead, the company will effectively recognise additional depreciation on the right-of-use asset and interest expense. In this example, applying the practical expedient increases reported earnings before interest, tax, depreciation and amortisation (EBITDA). |
3.3 Allocate the consideration
IFRS 16 requires both the lessee and lessor to allocate consideration to the lease and non-lease components. Payments for activities and costs that do not transfer a good or service to the lessee do not give rise to a component and are included in the consideration that is allocated to the separate lease and non-lease components in the contract. Therefore, the consideration includes all payments in the contract – i.e. those that relate to lease and non-lease component(s), and other payments that relate to items such as taxes, which are not separate components. [IFRS 16.13, IFRS 16.17, IFRS 16.B33]
The consideration in the contract is allocated to each lease and non-lease component. [IFRS 16.13, IFRS 16.17]
The allocation of the consideration is a two-step process.
- Determine the stand-alone price for each component.
- Allocate the consideration.
The following table summarises the process for allocating consideration between lease and non-lease components from both the lessee and lessor perspectives. [IFRS 16.13–17, IFRS 16.B33]
| When there is an observable stand-alone price for each component | Unless the practical expedient is elected (see Section 5.3), allocate the consideration based on the relative stand-alone price of components. | Always allocate the consideration following the IFRS 15 approach – i.e. on a relative stand-alone selling price basis. |
| When there is no observable stand-alone price for some or all components | Estimate the stand-alone prices maximising use of observable information. | |
| Taxes, insurance on the property and administrative costs | Activities (or costs of the lessor) that do not transfer a good or service to the lessee are not components in a contract. | |
| Practical expedient: accounting policy election by class of underlying asset | Combine lease and any associated non-lease components and account for them as lease components (see Section 5.3). | N/A |
Lessee perspective
If a contract contains a lease component and one or more additional lease or non-lease components, then the lessee allocates the consideration in the contract on the basis of:
- – the relative stand-alone price of each lease component; and
- – the aggregate stand-alone price of the non-lease components. [IFRS 16.13]
The lessee determines the relative stand-alone prices of lease and non-lease components based on the price that a lessor would charge a company for a similar component separately. [IFRS 16.14]
If an observable stand-alone price is not readily available, then the lessee estimates the stand-alone price of the components by maximising the use of observable information. [IFRS 16.14, IFRS 15.79 ]
Unless a lessee applies the practical expedient (see Section 5.3), it accounts for non-lease components in accordance with other applicable standards.
Lessor perspective
If a contract contains a lease component and one or more additional lease or non-lease components, then the lessor allocates the consideration in the contract in accordance with the requirements of IFRS 15 – i.e. according to the stand-alone selling prices of the goods and services included in each component. [IFRS 16.17]
If a stand-alone selling price is not directly observable, then the lessor estimates the price considering all information that is reasonably available to the lessor. IFRS 15 includes examples of acceptable approaches to estimating stand-alone selling prices. [IFRS 15.78]
| Does the lessor need to allocate consideration when the allocation does not have an impact on the income? |
| Yes, the lessor allocates the consideration to each of the lease and non-lease components, even if there is no impact on the profile of income recognised. This is necessary for presentation and disclosure purposes – i.e. the new standard requires a lessor to disclose lease income. IFRS 15 also requires a company to present and disclose revenue from contracts with customers separately. [IFRS 16.90, IFRS 15.114, IFRS 15.B87–B89] For example, when the lease is classified as an operating lease and the non-lease component is a service satisfied over time using a time-based measure, the income from both the lease and non-lease components is recognised over the period: the allocation does not impact the income recognised during the period. |
3.4 Allocate the variable consideration
It is common for a lease contract to include variable payments. If the contract contains more than one component and includes both variable and fixed payments, then a question arises about how to allocate the variable payments – e.g. whether the variable payments can be allocated to one or more, but not all, of the components.
Under IFRS 15, variable consideration is allocated entirely to one or more, but not all, performance obligations in the contract if the following criteria are met: [IFRS 15.84–86]
- the terms of a variable payment relate specifically to the company’s efforts to satisfy the performance obligation; and
- allocating the variable amount of consideration entirely to the performance obligation is consistent with the allocation objective when considering all of the performance obligations and payment terms in the contract.
This guidance applies directly to lessors. In addition, in the absence of specific guidance in IFRS 16, it appears that it is acceptable for a lessee to apply this guidance when allocating variable payments in a contract that contains a lease component, as follows. [IFRS 16.14, Ex12]
- If variable payments represent the stand-alone price of a specific component and other payments represent the stand-alone prices of other components, then the variable payments should be allocated to that specific component.
- If variable payments do not represent the stand-alone price of a specific component or other payments do not represent the stand-alone prices of other components, then the total consideration, including fixed and variable amounts, should be allocated to all of the components in the contract.
| Does a company need to reallocate the consideration during the terms of the lease? |
| Yes, in some cases. For example, when a company allocates the consideration, both fixed and variable, to multiple lease and non-lease components:
|
4. Determine the lease term
The lease term is a critical estimate. For lessees, the lease term affects the size of the lease liability. For lessors, it may impact the lease classification.
The lease term is the non-cancellable period of the lease, together with:
- optional renewable periods if the lessee is reasonably certain to extend; and
- periods after an optional termination date if the lessee is reasonably certain not to terminate early. [IFRS 16.18]
Termination options held only by the lessor are not considered when determining the lease term. [IFRS 16.B35]
To determine the lease term, a company first determines the length of the non-cancellable period of a lease and the period for which the contract is enforceable. It can then determine – between those two limits – the length of the lease term. In lease contracts that have no options, the non-cancellable period, the period for which the contract is enforceable and the lease term will all be the same.
At lease commencement date, a company determines:
- the non-cancellable period,
- the enforceable period, and
- the lease term.
4.1 The non-cancellable period
The ‘non-cancellable period’ is the period during which the lessee cannot terminate the contract. The lease term cannot be shorter than the non-cancellable period. [IFRS 16.B35, IFRS 16.BC127–BC128]
4.2 The enforceable period
The ‘enforceable period’ is the period for which enforceable rights and obligations exist between the lessee and lessor. This is the maximum potential length of the lease term. [IFRS 16.B34, IFRS 16.BC127]
To determine the enforceable period of the lease, a company applies the definition of a contract. For this purpose, the contract comprises the written agreement and applicable laws and regulations in the local jurisdiction that stipulate and govern the parties’ rights and obligations. Enforceability is a matter of law in the relevant jurisdiction and each contract will need to be evaluated based on its terms and conditions. This includes considering the guidance on enforceability in paragraph B34 of IFRS 16, including the role of penalties in assessing the enforceable period. [IFRS 16.2, IFRS 16.B34, IFRS 16.BC127]
The key steps to determining the enforceable period are as follows.
Renewal and termination options are considered in the assessment of the lease term if they are enforceable. [IFRS 16.B34, IFRS 16.BC127]
A lease is no longer enforceable beyond the point at which both the lessee and the lessor have the unilateral right to terminate the lease without permission from the other party, and with no more than an insignificant penalty. [IFRS 16.B34, IFRS 16.BC127]
Consequently, a contract is enforceable beyond the date on which it can be terminated if:
- both parties have the right to terminate but one party, or both, would incur a penalty on termination that is more than insignificant; or
- only one party has the right to terminate the lease without the permission of the other party.
A lease is no longer ‘enforceable’ when both the lessee and lessor have the right to terminate it without agreement from the other party with no more than an insignificant penalty. If only the lessee has the right to terminate a lease, then that right is considered to be an option available to the lessee to terminate the lease that a company considers when determining the lease term. Termination options held by the lessor only are not considered when determining the lease term because, in this situation, the lessee has an unconditional obligation to pay for the right to use the asset for the period of the lease, unless the lessor decides to terminate the lease. [IFRS 16.B34–B35, IFRS 16.BC127]
The following summarises the impact of penalties and termination rights on the determination of the enforceable period.
IFRS 16 does not define the term ‘penalty’. Therefore, questions have arisen in practice about whether a company considers the broader economics of the contract or only contractual termination payments when applying IFRS 16.B34. The IFRS Interpretations Committee discussed this issue and noted that when determining the effect of termination rights under IFRS 16.B34, a company considers the broader economics of the contract and not only contractual termination payments.
| What is the enforceable period when both the lessee and lessor have termination rights, but only one party would suffer a more than-insignificant penalty? |
| The existence of a penalty affects the enforceable period in different ways, depending on which party would suffer a more-than-insignificant penalty. In the following scenarios, relevant laws and regulations that govern the transaction do not stipulate any other rights and obligations of the parties in addition to those in the written contract. Scenario 1 – Both parties have termination rights without the permission of the other, but only the lessor’s right gives rise to a more-than insignificant penalty In this case, the enforceable period ends when the lessor’s exercise of its termination option no longer gives rise to a more-than-insignificant penalty – i.e. when both the lessee and the lessor have the unilateral right to terminate the lease with no more than an insignificant penalty. In contrast, if the lessor’s termination right will no longer result in a more than-insignificant penalty before the lessee’s termination option becomes exercisable, then the lessor’s termination option is disregarded for accounting purposes until the lessee’s termination option becomes exercisable. When the lessee’s termination option becomes exercisable, both the lessee and the lessor have the unilateral right to terminate the lease with no more than an insignificant penalty, and the enforceable period does not extend beyond that point. Scenario 2 – Both parties have termination rights without the permission of the other, but only the lessee’s right gives rise to a more-than insignificant penalty In this case, the enforceable period ends when the lessee’s exercise of its termination option no longer gives rise to a more-than-insignificant penalty. |
4.3 The reasonably certain threshold
IFRS 16 does not define ‘reasonably certain’ and there is no bright line when making the assessment. When determining the lease term, a company considers all relevant facts and circumstances that create an economic incentive for the lessee to exercise an option to renew or purchase, or not to exercise an option to terminate early. When assessing whether a lessee is reasonably certain to exercise an option to extend or purchase, or not to exercise an option to terminate early, the economic reasons underlying the lessee’s past practice regarding the period over which it has typically used particular types of assets (whether leased or owned) may provide useful information. [IFRS 16.19, IFRS 16.B37, IFRS 16.B40, IFRS 16.BC157]
IFRS 16 provides examples of factors to consider when assessing whether it is ‘reasonably certain’ that a lessee would exercise an option to renew or not exercise an option to terminate the lease. The assessment of the degree of certainty is based on the facts and circumstances at commencement of the lease, rather than on the lessee’s intentions. The following table provides examples of factors that create an economic incentive to exercise or not to exercise options to renew or terminate early. [IFRS 16.B37–B40]
| Does the existence of non-removable significant leasehold improvements impact the lease term? |
| Yes. The IFRS Interpretations Committee considered the interaction between the determination of the lease term and the useful life of non-removable significant leasehold improvements. [IFRS 16.B37] The Committee noted that a company considers all relevant facts and circumstances that create an economic incentive for the lessee when assessing whether it is reasonably certain to extend (or not to terminate) a lease. This includes significant leasehold improvements (made or planned to be made) over the term of the contract that are expected to have significant economic benefit when the option to extend (or terminate) becomes exercisable. |
| Can lessees and lessors reach different conclusions about whether it is reasonably certain that an option will be exercised? |
| Yes. Lessees and lessors may reach different conclusions about lease term because of information asymmetry and the judgemental nature of the assessment. The assessment of reasonably certain is based on judgements (e.g. about the importance of an underlying asset to the lessee) and estimates (e.g. of the fair value of the underlying asset in the future). Lessees and lessors may reach different conclusions about whether the lessee is reasonably certain to exercise an option to renew, or not to exercise an option to terminate early. |
4.4 Renewable and cancellable leases
In some cases, a lease contract may continue indefinitely until either party gives notice to terminate it (i.e. cancellable lease), or may renew indefinitely unless it is terminated by either party (i.e. renewable lease). For example, evergreen leases are leases that automatically renew on a day-to-day, week-to-week or month-to-month basis – i.e. they are cancellable leases. [IFRS 16.B34]
A question arises over how to determine the non-cancellable and enforceable period of such leases. The IFRS Interpretations Committee discussed this issue and noted that in doing so a company considers the broader economics of the contract and not only contractual termination payments. If only one party has the right to terminate the lease without permission from the other party and with no more than an insignificant penalty, then the contract is enforceable beyond the date on which the contract can be terminated by that party.
If a company concludes that the contract is enforceable beyond the notice period of a cancellable lease (or the initial period of a renewable lease), then it applies the reasonably certain threshold assessment to determine the lease term (see the reasonably certain threshold ). [IFRS 16.19, IFRS 16.B37–B40]
A penalty may expire or, over a period of time, the effect of a penalty that is initially more than insignificant may become insignificant. For example, a termination penalty that is more than insignificant if it is incurred after only one year of a lease may be insignificant if it is incurred after four or five years when considered in the context of the broader economics of the contract.
| Does the assessment of reasonably certain differ for evergreen leases? |
| No. For evergreen leases, once the enforceable period is established, the lease term is determined in the same manner as for all other leases. This involves considering whether the lessee is reasonably certain to exercise one or more of the renewal options. The assessment is based on all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option to renew. [IFRS 16.B37, IFRS 16.B39] Determining whether a lessee is reasonably certain to exercise a renewal option in an evergreen lease may involve significant judgement. In general, the shorter the non-cancellable period of a lease, the more likely a lessee is to exercise an option to extend the lease or not to exercise an option to terminate the lease. This is because the costs associated with obtaining a replacement asset are likely to be proportionately higher for a shorter non-cancellable period. For example, if a lessee leases a retail or warehouse space on a monthly basis and expects to need a substantially similar space for the next 18–24 months, then there may be a significant economic incentive (e.g. to avoid moving costs or customers having to find the lessee’s new location) to renew the lease rather than continually move to a similar space throughout the period. |
4.5 Changes in the lease term
After the commencement date, a lessee reassesses whether it is reasonably certain to exercise an option to extend the lease or to purchase the underlying asset, or not to exercise an option to terminate the lease early. The lessee revises the lease term consequently. The lessee does this when there has been a significant event or a significant change in circumstances that:
- is within its control; and
- affects whether it is reasonably certain to exercise those options. [IFRS 16.20, IFRS 16.36(c), IFRS 16.40]
IFRS 16 provides the following examples of significant events or changes in circumstances:
- significant leasehold improvements that the lessee did not anticipate at the commencement date, if it expects them to have a significant economic benefit when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable;
- a significant modification to, or customisation of, the underlying asset that was not anticipated at the commencement date;
- the inception of a sub-lease of the underlying asset for a period beyond the end of the previously determined lease term; and
- a business decision of the lessee that is directly relevant to exercising, or not exercising, an option – e.g. a decision to extend the lease of a complementary asset, to dispose of an alternative asset or to dispose of a business unit within which the right-of-use asset is used. [IFRS 16.B41]
If a lessee reassesses the lease term due to changes in its assessment of whether it is reasonably certain to exercise a renewal option, then it remeasures its lease liability using a revised discount rate. The lessee adjusts the carrying amount of the right-of-use asset for the remeasurement of the lease liability. If the carrying amount of the right-of-use asset is reduced to zero, then any further reductions are recognised in profit or loss.
In addition, both the lessee and the lessor revise the lease term when there is a change in the non-cancellable period of a lease. For example, the non-cancellable period of a lease will change if:
- the lessee exercises an option that was not previously included in the company’s determination of the lease term;
- the lessee does not exercise an option previously included in the company’s determination of the lease term;
- an event occurs that contractually obliges the lessee to exercise an option not previously included in the company’s determination of the lease term; or
- an event occurs that contractually prohibits the lessee from exercising an option previously included in the company’s determination of the lease term. [IFRS 16.21]
For example, a lessee and a lessor determined at commencement that the lease term was the non-cancellable period of five years, considering that it was not reasonably certain that the lessee would exercise a renewal option for an additional five years. However, if at the end of Year 4 the lessee exercises the renewal option for the additional five years by giving formal notification to the lessor, then the lessee and the lessor revise the remaining lease term to six years to reflect the new non-cancellable period.
When there is a change in the lease term, a lessee remeasures its lease liability using a revised discount rate and, generally, makes a corresponding adjustment to the right-of-use asset. [IFRS 16.40]
IFRS 16 is silent on how a lessor accounts for the remeasurement of the net investment in the lease when it revises the lease term. It appears that the lessor should choose an accounting policy, to be applied consistently, to remeasure the net investment in the lease by applying by analogy the guidance in: [IFRS 16.21]
- IFRS 9 on accounting for a change in expected cash flows; or
- IFRS 16 on remeasurement of a lease liability by the lessee.
| What are the major impacts for lessees of reassessing the lease term and remeasuring the lease liability? |
| Companies need to reassess key judgements – e.g. the lease term – and consider the need to remeasure lease balances each time they report. Significant judgement is needed in determining whether there is a change in relevant factors or a change in the lessee’s economic incentive to exercise or not to exercise renewal or termination options. Additionally, it may be difficult for a company to ignore changes in market-based factors (e.g. market rates) when performing a reassessment of the lease term. A lessee’s reassessment of key judgements may, in some cases, have a significant impact on the lease amounts recognised in the statement of financial position and the statement of profit or loss and other comprehensive income. Remeasurements during the lease term provide more up-to-date information to users of financial statements. However, they create volatility in reported assets and liabilities, which may impact the ability to accurately predict and forecast future financial performance. Additional resources need to be focused on lease accounting not only at lease commencement, but also at each reporting date. |
| Is a lessor allowed to reassess the lease term when the lessee reassesses whether it is reasonably certain to exercise an option? |
| No. Unlike a lessee, it appears that a lessor should revise the lease term only when there is a change in the non-cancellable period of the lease, as described in IFRS 16.21. In contrast, IFRS 16.20 requires reassessment in additional circumstances, but this applies only to lessees. [IFRS 16.20–21] |
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