Operating lease

Sale and leaseback accounting under IFRS 16

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Sale and leaseback accounting

A sale and lease back transaction is a popular way for entities to secure long-term financing from substantial property, plant and equipment assets such as land and buildings. IFRS 16 made significant changes to sale and lease back accounting in comparison with IAS 17. A sale and leaseback transaction is one where an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) for consideration and leases that asset back from the buyer-lessor.

The IFRS 16 guidance on ‘failed sales’ means that some sale-and-lease back transactions are accounted for as pure financing transactions by both lessors and lessees.

In a sale-and-lease back transaction, a company (the seller-lessee) transfers an underlying asset … Read more

Landlord Lease modifications

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Landlord Lease modifications / Rental modifications

Accounting for lease modifications has become a hot topic due to the COVID-19 pandemic, with many tenants seeking rent concessions and other changes to lease agreements.

Unlike IAS 17, IFRS 16 provides detailed guidance on the lessor accounting for lease modifications, with separate guidance for modifications to finance leases and operating leases.

A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of its original terms and conditions. Common examples are:

  • decreasing the scope of the lease by removing the right to use one or more underlying assets;
  • decreasing the scope of the lease by shortening the contractual lease term; and
  • changing the consideration in the lease by increasing or decreasing the lease payments.

Changes that result from renegotiations of the original contract are lease modifications.

The exercise of an option included in the original lease contract is not a modification. There is no lease modification when a lessor reassesses the lease term if:

  • the lessee exercises an option not previously included in the lessor’s determination of the lease term;
  • the lessee does not exercise an option previously included in the lessor’s determination of the lease term;
  • an event occurs that contractually obliges the lessee to exercise an option not previously included by the lessor; or
  • an event occurs that contractually prohibits the lessee from exercising an option previously included by the lessor (see Changes in the lease term).

The following diagram summarises the accounting for lease modifications by a lessor/landlord.

Original lease is a finance lease

Change to contractual terms and conditions

Original lease is an operating lease

Increase in scope of lease by adding right of use for one or more underlying assets and at stand-alone price for increase

All other contract modifications.

Classification at inception if modification had been in effect then as:

Operating lease

Finance lease

Separate lease

Not a separate lease

Apply IFRS 9

Modifications to operating leases

Food for thought – When does a lessor account for a lease modification?

Similar to a lessee, a lessor accounts for modifications to operating and finance leases on the effective date of the modification. This is the date when both parties agree to the lease modification. (IFRS 16.79–80, IFRS 16.87)

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Landlord lease definition

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Landlord lease definition

Identifying a lease of real estate is usually straightforward – but some scenarios will require judgement.

1 Overview

A lease is 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. (IFRS 16.B9)

The key factors to consider when applying the lease definition are as follows.

Landlord lease definition

2 Applying the definition to real estate

Types of properties common in real estate leases include:

  • land and buildings;
  • office space: e.g. a floor of a building;
  • retail space;
  • specified spots in a car park; and
  • residential property.

When applying the lease definition to real estate arrangements, it will usually be clear whether the arrangement meets the lease definition criteria.

Key factors to consider when applying the lease definition are as follows.

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Landlord accounting model – IFRS 16 best replacement for IAS 40

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Landlord accounting model

Landlords continue to classify leases as finance or operating leases, and continue to classify many real estate leases as operating leases.

1 Overview

The lessor follows a dual accounting approach for lease accounting. The accounting is based on whether significant risks and rewards incidental to ownership of an underlying asset are transferred to the lessee, in which case the lease is classified as a finance lease. This is similar to the previous lease accounting requirements that applied to lessors.

What are the impacts of IFRS 16 on lessors?

Much of the guidance in IFRS 16 on lessor accounting is a ‘carry forward’ from IAS 17 Leases – literally a cut-and-paste. This reflects feedback from financial statement users and other stakeholders that lessor accounting was not ‘broken’.

However, there are a number of changes in the details of lessor accounting. For example, lessors apply the new:

  • definition of a lease (see this page);
  • guidance on separating components of a contract (see this page);
  • guidance on lease term (see this page);
  • guidance on lease modifications (see this page);
  • guidance on sub-lease (see this page); and
  • guidance on sale-and-leaseback (see this page).

The same definition of ‘lease term’ applies to both lessees and lessors. IFRS 16 includes guidance on when extension options and termination options are taken into consideration when determining the lease term. Additional guidance has been issued about determining the lease term – an estimate that could significantly impact the overall lease accounting.

In addition, IFRS 16 includes specific guidance on separating the components of a contract and accounting for lease modifications by lessors.

The new guidance may significantly impact the accounting for sub-leases and sale-and-leaseback transactions.

2 Lease classification

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Determining a leases discount rate

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Determining a leases discount rate

The definition of the lessee’s incremental borrowing rate states that the rate should represent what the lessee ‘would have to pay to borrow over a similar term and with similar security, the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment.’ In applying the concept of ‘similar security’, a lessee uses the right-of-use asset granted by the lease and not the fair value of the underlying asset.

This is because the rate should represent the amount that would be charged to acquire an asset of similar value for a similar period. For example, in determining the incremental borrowing rate on a 5 year lease of a property, the security for the portion of the asset being leased (i.e. the 5 year portion of its useful life) would be likely to vary significantly from the outright ownership of the property, as outright ownership would confer rights over a period of time that would typically be significantly greater than the 5-year right-of-use asset contained in the lease.

In practice, judgement may be needed to estimate an incremental borrowing rate in the context of a right-of-use asset, especially when the value of the underlying asset differs significantly from the value of the right-of-use asset.

An entity’s weighted-average cost of capital (‘WACC’) is not appropriate to use as a proxy for the incremental borrowing rate because it is not representative of the rate an entity would pay on borrowings. WACC incorporates the cost of equity-based capital, which is unsecured and ranks behind other creditors and will therefore be a higher rate than that paid on borrowings.

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IFRS 16 Lessor accounting

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IFRS 16 Lessor accounting

Lessors continue to classify leases as finance or operating leases.

1. Lessor accounting model

The lessor follows a dual accounting approach for lease accounting. The accounting is based on whether significant risks and rewards incidental to ownership of an underlying asset are transferred to the lessee, in which case the lease is classified as a finance lease. This is similar to the previous lease accounting requirements that applied to lessors. The lessor accounting models are also essentially unchanged from IAS 17 Leases. [IFRS 16.B53, IFRS 16.BC289]

Are the lessee and lessor accounting models consistent?

No. A key consequence of the decision to retain the IAS 17 dual accounting model for lessors is a lack of consistency with the new lessee accounting model. This can be seen in the case Lease classification below:

There are also more detailed differences. For example, lessees and lessors use the same guidance for determining the lease term and assessing whether renewal and purchase options are reasonably certain to be exercised, and termination options not reasonably certain to be exercised. However, unlike lessees, lessors do not reassess their initial assessments of lease term and whether renewal and purchase options are reasonably certain to be exercised, and termination options not reasonably certain to be exercised (see changes in the lease term in the link).

Other differences are more subtle. For example, although the definition of lease payments is similar for lessors and lessees (see lease payments in the link), the difference is the amount of residual value guarantee included in the lease payments.

  • The lessor includes the full amount (regardless of the likelihood that payment will be due) of any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.
  • The lessee includes only any amounts expected to be payable to the lessor under a residual value guarantee.

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Sub-leases under IFRS 16

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Sub-leases under IFRS 16

The classification guidance in IFRS 16 means that many sub-leases are finance leases, impacting the financial position and financial performance of intermediate lessors.

A sub-lease is a transaction in which a lessee (or ‘intermediate lessor’) grants a right to use the underlying asset to a third party, and the lease (or ‘head lease’) between the original lessor and lessee remains in effect.

A company applies IFRS 16 to all leases of right-of-use assets in a sub-lease. The intermediate lessor accounts for the head lease and the sub-lease as two different contracts, applying both the lessee and lessor accounting requirements. [IFRS 16.3]

Sub-leases under IFRS 16

An intermediate lessor classifies the sub-lease as a finance lease or as an operating lease with reference to the right-of-use asset arising from the head lease. That is, the intermediate lessor treats the right-of-use asset as the underlying asset in the sub-lease, not the item of property, plant or equipment that it leases from the head lessor. [IFRS 16.B58]

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Leveraged buyout IFRS 3 best reporting

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Leveraged buyout IFRS 3 best reporting – In corporate finance, a leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of consideration. These transactions typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70 or 80 percent of the purchase price) and funds the balance with their own equity. Leveraged buyout IFRS 3 best reporting

1 The process and business reason

The use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE) and internal rate of return … Read more

IAS 16 Generation assets for Power and Utilities

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Generation assets for Power and Utilities

– are often large and complex installations. They are expensive to construct, tend to be exposed to harsh operating conditions and require periodic replacement or repair. This environment leads to specific accounting issues.

1 Fixed assets and components

IFRS has a specific requirement for ‘component’ depreciation, as described in IAS 16 Property, Plant and Equipment. Each significant part of an item of property, plant and equipment is depreciated separately. Significant parts of an asset that have similar useful lives and patterns of consumption can be grouped together. This requirement can create complications for utility entities, because many assets include components with a shorter useful life than the asset as a whole.

Identifying components of an asset

Generation assets might comprise a significant number of components, many of which will have differing useful lives. The significant components of these types of assets must be separately identified. This can be a complex process, particularly on transition to IFRS, because the detailed record-keeping needed for componentisation might not have been required in order to comply with national generally accepted accounting principles (GAAP). This can particularly be an issue for older power plants. However, some regulators require detailed asset records, which can be useful for IFRS component identification purposes.

An entity might look to its operating data if the necessary information for components is not readily identified by the accounting records. Some components can be identified by considering the routine shutdown or overhaul schedules for power stations and the associated replacement and maintenance routines. Consideration should also be given to those components that are prone to technological obsolescence, corrosion or wear and tear that is more severe than that of the other portions of the larger asset.

First-time IFRS adopters can benefit from an exemption under IFRS 1 First-time Adoption of International Financial Reporting Standards. This exemption allows entities to use a value that is not depreciated cost in accordance with IAS 16, and IAS 23 Borrowing Costs as deemed cost on transition to IFRS. It is not necessary to apply the exemption to all assets or to a group of assets.

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IFRS 10 Special control approach

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IFRS 10 Special control approach

– determines which entities are consolidated in a parent’s financial statements and therefore affects a group’s reported results, cash flows and financial position – and the activities that are ‘on’ and ‘off’ the group’s balance sheet. Under IFRS, this control assessment is accounted for in accordance with IFRS 10 ‘Consolidated financial statements’.

Some of the challenges of applying the IFRS 10 Special control approach include:

  • identifying the investee’s returns, which in turn involves identifying its assets and liabilities. This may appear straightforward but complications arise when the legal ownership of assets diverges from the accounting depiction (for example, in financial asset transfers that ‘fail’ de-recognition, and in finance leases). In general, the assessment of the investee’s assets and returns should be consistent with the accounting depiction in accordance with IFRS
  • it may not always be clear whether contracts and other arrangements between an investor and an investee
    • create rights or exposure to a variable return from the investee’s performance for the investor; or
    • transfer risk or variability from the investor to the investee IFRS 10 Special control approach
  • the relevant activities of an SPE may not be obvious, especially when its activities have been narrowly specified in its purpose and design IFRS 10 Special control approach
  • the rights to direct those activities might also be difficult to identify, because for example, they arise only in particular circumstances or from contracts that are outside the legal boundary of the SPE (but closely related to its activities).

IFRS 10 Special control approach sets out requirements for how to apply the control principle in less straight forward circumstances, which are detailed below:  IFRS 10 Special control approach

  • when voting rights or similar rights give an investor power, including situations where the investor holds less than a majority of voting rights and in circumstances involving potential voting rights
  • when an investee is designed so that voting rights are not the dominant factor in deciding who controls the investee, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements IFRS 10 Special control approach
  • involving agency relationships IFRS 10 Special control approach
  • when the investor has control only over specified assets of an investee
  • franchises. IFRS 10 Special control approach

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