The new IFRS 16 Leases effective as of 1 January 2019

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Cory Russell
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1 The new IFRS 16 Leases effective as of 1 January 2019 IFRS 16 was issued by IASB on 13 January The Standard is effective as of 1 January It has not yet been adopted by the EC. This is a Standard that has been developed in the course of a long period of time, launched in 2013, with multiple discussions on the draft level. The Standard is the outcome of a project jointly initiated by the IASB and the US FASB. Regardless, the two standards issued by the Boards remain divergent. The main objective of IFRS 16 is to respond to the information issues raised by users of the financial statements regarding the correct risk assessment of lease exposures caused by the reduced comparability of ratios in the financial statements of various entities, resulting from the substantially different accounting for operating and finance leases, as well as the limited disclosure in the financial statements on operating leases. Basically, the new Standard: Provides a comprehensive model for determining and considering certain agreements as leases; Provides rules on the accounting treatment by lessees and lessors; Introduces the "control" model in identifying leases which distinguishes a lease agreement from a service provision agreement; Makes substantial changes in the approach for the accounting treatment and reporting of leases by lessees; Does not envisage substantial changes in the approach for the accounting treatment and reporting of leases by lessors; Significantly changes the presentation of lease transactions in lessees' statement of financial position, statement of comprehensive income and statement of cash flows; Requires expansion of disclosures; and Allows modified initial retrospective application. Its advantages include: Enhancing the faithful representation of entity's assets and liabilities; Increasing the transparency of financial reporting; 1

2 Improving the comparability of indicators of entities which acquire assets under leases and entities which acquire assets using loans; No longer requiring the recalculation of certain parametres for the purposes of financial analysis. IFRS 16 shall apply to all leases, except for leases related to leasing out: non-regenerative resources (oil, natural gas, minerals); biological assets under IAS 41; concession arrangements under IFRIC 12; licences of intellectual property within the scope of IFRS 15 (new); rights held under licensing agreements within the scope of IAS 38. By way of an exception, a lessee may elect not to apply the requirements of this Standard for: short-term leases with a lease term of 12 months or less and leases where the underlying asset has a low value. In respect of the latter, the Standard does not specify a value threshold. The definition of a lease under the new IFRS 16 is: a contract is determined to be a lease where it conveys to the customer the right to control the use of an asset for a period of time in exchange for consideration. The new emphasis is placed on the introduction of the control principle. The right to control the use of an asset for the period of use is determined based on simultaneously meting both of the following two conditions: The right to obtain substantially all the economic benefits from the use of the asset (i.e. its main productivity leading to economic transactions with third parties), and The right to direct the use of the asset (i.e. how and for what purpose to use the asset, or to take a decision on how someone may use the asset, without the supplier of the asset having the right to change this decision). Decisions on how to use the asset relate to the type, timing, location and the extent of its use. The lease term is defined as the period comprising the non-cancellable period of the lease plus all extension options, if expected to be exercised, plus all termination options, if expected not to be exercised. Accounting treatment Lessee Initial recognition and measurement The biggest changes concern the accounting by lessees. A lessee shall recognise a right-ofuse asset and a lease liability on lease commencement date, i.e. the date on which the asset is available for use by lessee. Exempt from this accounting rule are short-term leases and lowvalue assets. The right-of-use asset shall be initially measured at cost which shall include: 2

3 the amount of the initial measurement of the lease liability; all payments at or prior to lease commencement date minus any amounts of lease incentives; all initial direct costs; and the provision for costs related to asset decommissioning or relocation. Accordingly, the lease liability shall be initially measured at the present value of all lease payments payable using the interest rate implicit in the lease or lessee's incremental borrowing rate. Subsequent measurement At subsequent measurement, the right-of-use asset shall be measured applying the rules of IAS 16 and using the two models: - the cost model at cost less accumulated depreciation and accumulated impairment; if title to the asset will be transferred at the end of the period and cost reflects this option depreciation of the asset shall be based on asset's entire useful life, otherwise, on the shorter of the useful life and the lease term, or - the revaluation model at the revalued amount less adjusted accumulated depreciation and accumulated impairment; if this refers to investment property accounted for under IAS 40, at fair value. The lease liability is subsequently changed: upwards by accruing interest; downwards by lease payments (interest and principal), and remeasurement of the liability due to: changes in the guaranteed residual value; changes in the future lease payments resulting from a change in an index or interest rate used to determine those payments; changes in the lease term; changes in the assessment of the purchase option. All adjustments to the lease liability shall also adjust the right-of-use asset and if the latter is fully depreciated they shall be accounted for as an expense in current profit or loss. Presentation and disclosure Statement of financial position Right-of-use separately from other assets or in the same class of assets (investment property shall be shown as such); 3

4 Lease liability separately from other liabilities. Statement of comprehensive income In current profit or loss Depreciation of the right-of-use asset Interest expense on the lease liability In other comprehensive income Revaluation Statement of cash flows Principal payments to cash flows from financing activities; Interest payments - to cash flows from operating or financing activities. Disclosures related to asset nature shall be made complying with the requirements of IAS 16, IAS 38 or IAS 40. The specific disclosure requirements of IFRS 16 itself relate to: the status and movements in the right-of-use asset and the finance lease liability, the accounted for income and expense, respectively, gains or losses. Additionally, disclosures shall also be made for lowvalue leases and short-term leases. Besides, the disclosure requirements related to risk exposure and the effects for the entity as provided for by IFRS shall also remain valid. Accounting treatment Lessor Substantially, the new Standard maintains the requirements and rules set out in IAS 17 on lease classification and accounting treatment operating or finance lease. A lease is a finance lease where the contract transfers substantially all the risks and rewards incidental to ownership/possession of an underlying asset. Indicators include: asset's economic life, present value of payments, ownership, specific nature of the asset, etc. An operating lease is any lease other than a finance lease. Accounting treatment Lessor Finance lease Initial recognition and measurement 4

5 At lease commencement date, a financial asset shall be recognised as a receivable at an amount equal to the net investment in the lease. The initial measurement of the net investment shall include: all direct costs related to the lease; the present value of the lease payments; and the present value of any guaranteed residual amount accruing to lessor, Subsequent measurement Subsequently, a lessor shall recognise finance income in current profit or loss over the lease term of a finance lease, based on a pattern reflecting a constant periodic rate of return on lessor's net investment. Lease payments over lease term shall be accounted for against decreasing principal and accruing lease interest receivable. Operating lease Lessor shall continue to account for the asset leased under operating lease in its statement of financial position, recognizing in its current expenses asset depreciation. The depreciation policy for leased assets shall be consistent with lessor's normal policy for similar assets, unless specific terms and conditions are provided for in the lease agreement. Initial direct costs arising upon lease negotiation and arrangement shall be capitalized to the value of the asset and recognized as an expense over lease term on the same basis as income. Lease income shall be recognized on a straight-line basis over lease term (even if not received on such a basis), unless another systematic basis is more representative of the benefits arising from the leased asset. Disclosure Finance lease The disclosures set out in IFRS 16 itself relate to the provision of information on: gain on sale of the asset; finance (interest) income from the net investment in the lease; other income based on variable lease payments, not included in the measurement of the net investment; material changes in the book value of the net investment; and a maturity analysis of lease payments for each of the years between 1 and 5 and in total for above 5 years, providing also a reconciliation between the undiscounted payments less the amount of unearned finance income and the net investment in the lease. The disclosures provided for in IFRS 7 also remain valid. 5

6 Additionally, disclosures are required to be made on the leasing activities and the risks related to those activities and the lease receivables. Operating lease The disclosures set out in IFRS 16 itself relate to the provision of information on: lease income; income from variable lease payments that are not linked to an index or interest rate; a maturity analysis of lease payments for each of the years between 1 and 5 and in total for above 5 years. The disclosures required by IAS 16, 38, 40, and 41 also remain valid. Similarly to finance lease, in the case of operating lease disclosures are also required on the type of leasing activity, the risks related thereto, the rights in leased assets and how management manages those rights. Sale and leaseback This type of transaction includes the sale by a lessee entity (seller) of an asset to a buyer-lessor and its lease back by the lessee entity. The accounting treatment of those transactions depends on whether the requirements for the recognition of a sale under IFRS 15 are satisfied. If IFRS 15's requirements are satisfied: Seller-lessee shall account for, as a result of the leaseback, a right-of-use asset at the proportion of the previous carrying amount that relates to the right of use retained in the sale. It shall account for the effect of asset disposal in current profit or loss only in respect of the portion transferred to the buyer-lessor; and Buyer-lessor shall account for the purchase of the asset in accordance with the relevant standards, i.e. IAS 16, IAS 38, IAS 40, and upon leaseback, account for the lease in accordance with the requirements of IFRS 16. If the fair value of the asset and/or the market rates of lease payments differ from the relevant contractual amounts, the differences shall be accounted for as prepayments or additional financing. If IFRS 15's requirements are not satisfied: Seller-lessee shall continue to account for the relevant asset and recognize financial liability equal to the transaction proceeds; and Buyer-lessor shall account for a financial asset equal to the transaction proceeds. 6

7 Both parties shall account for the financial liability, respectively the financial asset, as provided for in IAS 39 or IFRS 9, applying the rules on recognition, measurement, presentation and disclosure, including also the disclosures set out in IFRS 7. Implementation effects The implementation of this Standard would result in significant changes in the structure and key indicators of both the statement of financial position and the statement of profit and loss of certain lessees, in particular, merchants, hotels, shopping malls, airlines, etc). More specifically, it would lead to: recognition of new assets, and recognition of financial liabilities at material amounts, with a significant effect on the debt-to-equity ratio and ROCE; change in the type of expenditure and its allocation in different periods from lease payment (rentals) to depreciation charge and interest expense, from more constant expenditure by period to higher total expenses in earlier years of the overall period. with significant effect on key indicators such as EBIDTA, EPS. First-time adoption The transition provisions of this Standard set out two options: 1. Full retrospective application, or 2. Modified retrospective application which allows: Maintaining the classification under the old standard of contracts already effective at the date of transition; Maintaining the treatment of sale and leaseback transactions effected before transition; Measurement of the right-of-use asset and the lease liability (exemption from full retrospective restatement) at the date of transition. In modified retrospective application, no restatement is required for comparative information and the full cumulative effect is presented as an adjustment to the opening balance of retained earnings or another appropriate component of equity. The material herein is not exhaustive, is only of general nature and does not represent a specific advice or consultation. Should any additional questions arise please do not hesitate to contact us at tel.: 02/ , fax: 02/ , е-mail: office@afa.bg or at: 38, Oborishte Str., Sofia

In December 2003 the IASB issued a revised IAS 17 as part of its initial agenda of technical projects.

In December 2003 the IASB issued a revised IAS 17 as part of its initial agenda of technical projects. IFRS Standard 16 Leases In April 2001 the International Accounting Standards Board (IASB) adopted IAS 17 Leases, which had originally been issued by the International Accounting Standards Committee (IASC)