IFRS 16 Leases Breakfast Briefing Deloitte Financial Reporting Advisory

IFRS 16 Leases Breakfast Briefing Deloitte Financial Reporting Advisory

Introduction & Agenda Session # Topic Sub-Topic 1 Overview of IFRS 16 - Introduction - Definition of a lease - Measurement of asset and liability - Transition - Disclosure 2 Practical challenges - Discount rates - Data collation 3 Project Planning 4 U.S. GAAP versus IFRS 16 - IFRS 16 Project Planning - U.S. GAAP versus IFRS 16 5 Plan update - How is your plan progressing?

Overview of IFRS 16 Leases 3

Introduction 4

Highlights Effective for periods commencing on or after 1 January 2019 Shift in leasing principles IAS 17 Risk and rewards model IFRS 16 Control model IFRS 16 key change for lessees The finance lease/operating lease distinction under IAS 17 is no longer relevant under IFRS 16 for lessees. Instead, most leases will have to be recognised as right-of-use asset with a related liability, with subsequent accounting similar to the finance lease model under IAS 17. 5

Key Highlights Majority of operating leases on balance sheet Assets: Right-of-Use Asset Liabilities: Financing Significant impact on income statement & KPIs Finance costs Operating costs EBITDA Example KPIs Impacted: Gearing Ratio Asset turnover Current ratio 6

Definition of a lease 7

Definition of a lease - overview On transition can make policy choice whether to grandfather previous conclusions as to whether existing contracts are leases. Identified asset May be implicitly or explicitly specified. Is the asset physically distinct? If a capacity portion is it substantially all of the capacity? Supplier s substitution rights may mean no identified asset. No identified asset if supplier has both: Leases vs. service contracts The Now practical matters ability more whether to substitute something alternative is a lease or assets a throughout service the contract. period of use; and Identified asset Leases vs. service contracts Control: Right to direct use Control: Right to obtain benefit Control: Right to direct use Does the customer have the right to direct how and for what purpose the asset is used throughout the period of use? Relevant decisions may be type, when, where, whether output is produced. Decisions may be predetermined. Control: Right to obtain benefit Lessee has the right to obtain substantially all the economic benefits from that use over the life of the lease (rather than over the life of the asset). They would economically benefit from substitution. Lease and non-lease components Lease and non-lease components Expect to separate on basis of standalone prices but can choose not to. Definition of a lease 8

Illustrative examples Question: Is it a lease or a service contract? Background A manufacturing company, ProduceCo (the Hirer ), enters into a contract with a freight carrier, Transport Solutions (the Owner ), to transport goods on its behalf. Transport Solutions provides the truck and the driver to deliver the goods. This agreement is for a period of five years and the truck shall remain the exclusive property of Transport Solutions. The Hirer shall be entitled to make all relevant decisions regarding the use of the truck, including when the truck is in use, where it is used, and what goods it is used to transport. When not in use the truck may be kept at either the Hirer or the Owners premises. The Owner shall not be entitled to substitute the truck for a similar asset during the Lease Term. The Owner shall not be entitled to take possession of the truck during the Lease Term, unless the Hirer defaults on at least two consecutive payments. At the expiration of the Lease Term, the Hirer shall surrender the truck to the Owner by delivering the truck to the Owner or the Owner s agent in good condition and working order, (ordinary wear and tear is expected), as it was at the commencement of the Agreement. The Hirer shall pay 50,000 quarterly to the Owner, commencing on July 1, 2019 for the period of the Lease Term. 1. EQUIPMENT The Owner leases to the Hirer the following equipment Qty Manufacturer Model Description Unique ID New Not new Retained number 1 SteelWorks RC-08 Rail Truck car RC-081978 Y 1 SteelWorks RC-08 Rail Truck car RC-081979 Y 1 SteelWorks RC-08 Rail Truck car RC-081980 Y 9

Illustrative examples Solution: Is it a lease or a service contract? ProductCo has the right to control the truck identified in the contract, because: It has exclusive use of the truck, which gives it the right to obtain substantially all of the economic benefits from use of the identified assets. It has the right to determine how the truck is used at all points during the lease term meaning it has the right to direct the use of the identified asset. It is a lease! 10

Illustrative examples Question: Is it a lease or a service contract? Background Lets look at a different contract, for the use of the truck between Transport Solutions and another customer, ManuCo Inc. The contract between ManuCo and Transport Solutions requires Transport Solutions to transport a specified quantity of goods by using a specified type of truck in accordance with a stated timetable for a period of five years. The timetable and quantity of goods specified are equivalent to ManuCo having the use of the truck for five years. Transport Solutions provides the truck, drivers and engine as part of the contract. The contract states the nature and quantity of the goods to be transported and the type of truck to be used to transport the goods. Transport Solutions has a large pool of similar trucks that can be used to fulfil the requirements of the contract. Similarly, Transport Solutions can choose to use any one of a number of engines to fulfill each of ManuCo s requests and each engine could be used to transport not only ManuCo s but also the goods of other customers. The trucks and engines are stored at Transport Solutions premises when not being used to transport goods. 11

Illustrative examples Solution: Is it a lease or a service contract? There is no identified asset in this contract. As a result Solutions is only providing freight capacity to ManuCo s. This contract is a service contract and IFRS 16 does not apply. It is not a lease! 12

Recognition exemptions and practical expedients Lessee accounting Optional lessee recognition exemptions: Can straight-line expense and keep off-balance sheet: i) leases with a lease term of 12 months or less and no purchase options election made by class of underlying asset; and ii) leases where underlying asset has a low value when new (e.g. personal computers or small items of office furniture) election made on lease-bylease basis Treating an entire contract that contains a lease, as a lease: IFRS 16 only requires lessees to bring the lease component of a contract onbalance sheet. Payments for non-lease services such as maintenance or security are expensed as incurred. Allocation of contract payments between lease and service components made on basis of relative standalone prices: considerable judgement may be required to estimate. Lessee can elect, as practical expedient, to treat entire contracts that contain a lease as a single lease, removing the need for an unbundling exercise but increasing the liability and asset recorded. Accounting for leases on a portfolio basis: Where an entity has portfolios of leases with similar lease characteristics the standard permits the accounting to be on a portfolio basis, using estimates and assumptions for the portfolio, if it is not expected to result in materially different accounting. May be of particular relevance to leases of low value items of equipment, or short-term property leases. May be of particular relevance for multioccupancy properties such as office blocks, industrial estates, and shopping centres. Likely to apply to leases for items such as cars where they are all part of a master agreement. 13

Initial recognition 14

Lessee accounting The balance sheet Right-of-use asset and liability recognised on lease commencement under single model Liability Initially measured at present value of lease payments Lease term similar to IAS 17 ( reasonably certain ) Variable lease payments that depend on index or rate included in initial measurement using rate at commencement Subsequently remeasured (and asset adjusted) for changes in: lease term and purchase option assessments, using revised discount rate; and residual value guarantees and future lease payments resulting from index/rate changes, using original discount rate Asset Initially measured at amount of liability plus initial direct costs Adjusted for lease incentives, payments at or prior to commencement and restoration obligations Subsequently measured at cost less depreciation and impairment (unless investment property that is fair valued or belongs to class of PPE that is revalued) Test for impairment under IAS 36 (instead of onerous lease provisions) 15

Illustrative examples Question: Can you calculate the Right of Use Asset and the lease liability? Background A Landlord leases to a Tenant, and the Tenant rents from the Landlord the following premises: 1 Meadow Lane, Dublin (the Premises ). This agreement is for a period of ten years, commencing on March 1, 2020 ( the Lease Term ). The tenant has the option to extend the lease agreement for an additional five years, which is to be exercised before the end of the Lease Term. The Tenant shall pay 200,000 annually to the Landlord, with the first payment due for payment on March 1, 2020. The non-cancellable period of the Lease Term is two years. Should the Tenant terminate the lease after two years, a penalty fee will be payable to the Landlord. The penalty fee will comprise of the remaining payments + 15%. The contract signing date is 1 February 2020. Additional facts about the contact: It is reasonably certain that tenant will exercise the option to extend the lease for an additional five years. Initial direct costs have been incurred of 3,000. These fees related to professional fees including real estate commission fees and legal review of the lease agreement. The tentant s incremental borrowing rate has been assessed to be 8%, as the interest rate implicit in the contract cannot be readily determined. 16

Illustrative examples Solution: Can you calculate the initial Right of Use Asset and the lease liability? The interest rate implicit in the contract is not readily determinable so the tenant should use the incremental borrowing rate of 8% as the discount rate to calculate the PV of the lease payments. At the commencement date, the tenant shall measure the lease liability at the PV of the lease payments that are not paid at that date. As the first payment was due on the commencement date (i.e. 1 march) this was excluded from the calculation of the PV of the lease payment. Discount rate 8.00% The lease term used for computation is fifteen years (i.e. 10 years plus the option to extend the contract for another 5 years) as it is reasonably certain that tenant will exercise the option. Year Date Discount rate Payment Liability Right of use asset 0 01-Mar-20 1.00 200,000 200,000 1 01-Mar-21 1.08 200,000 185,185 185,185 2 01-Mar-22 1.17 200,000 171,468 171,468 3 01-Mar-23 1.26 200,000 158,766 158,766 4 01-Mar-24 1.36 200,000 147,006 147,006 5 01-Mar-25 1.47 200,000 136,117 136,117 6 01-Mar-26 1.59 200,000 126,034 126,034 7 01-Mar-27 1.71 200,000 116,698 116,698 8 01-Mar-28 1.85 200,000 108,054 108,054 9 01-Mar-29 2.00 200,000 100,050 100,050 10 01-Mar-30 2.16 200,000 92,639 92,639 11 01-Mar-31 2.33 200,000 85,777 85,777 12 01-Mar-32 2.52 200,000 79,423 79,423 13 01-Mar-33 2.72 200,000 73,540 73,540 14 01-Mar-34 2.94 200,000 68,092 68,092 15 01-Mar-35 2.94 - - 1,648,847 1,848,847 The right of use assets is measured at the present value of the expected lease payments at the commencement of the lease. 17

Illustrative examples Solution: Can you calculate the Right of Use Asset and the lease liability? Dr Right of use asset 1,848,847 Cr Lease liability 1,648,847 Cr Cash 200,000 Being the recording of the right of use asset and lease liability at inception at the present value of the lease payments over the lease term Dr Right of use asset 3,000 Cr Cash (Initial direct costs) 3,000 Being recording of the payment of initial direct costs. The right of use asset should include the initial direct costs of 3,000. 18

Other key considerations Sale and leaseback Profit on disposal is restricted to right of use asset transferred Disclosing expected impact IFRS 16 disclosure requirements IFRS 16 disclosure requirements Disclosure is more extensive than under IAS 17; judgement required to determine what to disclose and how. Impairment review Onerous lease provisions are a thing of the past; reviewing rightof-use asset for impairment may present new challenges. Impairment review Impact on KPIs/ratios Disclosing expected impact FRC and ESMA require expected impact of forthcoming standards to be disclosed. Subleases Subleases Sublease is classified as operating or finance. If a finance lease it is derecognized from the balance sheet. Wider considerations 19

Transition 20

Lessee accounting Transition Choice of transition approach determines impact on transition date balance sheet and future P&L Options for transitioning to IFRS 16 Effective for periods beginning on or after 1 Jan 2019 Earlier application permitted if IFRS 15 has also been applied Retrospective application or cumulative catch-up approach? This is a single choice that must be applied to all leases Option 1 retrospective Restate comparatives as if IFRS 16 always applied Not required to reassess whether a contract is, or contains, a lease at the date of initial application Challenge for systems to capture all data? Option 2 cumulative catch-up Leave comparatives as previously reported Any difference between asset and liability recognised in opening retained earnings at transition Carry forward existing finance lease liabilities Calculate outstanding liability for existing operating leases using incremental borrowing rate at date of transition Choose how to measure asset on lease-by-lease basis A lessee must make a single choice on how to transition Transition choice will impact net assets, distributable reserves and future P&L Option 2A Measure asset as if IFRS 16 had been applied from lease commencement (but using incremental borrowing rate at date of transition. Option 2B Measure asset at amount equal to liability (adjusted for accruals and prepayments) 21

Lessee accounting Transition Application of transition options example Example facts: 5-year lease, entered into on 1 Jan 2017; 100k payable on second day of each year. 8% discount rate at lease commencement; 12% discount rate at date of transition. Right-of-use asset is depreciated straight-line. Option 1 Option 2A Option 2B 22

Disclosure 23

The objective of the disclosures is for lessees to disclose information in the notes that, together with the information provided in the statement of financial position, statement of profit or loss and statement of cash flows, gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee. 24

Key disclosures Lessee accounting A lessee shall disclose information: In a single note or separate section in its financial statements. In a tabular format, unless another format is more appropriate. Disclosure is required of the expense recognised for shortterm leases and leases of low value assets when either practical expedient is used. Detail on sale and leaseback transactions Restrictions or covenants imposed by leases. Depreciation by class of underlying asset; income from sub-leases of right-of-use assets; interest expense; gains and losses on sale and leaseback transactions; and variable lease payments expensed. An explanation of any difference between: operating lease commitments disclosed applying IAS 17 at the end of the annual reporting period immediately preceding the date of initial application, discounted using the incremental borrowing rate at the date of initial application; and lease liabilities recognised in the statement of financial position at the date of initial application. Additional qualitative and quantitative information about its leasing activities is necessary. If a lessee uses one or more of the specified practical expedients in paragraph, it shall disclose that fact. Must maintain a record of low value leases. 25

Key disclosures Lessee accounting Meeting the disclosure objective Consider: 1. The flexibility provided by leases. 2. Restrictions imposed by leases. 3. Sensitivity of reported information to key variables. 4. Exposure to other risks arising from leases. 5. Deviations from industry practice. Additional information relating to extension options or termination options Additional information relating to residual value guarantees Additional information relating to variable lease payments 26

Practical challenges 27

Discount rates 28

Lessee accounting The discount rate Interest rate implicit in the lease The rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) (ii) the fair value of the underlying asset and Any initial direct costs of the lessor. Incremental borrowing rate The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the rightof-use asset in a similar economic environment. Determining appropriate discount rates The interest rate implicit in the lease should be used if it can be readily determined; otherwise, use the incremental borrowing rate. Determining the rate implicit in the lease requires knowledge of the underlying asset s residual value and its fair value; information unlikely to be readily available to lessees. 29

Lessee accounting The discount rate Why does it matter? Example fact pattern: On 1 Jan 2020, a company enters into 700 new 10-year leases with rentals of 48,000 each per year paid in arrears. Under IAS 17 it would have recognised a straight-line expense of 33.6m per year. Discount rate 5% 7% 10% Initial liability 259m 236m 206m Year 1 expense Year 5 expense Year 9 expense 39m 40m 41m 34m 35m 35m 29m 28m 26m Total payable 336m 336m 336m 30

Discount rate How to calculate an incremental borrowing rate Align weighted average payment term of the lease with the term for the source of the risk free rate Adjust risk free rates for unusual items such as hyperinflationary economies, currency unions and countries which use a currency that is not their own Risk free rate Ensure credit spread data points are relevant at the lease inception date Use credit spreads from debt that best matches the weighted average payment term of the lease, otherwise estimate Be aware that group funding policies may not be relevant considerations for determining the IBR Make an adjustment if there is benefit to the lender in the form of a secured asset Get data from banks or lenders as unlikely to have secured borrowing rates The IFRS 16 IBR is not: IAS 23 Borrowing Rate IAS 36 impairment discount rate 31

Some final thoughts The challenge doesn t end once you have some rates 32

Data Collation 33

Lease Information Collation Data Points Start & End Date Termination Purchase, Extension Clauses Monthly/ Annual Rent Charge Renewal Terms Future Restoration Costs Collars & Caps Service Element Payments Initial Direct Costs Is asset sublet Lease incentives Asset Identifiers Frequency of Lease Payments Asset value at new IRIIL Variable Lease Payment & Index Frequency of Rent Increases Fixed Rate Increase Percentage Guaranteed Residual Value 34

U.S. GAAP versus IFRS 16 35

U.S. GAAP and Dual reporters IASB s and the FASB s new leases standards Effective date Day 1 versus Day 2 There is no exemption for leases of lowvalue assets Leases recognised on the balance sheet Remeasurement assessment for leases tied to an index or rate Transition approach 36

Project Management 37

Illustrative IFRS 16 Timelines Interim FS IFRS 16 is much more than just an accounting change. Companies need to give consideration to the impact on data, systems, processes and controls and broader impacts including tax, remuneration, treasury and regulatory requirements. Project governance Train all staff Develop project plan, timeline of activities, resources (including structure) & budget Identify & engage key stakeholders Assess, analyse and prepare Perform readiness assessment Establish scope of IFRS 16 Develop accounting policy including transition Define data requirements Define technology strategy Implement Collect and analyse lease data Build lease calculator / lease models Implement required system changes Prepare draft IFRS 16 disclosures Embed Define business-asusual state objectives and implement changes Update financial reporting processes and controls Define test strategy Perform dry runs & UAT (as appropriate) Mitigate and strategise Share learnings and educate stakeholders Consider impacts on treasury, remuneration, performance measurement, and regulatory requirements Scrutinise significant contractual arrangements and future contract governance 38

Readiness and resources 39

Additional resources IAS Plus https://www.iasplus.com/en/standards/ifrs/ifrs-16 IFRS 16 website www.deloitte.com/ie/ifrs16-10-questions Deloitte e-learning IFRS 16 (basic) https://www.iasplus.com/en/publications/e-learning/ifrs-16-basic Deloitte e-learning IFRS 16 (advanced) https://www.iasplus.com/en/publications/e-learning/ifrs-16-advanced Deloitte Accounting Research Tool DART https://dart.deloitte.com/usdart Alternatively please refer to your Deloitte contact. 40

Questions 41

The Deloitte Team Kevin Butler Partner Audit & Assurance T: +353 (0)21 4907047 E: kevbutler@deloitte.ie John Kelly Director Audit & Assurance T: +353 (0)21 4207867 E: johkelly@deloitte.ie Oliver Holt Director Audit & Assurance T: +353 (0)1 4175731 E: oliverholt@deloitte.ie 42

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