Back in January 2019, it was reported that ongoing issues around public sector compliance with the new lease accounting standard, IFRS 16, had been recognised by The Financial Reporting Advisory Board (FRAB), the oversight body for accounting framework compliance across the public sector.
With those "ongoing issues", the onerous nature of the transition to IFRS 16, and the strain on internal resources undoubtedly felt as a consequence of the COVID-19 pandemic the following was issued to reflect that -
Update December 2020: In light of COVID-19 pressures, HM Treasury, the Financial Reporting Advisory Board (FRAB) and the CIPFA LASAAC Local Authority Accounting Code Board have agreed to defer the implementation of IFRS 16 Leases in the public sector a further year, until 1 April 2022.
IFRS 16 - A quick overview
IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases and replaces the previous Standards IAS 17 Leases and related IFRIC and SIC Interpretations. The IASB published IFRS 16 with the aim of improving the recognition of assets in use and the associated liabilities for those assets by requiring lessees to treat assets and liabilities arising from operating leases just as they would for finance leases. This single lessee accounting model means that though an entity’s balance sheet and P&L might both be impacted the result would give a more faithful and transparent picture of the lessee’s financial leverage and capital employed.
The deferral guidance issued by CIPFA/LASAAC, back in December 2018, will remain just as pertinent now –
“The CIPFA/LASAAC would encourage local authorities to continue to progress with their plans for implementation and ensure that they have the information, processes and systems in place”.
Our own experience, with NHS bodies, tells us that for many years, there has been a desire for -
- Better lease management
- Improved lease terms and rates
- Timely serving of termination notices
- Asset return conditions
- True and transparent lease accounting
The implementation of IFRS 16 represents an opportunity to achieve both "true and transparent" lease accounting and a process that accomplishes those additional requirements. With transparency in mind uncertainty around what leases should be included, has left entities questioning their ability to prepare for, meet and report on those IFRS 16 lease accounting requirements.
So just what constitutes a lease under IFRS 16?
IFRS 16 defines a lease contract as one that -
“conveys the right to control the use of an identified asset for a period of time in exchange for consideration”.
Financial Reporting Manual (FReM) broadens the standard IFRS 16 lease definition to include two further types of arrangement.
- Intra-UK government agreements - though not legally enforceable they are similar in nature to enforceable contracts whereby “control” of an “identified asset” is transferred.
- Contracts that transfer the right to “control” an “identified asset” between two public bodies with nil consideration
If an asset is specifically detailed in a contract and the supplier has no right of substitution, then it qualifies as an "identified asset".
If the lessee has the right to obtain “all of the economic benefits” from the use of the asset and the right to direct its use, then the lessee has "control" of the identified asset.
How are the different types of leases treated under IFRS 16
Short Term Leases having 12 months or less to run can continue to be expensed rather than capitalised. Any lease that includes a purchase option cannot qualify as a short-term lease. The recognition and measurement exemption for short-term leases in IFRS 16 is made by class of underlying asset.
Examples of short-term leases typical within the public sector include software licences, specialised equipment, hire cars and some property leases.
Low Value Asset Leases can be treated likewise, but in the absence of a threshold in IFRS 16, adopters will need to review their asset portfolios against the official guidance to determine whether any leases qualify for this exemption – if adopted then the treatment applies to all assets of that type. The separate “general materiality” consideration applicable to all reporting standards can also be utilised where the effort to report outweighs the improvement in the quality of reported information.
Whilst a numerical threshold as to what constitutes a low value lease is not provided under IFRS 16, it does provide some examples of low-value underlying assets. These include small items of office furniture, personal computers/tablets and telephones. Under the standard, it explicitly establishes that a car would not qualify as a lease of a low-value asset.
Operating Leases, other than those that might be exempted by the above can no longer be treated as an expense but will need to have the "identified asset" or "right of use" asset placed on the balance sheet together with an associated monetary liability.
Reviews of "Service Agreements" may reveal a lease component as well as the service element. Public Sector bodies will have the option of separating the lease and service components such that only the lease elements need be capitalised in the balance sheet. For existing contracts, the identification and separation of these components is not compulsory, and where it might prove costly, complicated or immaterial the option of leaving the service and leasing elements together and accounting for the contract as previously is available to the lessee.
The treatment of "Finance Leases" remains broadly as before but where they have become “Peppercorn Leases", the FReM states that
“they will need to be measured at their current value, based on the way in which the asset is being used by the lessee or else based on the asset’s fair value”.
Exceptions such as "heritage assets" will need to be measured in accordance with the specific rules relating to that type of asset – in this case
- Market approach: uses prices generated by market transactions for identical or similar assets to determine value.
- Cost approach: this approach reflects the amount required to replace the service capacity of an asset.
Preparation for IFRS 16?
Collation –The lease data and disclosure requirement under IFRS 16 is substantially larger than it was under IAS 17. Collating, extracting and validating the relevant lease data from contracts or locating the requisite data from various systems/databases is extremely challenging and demands a significant level of resource. In anticipation, Public sector bodies should look to consolidate their lease data on to a single centralised data respiratory that will enable them to manage, maintain and report on a complete and accurate lease population more efficiently.
Discount Rate – IFRS 16 requires the lease liability to be discounted using the rate implicit in the lease, or where this is not readily determined, the lessee’s incremental rate of borrowing. The incremental rate of borrowing is defined as 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 right-of-use asset in a similar economic environment. For the Public Sector where entities cannot readily determine the interest rate implicit in the lease, they will instead be required to use the HM Treasury discount rate promulgated in PES (public expenditure system) papers as their incremental borrowing rate, unless the entity can demonstrate that another discount rate would more accurately represent their incremental borrowing rate. In that case, they shall use that rate as their incremental borrowing rate.
Impact Modelling – undoubtedly if a public body leases then IFRS 16 will impact the way its financial statements and prudential indicators are reported and then viewed by all interested parties including lenders, lessors, auditors and the public. A lessee is required to recognise assets and liabilities for leases with a term of more than 12 months, unless the underlying asset is of low value. A lessee is required to recognise a right-of-use asset representing its right to control the use of the identified asset together with a lease liability reflecting its obligation to make lease payments. As a consequence, a lessee also recognises depreciation of the right-of-use asset and interest on the lease liability and classifies cash repayments of the lease liability into a principal portion and an interest portion and presents them in the statement of cash flows applying IAS 7 Statement of Cash Flows.
There is software modelling available and one such trusted and well proven solution is Innervision’s LOIS Lease Accounting (LLA). Such a solution can allow a lessee to load leases, compare the effect of available expedients, cater for the whole life of a "right of use asset" (including upgrades and extensions), reclassify leases, analyse exemptions and generate the reports and journal entries to enable correct recording in your ledgers. Impact modelling allows the lessee to choose the most suitable path within the guidelines and alert those interested parties via disclosures in the 2020-21 accounts.
How Lease Accounting Software can help public sector bodies comply with IFRS 16
Innervision’s lease accounting solution - LOIS Lease Accounting (LLA), is a cloud-based application designed specifically to address the accounting requirements of the new IFRS 16 accounting standard and help minimise the associated audit risk. The system allows users to comply with the complex requirements of standards and manage all lease asset types, ranging from IT, plant and machinery to material handling equipment, vehicles, and property.
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Disclaimer: this article contains general information about the new lease accounting standards only and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.