With the transition to and on-going compliance with IFRS 16 Leases, lessees will be required to bring most if not all of their leases, that is each “right of use asset” (ROU) and its associated liability, onto their balance sheets.
The associated lease liability for each ROU is calculated as the present value of the outstanding committed lease payments. The impact of this change in accounting practice on the financial reports will depend very much on which lease payments are included in the liability initially and then onwards during the lease term.
The new standard simplifies things in one way by doing away with the necessity for lessees to forecast future liabilities based on sales, usage or inflation but there are fundamental rules with IFRS 16 that vary current practice in important ways.
As an example, under the new standard certain lease liabilities are reassessed over the term of the lease each time there is a recognisable change in the length of term or an option relating to the ROU is exercised. This volatility has an obvious impact on the next balance sheet but also highlights a new requirement in reporting lease transactions – a solution able to determine the revised lease payments, once again amortise the ROU and report the associated lease liability.
Under IFRS 16 what type of payments should be included in the lease liability?
The lessee will need to calculate the lease liability from the commencement date based on the present value of lease rentals outstanding at that time. The discount rate applied will be the actual interest rate or the incremental borrowing rate of the lessee. See IFRS 16.27.
Lease payments used to measure the lease liability at commencement date include the following (to the extent they have not yet been paid):
- fixed rentals (including in-substance fixed payments), less any lease incentives receivable;
- variable lease payments that depend on an index or rate;
- amounts expected to be payable by the lessee under any residual value guarantees;
- the full cost of any purchase option which the lessee is reasonably certain to exercise; and
- payments for terminating the lease where it is reasonably certain that an early termination option will be exercised.
For clarification, “In-substance” fixed lease payments are payments whose form appears to contain some variability although they are, in substance, unavoidable. This can occur where:
- payments are structured as variable but there is no genuine variability in those payments
- there is more than one set of payment options described in the lease but only one set of those payments is realistic, or
- there is more than one realistic set of payments described in the lease, but the lessee must select at least one of those sets of payments.
Under IFRS 16.15 what type of payments are excluded from the lease liability?
Unless they apply the practical expedient in paragraph 15, the new standard requires lessees to separate lease and any non-lease components of a contract. See IFRS 16.15
- non-lease components – proportion of rental for initial and on-going services, and
- any variation in lease rentals that depend on sales or usage of the underlying asset.
Has the treatment of “payments” changed?
The simple answer is yes and yes again. Under IAS 17 the lessee was expected to report minimum payments with regard to rentals and the maximum exposure with regard to residual guarantees, buy out costs or early termination costs. Additionally, it was generally accepted that the assets and liabilities associated with a lease were not restated if things changed – even if they changed drastically. The various options impacted the classification of the lease rather than the associated liabilities.
IFRS 16 introduces the concept of “reasonably certain to exercise an option” – a concept that has to be continually revisited during the term of the lease, as any change at any time in the likelihood or otherwise to –
- exercise an option to extend the lease term
- terminate early
- buy out the asset
- affect residual guarantee
results in a new requirement to remeasure the lease liability. This now introduces new financial statement volatility in gross assets and liabilities where there was none before. Lessees will need to develop new processes to keep these options under review and to document their assessment at each reporting date.
Finally, we can look at lease contracts that depend on indexing and thus have the potential for genuine rather than “in-substance” variable lease payments, often applicable to property leases. We are not talking about fixed rental increases but those based on a movement in perhaps –
- Producer price indices (PPIs).
- Consumer price index (CPI).
- Retail prices indices (RPIs).
- House price indices.
- Average earnings indices.
In such circumstances, the lessee initially calculates the lease liability based on the commencement date committed rentals amounts. At the end of Year 1, if as a result of a change in the index an increase in rental follows then the revised lease liability based on the variable payments for Year 2 and beyond is adjusted to reflect the change based on an unchanged discount rate. The adjustment is calculated as the difference between the original lease payments and the reassessed payment over the remaining lease term, discounted at the original discount rate. Similarly, an adjustment may follow for each year depending on the volatility of the index used.
With IFRS 16 the new payment requirements are designed with transparency and simplicity at the fore.
Whilst lessees no longer need forecast future lease payments dependent on sales, usage or inflation, the detailed rules do vary from the traditional treatment of leases in several different but key areas.
One such area is the balance sheet which now has a volatility not previously associated with it as a result of certain lease payments being reassessed and possibly reassessed again over the term of the lease depending on the “reasonable certainty” of available options being exercised, with the associated lease liability on the “volatile” balance sheet being adjusted accordingly.
For companies that apply the modified retrospective approach in transitioning leases, the new standard does permit the use of hindsight, an expedient not available with fully retrospective. Most companies and operations will have transitioned or be well down the path of compliance by now, but as suggested above the pitfalls are still there. Lessees are well-advised to investigate and implement robust and proven software solutions to assist them in the continual remeasurement of lease liabilities. To view a system that simplifies any ongoing remeasurement under the new standard and that encourages you to deploy new processes, that is transparent to your auditors and works with you to keep compliance on track request a demo of the Innervision lease accounting solution today.
For additional information on the new IFRS 16 standard and guidance on how to comply, download the '7 Step Guide to Lease Accounting Compliance' – just follow the link below to access your copy.
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.