IFRS 16

IFRS 16: Leases

IFRS 16 specifies how an IFRS reporter will recognise, measure, present and disclose leases.

IFRS 16 Leases prescribes a single lessee accounting model that requires the recognition of asset and corresponding liability for all leases with terms over 12 months unless the underlying asset is of low value. Lessors continue to apply a two-model approach.

The objective of the standard is to ensure that lessees and lessors provide relevant information that faithfully represents those transactions.

Lease

A lease is an agreement whereby the lessor (the legal owner of an asset) conveys to the lessee (the user of the asset) the right to use an asset for an agreed period of time in return for a payment or series of payments.

The approach of IAS 17 (the old Lease Standard) was to distinguish between two types of lease. Leases that transfer substantially all the risks and rewards of ownership of an asset were classified as finance leases. All other leases were classified as operating leases. The lease classification set out in IAS 17 was subjective and there was a clear incentive for the preparers of lessee’s financial statements to ‘argue’ that leases should be classified as operating rather than finance leases in order to enable leased assets and liabilities to be left out of the financial statements.

It was for this reason that IFRS 16 was introduced.

Scope

IFRS 16 Leases applies to all leases, including subleases, except for:

• leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
• leases of biological assets held by a lessee (see IAS 41 Agriculture);
• service concession arrangements (see IFRIC 12 Service Concession Arrangements);
• licences of intellectual property granted by a lessor (see IFRS 15 Revenue from Contracts with Customers); and
• rights held by a lessee under licensing agreements for items such as films, videos, plays, manuscripts, patents and copyrights within the scope of IAS 38 Intangible Assets

A lessee can elect to apply IFRS 16 to leases of intangible assets, other than those items listed above.

Recognition exemptions

Instead of applying the recognition requirements of IFRS 16 described below, a lessee may elect to account for lease payments as an expense on a straight-line basis over the lease term or another systematic basis for the following two types of leases:

• leases with a lease term of 12 months or less and containing no purchase options – this election is made by class of underlying asset; and
• leases where the underlying asset has a low value when new (such as personal computers or small items of office furniture) – this election can be made on a lease-by-lease basis.

The assessment of whether an underlying asset is of low value is performed on an absolute basis. Leases of low-value assets qualify for the simplified accounting treatment regardless of whether those leases are material to the lessee. The assessment is not affected by the size, nature or circumstances of the lessee. Accordingly, different lessees are expected to reach the same conclusions about whether a particular underlying asset is of low value.

An underlying asset can be of low value only if:

• The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee; and
• The underlying asset is not highly dependent on, or highly interrelated with, other assets.

A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value.

Examples of low-value underlying assets can include tablet and personal computers, small items of office furniture and telephones.

Identifying a lease

A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

Control is conveyed where the customer has both the right to direct the identified asset’s use and to obtain substantially all the economic benefits from that use.

An asset is typically identified by being explicitly specified in a contract, but an asset can also be identified by being implicitly specified at the time it is made available for use by the customer.

However, where a supplier has a substantive right of substitution throughout the period of use, a customer does not have a right to use an identified asset. A supplier’s right of substitution is only considered substantive if the supplier has both the practical ability to substitute alternative assets throughout the period of use and they would economically benefit from substitution.

A capacity portion of an asset is still an identified asset if it is physically distinct (e.g. a floor of a building). A capacity or other portion of an asset that is not physically distinct (e.g. a capacity portion of a fibre optic cable) is not an identified asset, unless it represents substantially all the capacity such that the customer obtains substantially all the economic benefits from using the asset.

The right to direct the use of the asset

IFRS 16 states that a customer has the right to direct the use of an identified asset if either:

• The customer has the right to direct how and for what purpose the asset is used throughout its period of use; or
• The relevant decisions about use are pre-determined and the customer has the right to operate the asset throughout the period of use without the supplier having the right to change these operating instructions.

Separating components of a contract

For a contract that contains a lease component and additional lease and non-lease components, such as the lease of an asset and the provision of a maintenance service, lessees shall allocate the consideration payable on the basis of the relative stand-alone prices, which shall be estimated if observable prices are not readily available.

As a practical expedient, a lessee may elect, by class of underlying asset, not to separate non-lease components from lease components and instead account for all components as a lease.

Lessors shall allocate consideration in accordance with IFRS 15 Revenue from Contracts with Customers.

Key definitions

Interest rate implicit in the lease

The interest rate that yields a present value of (a) the lease payments and (b) the unguaranteed residual value equal to the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

Lease term

The non-cancellable period for which a lessee has the right to use an underlying asset, plus:

• Periods covered by an extension option if exercise of that option by the lessee is reasonably certain; and
• Periods covered by a termination option if the lessee is reasonably certain not to exercise that option

Lessee’s 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 right-of-use asset in a similar economic environment.

Gross investment in the lease

The sum of: (a) the lease payments receivable by a lessor under a finance lease; and (b) any unguaranteed residual value accruing to the lessor.

Net investment in the lease

The gross investment in the lease discounted at the interest rate implicit in the lease.

Unguaranteed residual value

That portion of the residual value of the underlying asset, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor.

Accounting by lessees

Upon lease commencement a lessee recognises a right-of-use asset and a lease liability.

Recording the asset

The ‘right of use asset’ would include the following amounts, where relevant:

• Any payments made to the lessor at, or before, the commencement date of the lease, less any lease incentives received.
• Any initial direct costs, incurred by the lessee
• An estimate of any costs to be incurred by the lessee in dismantling and removing the underlying asset, or restoring the site on which it is located (unless the costs are incurred to produce inventories, in which case they would be accounted for in accordance with IAS 2 – Inventories). Costs of this nature are recognised only when an entity incurs an obligation for them. IAS 37 – Provisions, Contingent Liabilities and Contingent Assets would be applied to ascertain if an obligation existed.
• Adjustments may also be required for restoration obligations or similar.

Depreciation

After lease commencement, the right of use asset is subsequently depreciated. Depreciation is over the shorter of the useful life of the asset and the lease term, unless the title to the asset transfers at the end of the lease term, in which case depreciation is over the useful life.

A lessee shall measure the right-of-use asset using a cost model, unless:

• The right-of-use asset is an investment property and the lessee fair values its investment property under IAS 40; or
• The right-of-use asset relates to a class of PPE to which the lessee applies IAS 16’s revaluation model, in which case all right-of-use assets relating to that class of PPE can be revalued.

Under the cost model a right-of-use asset is measured at cost less accumulated depreciation and accumulated impairment.

Lease Liability

The lease liability is initially measured at the present value of the lease payments payable over the lease term, discounted at the rate implicit in the lease if that can be readily determined, as the effective interest rate. If that rate cannot be readily determined, the lessee shall use their incremental borrowing rate.

Variable lease payments that depend on an index or a rate are included in the initial measurement of the lease liability and are initially measured using the index or rate as at the commencement date. Amounts expected to be payable by the lessee under residual value guarantees are also included.

Variable lease payments that are not included in the measurement of the lease liability are recognised in profit or loss in the period in which the event or condition that triggers payment occurs, unless the costs are included in the carrying amount of another asset under another Standard.

The lease liability is subsequently remeasured to reflect changes in:

• the lease term (using a revised discount rate);
• the assessment of a purchase option (using a revised discount rate);
• the amounts expected to be payable under residual value guarantees (using an unchanged discount rate); or
• future lease payments resulting from a change in an index or a rate used to determine those payments (using an unchanged discount rate).

The remeasurements are treated as adjustments to the right-of-use asset.

Lease modifications may also prompt remeasurement of the lease liability unless they are to be treated as separate leases.

Covid-19-related rent concessions

A lessee may elect not to assess whether a COVID-19-related rent concession is a lease modification. A lessee that applies the exemption accounts for COVID-19-related rent concessions as if they were not lease modifications.

Accounting by lessors

Lessors shall classify each lease as an operating lease or a finance lease.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Otherwise a lease is classified as an operating lease.

Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

• the lease transfers ownership of the asset to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised
• the lease term is for the major part of the economic life of the asset, even if title is not transferred
• at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
• the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made

Upon lease commencement, a lessor shall recognise assets held under a finance lease as a receivable at an amount equal to the net investment in the lease.

A lessor recognises finance income over the lease term of a finance lease, based on a pattern reflecting a constant periodic rate of return on the net investment.

At the commencement date, a manufacturer or dealer lessor recognises selling profit or loss in accordance with its policy for outright sales to which IFRS 15 applies.

A lessor recognises operating lease payments as income on a straight-line basis or, if more representative of the pattern in which benefit from use of the underlying asset is diminished, another systematic basis.

Sale and leaseback transactions

To determine whether the transfer of an asset is accounted for as a sale an entity applies the requirements of IFRS 15 for determining when a performance obligation is satisfied. The relevant performance obligation would be the effective ‘transfer’ of the asset to the lessor by the previous owner (now the lessee)

If an asset transfer satisfies IFRS 15’s requirements to be accounted for as a sale:

• the seller measures the right-of-use asset at the proportion of the previous carrying amount that relates to the right of use retained. Accordingly, the seller only recognises the amount of gain or loss that relates to the rights transferred to the buyer.

• The buyer-lessor shall account for the purchase of the asset applying applicable Standards, and for the lease applying the lessor accounting requirements in IFRS 16 (these being essentially unchanged from the predecessor standard)

If the fair value of the sale consideration does not equal the asset’s fair value, or if the lease payments are not market rates, the sales proceeds are adjusted to fair value, either by accounting for prepayments (for below-market terms) or additional financing (above-market terms provided by the buyer-lessor to the seller-lessee).

Transaction not constituting a ‘sale’

In these circumstances the seller does not ‘transfer’ the asset and continues to reconise it, without adjustment. The ‘sales proceeds’ are recognised as a financial liability and accounted for by applying IFRS 9 – Financial Instruments. In the same circumstances, the buyer recognizes a financial asset equal to the ‘sales proceeds’.

Disclosure

The objective of IFRS 16’s disclosures is for information to be provided in the notes that, together with information provided in the statement of financial position, statement of profit or loss and statement of cash flows, gives a basis for users to assess the effect that leases have. Paragraphs 52 to 60 of IFRS 16 set out detailed requirements for lessees to meet this objective and paragraphs 90 to 97 set out the detailed requirements for lessors.

Further Information