IFRS 16 Complete Guide

Where to start

IFRS 16 is the new leasing standard, superseding IAS 17. The earliest period it is effective from is January 1st, 2019 (check your local jurisdiction). IFRS 16 has caused a lot of commotion due to the implementation and adherence to the standard’s requirements.

What has changed?

We still have the lessee & lessor classification. For lessors and lesses alike, most remains the same. However, the main change comes if you have an operating lease under IAS 17. In this case, you’re in for some major changes in how you’re currently accounting for those contracts under IFRS 16.

Those contracts will essentially become finance leases, which means they come on balance sheet. Under IFRS 16, the first thing you’ll do is recognize:

• A right-of-use asset - this represents the value of the item being leased
• Lease liability - the present value of the minimum future lease payments

Compared to IAS 17, there’s a lot more work involved for the finance teams to handle. With the new accounting standard, can have a tangible impact on how you run your business, including:

• New internal processes required for contract management
• Increased communication between finance teams and property & asset management teams
• Increased time for staff adhering to the financial reporting requirements
• Significant impact to your financial statements and reporting ratios i.e. EBITA

Most, if not all, business decisions are made with the accounting impacts considered later, and IFRS 16 is no different. What is important to understand, is how your finance team will continue to be in compliance with IFRS and IFRS’s new leasing standard.

Change of focus

Under IFRS 16 your auditors will no longer be concerned with whether it’s an operating or finance lease, but put the main focus on the step prior to that, to determine if it is this a contract lease and if it is in scope of IFRS 16.

New lease definition & practical expedients

IFRS 16 brings a new lease definition which you’ll have to adjust to your head around initially, however the standard setters have conveniently given you the option to grandfather in your previous assessments, if the contract contains a lease. In other words, you don’t have to retrospectively go back over all contracts and decide if they meet the definition of a lease under IFRS 16, which allows for you to apply a practical expedient.

Low value & Short term

The standard gives you two options where the lessee is not required to apply the lessee accounting model:

• Low value - when the lease is for a low-value item, the lessee can elect not to apply the new on-balance sheet accounting model. The value of the item that is to be assessed is the value of the asset when new the IASB has said this value is ~5k USD
• Short term - relates to short-term leases – i.e. leases with a term of 12 months or less, this can be applied from the transition date.

IFRS 16 is in scope, what now?

Is it a lease?

So the above practical expedients can’t be used, so now we’ll go through the following steps that apply with deciding if the contract meets the definition of a lease, under IFRS 16.

All of the above criteria must be met for it to be considered a lease under IFRS 16.

Lease Components

Lessees will often enter into a contract with lessors that includes a right to use multiple underlying assets. So when the underlying asset is considered to be a ‘separate lease component’, that is, a separate lease.

How to identify a separate lease component

Both of the above criteria must be met to be considered a separate lease component.

Non-lease components

It is not uncommon for a lease to contain a non-lease components. For example, a cleaning service offered in the renting of a building. There is no right of use asset available to the lessee for the service of cleaning. As a result, the standard allows you to calculate the stand alone selling price (if needed) of that service and remove those payments from the present value of future lease payments.

As a practical expedient, the lessee can elect, by class of underlying asset, is to not separate the non-lease components from lease components, and instead account for the entire arrangement as a single lease component (lease). This practical expedient can provide relief to lessees by reducing cost and complexity in some cases, however it will also result in higher lease liability and ROU Asset.

Initial recognition

Initial recognition - lease liability

Once the contract is deemed to be in the scope of IFRS 16, there are a number of considerations to make, which will have a direct impact on your debits and credits. Firstly, we’ll focus on the lease liability.

The lease liability consists of three inputs:

• lease payments: these are the contractually agreed upon future payments the lessee will pay to the lessor
• Lease term: the most reasonably likely period of time the lessee expects to use the ROU Asset.
• Discount rate: the rate used to present value the future lease payments

Lease payments

The below information is what the lessee has at the commencement of the lease and that they are reasonably certain to pay. Future market rent reviews, CPI & LIBOR increases cannot be accounted for at initial recognition as these increases are not known at the commencement of the lease.

As per IFRS 16, the inputs to the lease liability is the present value of the known future lease payments known at initial recognition (commencement of the lease). Here is precisely what the standard states when determining what lease payments are included in the lease liability:

Variable lease payments

The standard is confusing as it names variable lease payments to be included the future payments of the lease liability. If the payments are truly variable i.e. % of sales you will not know what you owe the lessor until communicated. These payments are expensed when incurred in the profit and loss and have no impact on the lease liability.

As mentioned above, for CPI, MRR & Libor, when the increased amount is communicated from the lessor, it will result in the remeasurement of the lease liability as you update the NPV calculation to reflect these future increases in payments.

Lease Term

One of the key judgemental areas auditors will focus on is the lease term. The lease term starts when the lessee takes control of the underlying asset. It also includes any rent-free periods provided under the lease contract.

The term also consists of the non-cancellable period plus the periods the lessee is “reasonably likely” to renew. If the lessee is reasonably certain to terminate the lease that would mark the end date of the lease.

When determining “reasonably likely”, the lessee also takes into consideration if there is any ‘economic incentives’ to exercise or not exercise an option. For example, in a property lease, significant leasehold improvements undertaken at inception that have a significant economic benefits for the lessee over the period covered by the option period.

The lessee does not reassess lease term unless a significant event or change in circumstances occurs that is within lessee’s control.

Discount Rate

Once the lease payments & term are set, there’s one last input to finish the NPV calculation and that’s the discount rate. This input is highly judgmental which will mean your auditors will love understanding why you chose 3% instead of 3.5%.

The standard instructs you to use the “rate implicit in the lease”, however if that can't be determined, it is acceptable to use the “incremental borrowing rate”. These are the same definitions found in IAS 17.

The rate implicit in the lease, can be extremely difficult for the lessee to determine, as you need to understand within the lease payment you’re making, what portion is for using the actual asset and what portion is the interest (as you didn’t pay all upfront).

The lessee's incremental borrowing rate is the rate that a lessee would have to pay on the initial recognition date of the lease for a loan of a similar term, and with similar security, to obtain an asset of similar value to the ROU asset in a similar economic environment.

With the 3 inputs mentioned above, you get a lease liability, allowing you to now tackle the right of use asset.

Here is the exact wording with IFRS 16:

Right of use asset (ROU Asset)

The above diagram is a great illustration of what values you input into the measurement of the ROU Asset. We’ll now go through each of those inputs you need to consider when recognizing your ROU Asset on the balance sheet.

Lease Liability

This is what you’ve just worked out, the foundation of the ROU Asset is the NPV calculation of the lease liability. As a result, if your lease liability is wrong your ROU Asset will be too!

Initial direct costs

A lessee’s initial direct costs are the incremental costs of obtaining a lease that would otherwise not have been incurred. These include examples such as:

• commissions
• legal fees (if contingent on origination of the lease)
• costs of negotiating lease terms and conditions (if contingent on origination of the lease)
• costs of arranging collateral

Items that are not considered to be an initial direct costs include:

• allocation of internal overhead costs e.g. those incurred by a sales or marketing;
• costs of evaluating a prospective lessee’s financial condition and costs to obtain offers for potential leases

Costs to dismantle and remove an underlying asset

The costs to dismantle and remove an underlying asset at the end of the lease term that are imposed by the lease agreement are also included in ROU asset if there is a provision to be recognised under IAS 37. For example, in many cases, the lessee is obliged to return the underlying asset to the lessor in a specific condition or to restore the site on which the underlying asset has been located. The lessee recognises a provision in accordance with IAS 37 with the other side of the entry to the ROU asset.

Transition options

Transition to IFRS 16

If the lease starts after the transition date, there’s no election to be made and you account for the lease following the above steps. For all leases that start before your transition date, you have a few decisions to make which will affect your lease liability and right of use asset calculations.

You must apply your decision to your entire lease portfolio, there’s no picking and choosing. If the lessee selects modified retrospective there are some practical expedients you can apply on a lease by lease basis.

As mentioned earlier, before you get to the choices of what transition method to use, there are a number of practical expedients that you can apply that may or may not take you out of the scope of IFRS 16.

Full restrospective

If the lessee selects the full retrospective transition option, it assumes you have always accounted with IFRS 16 in effect. The most complicated aspect of adopting this transition method is that you will have to reverse all accounting under IAS 17, and given you’re applying the standard retrospectively, you must do so in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors which:

• applies the standard to all leases in which it is a lessee
• restates its prior financial information
• recognises an adjustment in equity at the beginning of the earliest period presented
• makes the disclosures required by paragraph 28 of IAS 8 on a change in accounting policy

Why would you want to adopt a fully retrospective model? Well, it’s actually the most accurate transition method. It does require more work, however, it means your lease data has been captured from commencement for all active leases.

Refer to the below example to help illustrate the impact of the full retrospective model.

Modified retrospective

The standard setters have given some allowances when adopting IFRS 16 and those are available when the modified retrospective approach is adopted. The extent of these allowances will depend on what practical expedients you decide to take. Here at Cradle, we’ve called them the “simplified” method or the “modified retrospective”.

Simplified method

Adopting this method is the easiest way to get ahead of IFRS 16. As per the above diagram the ROU Asset is calculated from the transition date. What does this mean? You only need prospective lease information from the date of transition, so no digging through files to find modifications of a lease that commenced 20 years ago! The lease liability is also only calculated from the transition date.

There are only a few other inputs you need to consider when dealing with ROU Asset when using the simplified method: Prepayments: Let’s say when you were accounting for the lease under IAS 17 and your transition date is 1 January 2019. In December 2018, you prepaid a lease payment, before you consumed all of that prepaid asset, what happens at transition? Reverse out that prepayment and add it to your ROU Asset. Accrued payments: This is the exact same principle above, but instead of making a prepayment, you did not pay a lease payment when due, in that case, the amount owed is subtracted from the ROU asset. Onerous lease provision: You have an onerous lease provision raised against your current lease under IAS 17. Reverse the amount out and subtract from the ROU Asset (saves you having to impair it in the future)

If none of the above is applicable, all you need to do is work out the NPV of the lease liability at the transition date and you’ve got your ROU Asset as well.

So, what are the drawbacks of adopting the simplified approach?

Accuracy: you could technically argue that the accuracy of your lease will not be spot on, but if it was going to be “material” the standard setters would have never given you the option.

The positives are:

• No historic data required: account for all of your lease prospectively with the information you have at hand, at transition date.
• Cost: no need to dig up historical records, to do any other method you need to know what was happening between commencement and the transition date
• Restatement of financial statements: no need to apply IAS 8
• Uncomplicated: no need to start modification accounting until they occur after the transition date.

Modified retrospective method

The modified retrospective method is a more intensive method of adoption compared to simplified. As per the diagram you need to start accounting for the ROU Asset at commencement, but what that means is you also need to calculate the lease liability as that is the key input in the ROU Asset. By doing this from a calculation perspective you’re essentially following the exact process of full retrospective the only difference being you’ll use a discount rate at transition.

You’ll have to keep track of all modifications of the lease liability between commencement and transition as they impact the ROU Asset. As a result, this requires a far greater amount of work then simplified.

When transition happens you’ll pick up a ROU Asset value that’s not in-line with the lease liability, that’s a result of the ROU Asset being depreciated from commencement. The difference between those two values goes to retained earnings.

Subsequent measurement and modifications

When does modification accounting occur?

A lease modification is a change in the scope of a lease, or the consideration for a lease that was not part of its original terms and conditions. From a lease liability perspective, the key inputs that can be modified are:

• lease payments
• lease term

The standard classifies these contractual changes as either an increase or decrease in scope. An increase in scope results in the lessee having greater access to the underlying asset(s) either due to increase in term (control the asset for a longer period of time) or the scope of the asset has increased i.e. an extra vehicle. A decrease in scope is the opposite to the above, the lessee has a decrease in the right to use the asset either being the physical use i.e. one less vehicle or reduction in the lease term.

Does the modification result in a new lease?

Before applying modification accounting a key judgement needs to be made, does this result in a new lease?

A lessee accounts for a lease modification as a separate lease if both the following conditions exist:

• The modification results in a right to use one or more assets
• The consideration for the lease increase is equivalent to the stand-alone selling price (same definition as IFRS 15) for the increase in scope

If the above criteria are met, the lessee accounts for the modification as a new lease no different to any other lease.

If the conclusion is made that it is not a new lease, modification accounting is required.

Increase and decrease in scope

The accounting for increase and decrease in scope is different, so the first step is to work out if it’s an increase or decrease in scope. As noted above, an increase in scope is either an increase in lease payments or term and a decrease is a reduction of one of the two. For example:

• Increasing the scope: Adding the right to use one or more underlying assets, for example, an extra floor of a building
• Decreasing the scope: Removing the right to use one or more underlying assets – reducing the space rented in an office building.
• Increasing the scope: Extending the contractual lease term.
• Decreasing the scope: reducing the lease term of the leased asset

Decrease in scope

All decreases in scope affect both the lease liability and ROU Asset if there’s no impact on the ROU Asset - by either what you have the right to access (asset size) or a reduction in the term, it’s not a decrease in scope. For example, a decrease in fixed payments due to renegotiation of pricing which has no impact on the lease term or asset size, then you simply remeasure the lease liability and the balancing credit will go to the ROU Asset.

A decrease in the term length is accounted for differently to a decrease in the asset size.

Decrease in scope - decrease in term length

An example of this is the original lease agreement was 10 years, in year 2 of the lease it’s modified to 7 years. Correspondingly, the lease will now end in year 7, that’s 3 years less you no longer can access the ROU Asset. That decrease in scope would be calculated as 30% decrease (10 less 7 = 3 / 10 = 30%) in the ROU Asset.

Most importantly, with any decrease in scope, term length or reduction in asset size, the percentage decrease of the right to use the asset of the right of use asset must be captured.

Using Cradle with decreases in term length, we automatically calculate the decrease of the ROU Asset percentage for you.

Decrease in term length calculation methodology

There are two key aspects of the calculation:

1. Calculate the gain or loss of the decrease in scope, which is driven by the difference between the ROU asset and lease liability applying the ROU percentage decrease.
2. The remeasurement of the lease liability using an updated discount rate.

The steps are:

1. Calculate the ROU asset carrying value before modification
2. Calculate and apply the ROU asset % reduction to the ROU asset
3. Calculate the lease liability carrying value pre-modification & post modification using the current discount rate
4. Calculate gain and loss: this is the balancing entry between the difference between the lease liability and right of use asset.
5. True up the lease liability based on a new discount rate based on the mvflp with the balancing side to the right of use asset

That may seem confusing, so let’s walk through an example of how to calculate the decrease in scope for a reduction in the lease term.

Decrease in scope - asset size

The other type of decrease in scope is decrease in asset size. For example, the original lease agreement was for 2 floors in a building, turns out you only need one floor and renegotiate new terms with the lessor to remove the additional floor. This is a decrease in the scope of asset size, in this case, a 50% reduction of the ROU Asset. The standard has prescriptive guidance on how to account for these scenarios and like a decrease in the lease term, a gain/loss calculation to the profit and loss is required. Followed by a true-up of the lease liability using the latest discount rate.

The steps are:

• Calculate the ROU asset pre-modification
• Calculate the ROU asset % decrease and apply to ROU asset
• Calculate lease liability pre-modification amount & apply % asset decrease to lease liability
• Calculate the gain/loss
• True up the lease liability based on the mvflp

Increase in scope

Assuming the modification does not result in a new lease, the lessee’s ability to use the right of use asset has increased, unlike decrease in scope all increases are accounted for the same way, that is an increase in asset size i.e. leasing an additional floor of office space or increasing the term of the lease. When this occurs, the lessee remeasures the lease liability based on the updated future payments to be incurred, this will increase the liability and in turn, the other side of the journal (Dr) will go to increasing the ROU Asset.

IFRS 16 adoption process

After digesting the information above, you may have even more questions than answers. The first question might be where to start and what to do with all my leases currently under IAS 17 as operating leases?

Where to start

The first thing you’ll need to do is select your transition method. If the simplified method is adopted you’ll need no historic information, if any other method is chosen (full or modified retro) you’ll need all historic leasing details to account under IFRS 16 correctly.

Process and record keeping

One of the biggest challenges of IFRS 16 will be ensuring your company’s processes and record-keeping are adequate. Previously under IAS 17, changes under operating leases didn’t require much attention, the invoice was paid and there was a lease expense recognised in the P&L.

This has all changed under IFRS 16, changes to lease contracts need to be tracked and accounted for (not just by accounts payable), as these changes can have a material impact on a company’s financial statements. Who is going to manage the lease portfolio? Do you have a lease management team or is the finance team going to do it?

Regardless, a member of the finance team will need to perform the initial recognition NPV calculations for all leases previously classified as operating leases under IAS 17 which isn’t a step to take lightly.

To perform these tasks is going to require a significant amount of time, that’s the reason why Cradle will do it all for you, literally.