Troubles with IFRS 16 Leases
The new lease standard IFRS 16 can initially cause some troubles to the affected companies, because it introduces huge changes in the lessee’s accounting for leases.
It was issued in January 2016 and we have to apply it for the periods starting 1 January 2019 or later, with earlier application permitted.
I wrote an article that illustrates the main differences between the older standard IAS 17 and the new standard IFRS 16 here and I have been receiving a lot of questions about its practical application since then.
Therefore today, I’d like to outline the main challenges related to the application of the new IFRS 16 and the main impacts that you should be looking at.
Some companies are greatly affected, some companies are affected just a little bit – this depends on the specific circumstances, such as:
- Are you a lessee or a lessor?
- Are your operations centralized or decentralized?
- Are you currently using finance leases or operating leases?
- Are most of your leases under 1 year?
And many others factors.
What has changed by IFRS 16?
Let me shortly sum up the main changes introduced by IFRS 16:
- Single accounting model for all leases (lessees only)
Lessees will NOT classify the leases as finance or operating. Instead, all leases are recognized in the balance sheet, similarly as finance leases before the change.
There are 2 exceptions: leases under 1 year and leases of low value assets when new. Lessees can account for the payments under these leases straight in profit or loss.
I would also like to point you to the IFRS Kit that now contains 13 detailed videos with lots of illustrative examples solved in Excel about IFRS 16 Leases. It runs almost 3 hours and after watching it, you’ll understand what and how to do. (Just a note – there’s more than 110 IFRS videos inside the IFRS Kit, with total running time of almost 40 hours, just to make the things clear).
- No significant change in lessor’s accounting
That’s the good news!
- Sale and leaseback transactions
The accounting for sale and leaseback transactions depends on whether the sale meets the definition of a sale under IFRS 15 Revenue from Contracts with Customers.
This is a good change, because IAS 17 Leases was very messy and you really needed to think twice what type of sale and leaseback you assess.
- More disclosures required
The change n. 1 can have a HUGE impact on the company’s operations, taxes and financial position.
Also, exactly the change n. 1 can cause a headache when trying to implement it.
The reason is that while the accounting for operating leases was very easy and straightforward under IAS 17, IFRS 16 requires you to gather substantially more information to make it happen.
Which industries are the most affected?
It’s difficult to assess the reality, because this is still very fresh and as far as I know, not many companies have completed the adoption of IFRS 16 and its impact (I’m writing this in April 2017).
However, a number of reports and preliminary assessments warn the following industries to watch out and start the implementation early:
- Retail and consumer products
These industries largely use assets owned by other parties and often, the contracts are not directly titled “lease contract”, but the leases can be hidden in the service contracts.
I’m not referring solely to the rent of premises, but also to the arrangements related to the towers, transmission devices, ATMs, data storage facilities and other.
Financial impacts of IFRS 16
Impact on the financial statements
Lessees will bring the operating leases from off-balance sheet to the balance sheet by showing the assets and liabilities related to these leases.
Also, the expense structure will change in profit or loss, because before the change, all operating lease expenses were shown under “operating expenses”, but now, a part of them falls under the “depreciation” (you depreciate the right-of-use asset) and a part of them falls under the “finance cost” or interest expense.
As a result, your EBITDA changes. This is clearly illustrated in this picture:
If you have more assets and liabilities in your financial statements, that can also affect your financial indicators, like ROA (return on assets) – this is likely to go down, due to about the same profit in comparison with higher assets.
Let me make one thing clear: IFRS do NOT tell you how much tax you should pay. It’s your local tax legislation that prescribes how to calculate your tax payable.
Now, when lessees stop recognizing operating lease payments in profit or loss in full amount, but instead, they start accounting for the depreciation of the right-of-use asset and an interest expense, will these expenses be deductible for your income tax purposes?
I don’t know. You should look to your own tax law. But let me describe how it works in our country.
Here, only a lessor can deduct the depreciation charge, not the lessee under the operating lease.
In this case, under IFRS 16, both lessor and lessee will show some asset in their financial statements (not in the same amount), but only the lessor can depreciate the asset for the tax purposes.
The lessee will depreciate only for accounting purposes and in his tax return, the accounting depreciation charge is tax non-deductible and will be added back to the net profit for the purpose of current tax liability calculation.
On the other hand, the lease payments made by the lessee are fully tax-deductible (for operating leases). So these payments will be deducted from the lessee’s accounting profit to arrive at the taxable profit.
I hope that the national legislations of countries that adopted IFRS will acknowledge this change, too and will be amended.
Meanwhile, you have no other choice but to recognize a LOT of deferred taxes. Not a LOT due to their amount, but due to the complexity of tracing and following up its changes.
Main difficulties with IFRS 16 Leases
Is there a lease in the contract?
IFRS 16 defines a lease as a contract (or a part of it) that conveys the right to use an asset for a period of time in exchange for consideration (refer to IFRS 16, Appendix A).
This is a very broad definition and as a result, some leases are “hidden” in the contracts that are not lease contracts.
Imagine you are a retail company and you need to import XY tons of coal to your plants. You agree with the local railways to transport the coal for some period of time from the place of origin to your factories.
Is there a lease?
Maybe yes, maybe not. You need to assess it carefully.
Are the particular rail cars exclusively selected for your use? Can you decide how and when you will use the cars? In this case, there could be a lease.
Does the supplier guarantee you the transport of coal in predetermined times, but without the specification of particular rail cars? In this case, there is no lease, just a service contract.
This was the illustration of a situation when you actually CAN have a lease in a contract that appears NOT to be a lease.
Another illustration of the opposite situation:
Imagine you are a retail company and want to store some of your inventories in a local warehouse.
Is there a lease? Again, it depends.
Does the contract specify the exact place in a warehouse, for example, unit 1A in the warehouse and can you exclusively use it? If yes, then there is a lease.
Does the contract specify XY cubic meters in a warehouse, without the specification of a particular place? Can the warehouse manager shift places time to time? In this case, no, there is no lease under IFRS 16.
This was the illustration of a situation when there is NO lease even if a contract was titled “Lease contract”.
Under IFRS 16, you always need to look whether there’s an identified asset and whether you have a right to control the use of it.
When you implement IFRS 16, please bear this in mind. Look to all possible contracts (not only the “lease” contracts) and identify whether you have a lease or not.
Use of judgments
Personally, I don’t like using lots of judgments, because there’s a room for manipulation and two different accountants will always arrive at two different numbers.
On the other hand I understand that sometimes, you can’t avoid judgments and they are truly necessary.
With IFRS 16, you will need to use much more judgment than before under IAS 17.
Let me outline where:
- Setting the discount rate
Under IAS 17, you need to use the interest rate implicit in the lease. The same applies in IFRS 16, but there’s a difference in the definition of that rate.
IFRS 16 defines the interest rate implicit in the lease as “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) the fair value of the underlying asset and (ii) any initial direct costs of the lessor. “ (IFRS 16, Appendix A)
Please note the word “lessor” in the end of the definition.
Yes, even lessees need to determine the interest rate implicit in the lease with reference to the lessor’s initial direct costs and unguaranteed residual value.
If you are a lessee and you take an asset under the lease, will you know what the initial direct costs of the lessor are? And what the unguaranteed residual value is?
I bet no. I’m sure that most lessors would not tell you their costs.
Therefore, you, as a lessee, in most cases cannot determine the interest rate implicit in the lease and you will need to use your incremental borrowing rate.
In other words – use judgment to set the appropriate discount rate. Here you go.
- Setting the lease term
The lease term is the non-cancellable period for which a lessee has the right to use an underlying asset, together with both:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, and
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise the option. (IFRS 16 Appendix A)
Where do you use judgment here?
If you have the option to extend the lease (or to terminate it), you should consider these options at the lease inception.
So, you should be able to say whether you want to continue the lease or not right at the start, because these periods are included in the lease term.
It’s relatively easy for the lease terms with medium horizon, like 2-3 years, but what about the leases for 10 or more years?
You need to use judgment and consider a few factors to assess whether you’re likely to exercise the option or not.
What happens when your judgment proved to be false?
In other words, what if you assessed not to extend the lease, but later, you decided to exercise the option and to continue?
In this case, you need to remeasure the lease when the assumptions change. Let me again point you to the IFRS Kit, where I solve similar situation in a great detail.
Is there some relief?
Before you start worrying about all “that IFRS 16”, familiarize yourself with a few reliefs you can actually apply.
I don’t list all of them here, just the most important ones.
Short-term and low value leases
When the lease term is max. 1 year, or when an underlying asset has low value when new, you can apply the exemption as a lessee and account for the lease payment straight in profit or loss.
There’s no definition of what “low value” means, but the standard refers to furniture or computers.
It’s a great exemption, because it saves you lots of troubles and money.
You just need to know how to apply it.
Therefore, look to a definition of the lease term again. I would like to draw your attention to the word “non-cancellable”.
When you’re assessing the lease term, you always look only to non-cancellable periods, i.e. periods when the lease is enforceable and no party can terminate the lease without permission from the other party with no more than insignificant penalty.
Imagine you rent an office space and you can terminate the contract anytime with 3-months notice.
What’s the lease term?
Just 3 months, even if you plan to rent an office space for a longer period. Only 3 months are non-cancellable.
It means, that the lease term is shorter than 1 year and you as a lessee can apply the exemption for short-term leases and forget about accounting for a right-of-use asset and a lease liability.
Portfolio lease accounting
When you have a lot of lease contracts with similar characteristics, you can apply a portfolio approach.
It means that you would account for all the leases as for one aggregate lease and not for lots of individual lease contracts.
You can do so only when the results of portfolio accounting would not be materially different from individual approach.
No separating the lease elements
When you have more elements in the same contract, you should separate the lease elements from non-lease elements and account for them accordingly.
For example, imagine you rent an office space and you pay CU 10 000 monthly for the rent. The price includes the cleaning services.
Normally, you would need to split the payment of CU 10 000 into the payment for the lease element (rent) and non-lease element (cleaning).
However, if you are a lessee, you can decide not to do it and account the full amount of CU 10 000 as the lease.
Warning: Lessors need to separate, they can’t apply this expedient!
Implementing IFRS 16 in your company will be a challenge, that’s sure. But, IFRS 16 offers some reliefs or practical expedients at the transition process, too.
However, this article is much longer than I expected to write, so I will cover the transition to IFRS 16 in the near future.
If you have any questions or comments, please let me know below, thank you!
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