IFRS 16 – Leases (Recognition, Measurement and Disclosure)

The International Accounting Standards Board introduced IFRS 16 in 2019, which marked an enormous change in the accounting treatment of leases.

Earlier, a company was permitted to classify leases into two types, viz., a finance lease and an operating lease. And if the lease was of an operating nature, then the subject of the lease would remain an off-balance-sheet item. However, with IFRS 16, that distinction was removed for lessees, so most leases have to be reported on the balance sheet. This should provide investors and other stakeholders with a clearer view of the assets and liabilities related to a company’s leases.

The recognition, measurement and disclosure issues in IFRS 16 are covered in further detail in the next section below.

Objective

IFRS 16 establishes principles for recognising, measuring, presenting, and disclosing leases, ensuring that lessees and lessors provide relevant information that faithfully represents those transactions.

Scope

IFRS 16 Leases applies to all leases, including subleases, except for: [IFRS 16:3]

• 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.

Identifying a lease

A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for some 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 all the economic benefits from that use substantially.

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

When a provider has a substantive right of substitution, a customer cannot utilise an identifiable asset. A supplier’s right of substitution is only substantive if the provider can substitute alternative assets during use and would gain economically.

Physically separate capacity is still a defined asset (e.g. a floor of a building). Unphysically separate capacity or another piece of an asset (e.g., a portion of a fibre optic cable) is not an identifiable asset unless it represents substantially all the capacity so that the customer enjoys all the economic advantages from utilising the asset.

Separating components of a contract

Lessees must allocate the consideration payable for a contract with a lease component and additional lease and non-lease components, such as the lease of an asset and the provision of maintenance service, based on the relative stand-alone prices, which must 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 following IFRS 15 Revenue from Contracts with Customers.

Accounting by lessees

A lessee recognises a right-of-use asset and a lease liability upon lease commencement. [IFRS 16:22]

The right-of-use asset is initially measured at the amount of the lease liability plus any initial direct costs incurred by the lessee. Adjustments may also be required for lease incentives, payments at or before commencement and restoration obligations. [IFRS 16:24]

After lease commencement, a lessee shall measure the right-of-use asset using a cost model, unless: [IFRS 16:29, 34, 35]

i) the right-of-use asset is an investment property, and the lessee fair values its investment property under IAS 40; or

ii) 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. [IFRS 16:30(a)]

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. If that rate cannot be readily determined, the lessee shall use their incremental borrowing rate. [IFRS 16:26]

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. [IFRS 16:39]

Lease modifications may also prompt remeasurement of the lease liability unless they are to be treated as separate leases. [IFRS 16:36(c)]

Covid-19-related rent concessions

A lessee may not 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 did not lease modifications. [IFRS 16:46A, 46B]

IBOR reform

A lessee accounts for modifications required by the IBOR reform (modifications required as a direct consequence of the IBOR reform and made economically equivalent) by updating the effective interest rate. All other modifications are accounted for using the applicable requirements. [IFRS 16:105-106]

Accounting by lessors

Lessors shall classify each lease as an operating lease or a finance lease. [IFRS 16:61]

A lease is classified as a finance lease if it substantially transfers all the risks and rewards incidental to ownership of an underlying asset. Otherwise, a lease is classified as an operating lease. [IFRS 16:62]

Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are: [IFRS 16:63]

• 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 the 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 receivable at an amount equal to the net investment in the lease. [IFRS 16:67]

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. [IFRS 16:75]

At the commencement date, a manufacturer or dealer lessor recognises selling profit or loss following its policy for outright sales, to which IFRS 15 applies. [IFRS 16:71c)]

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. [IFRS 16:81]

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. [IFRS 16:99]

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 related to the retained right of use. Accordingly, the seller only recognises the amount of gain or loss that relates to the rights transferred to the buyer.

If the fair value of the sale price 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 or extra financing.

Disclosure

The purpose of IFRS 16’s disclosures is to provide information in the notes that, when combined with the information in the statement of financial position, statement of profit or loss, and statement of cash flows, provides users with a foundation for evaluating the effect of leases. IFRS 16, paragraphs 52 to 60, clarify the requirements for lessees to accomplish this target, while paragraphs 90 to 97 detail the criteria for lessors to meet this purpose.