IFRS 16 – A new era of lease accounting: PwC In depth INT2016-01

Publication date: 21 Nov 2018

In January 2016 the International Accounting Standards Board (IASB) issued IFRS 16, ‘Leases’, and thereby started a new era of lease accounting – at least for lessees. Whereas, under the previous guidance in IAS 17, 'Leases', a lessee had to make a distinction between a finance lease (on balance sheet) and an operating lease (off balance sheet), the new model requires the lessee to recognise almost all lease contracts on the balance sheet; the only optional exemptions are for certain short-term leases and leases of low-value assets. For lessees that have entered into contracts classified as operating leases under IAS 17, this could have a huge impact on the financial statements.

Thisadobe_pdf_file_icon_32x32In depth provides a summary of IFRS 16 and the main differences between IFRS 16 and the expected new guidance in US GAAP are included in the Appendix.

The following industry publications are also available:

adobe_pdf_file_icon_32x32Banking & Capital Markets industry supplement for IFRS 16 'Leases'

adobe_pdf_file_icon_32x32Pharmaceutical and life sciences industry supplement for IFRS 16 ‘Leases’

adobe_pdf_file_icon_32x32Shipping industry supplement for IFRS 16 'Leases'

adobe_pdf_file_icon_32x32Retail and consumer industry supplement for IFRS 16 ‘Leases’

adobe_pdf_file_icon_32x32Corporate treasury industry supplement for IFRS 16 ‘Leases’

adobe_pdf_file_icon_32x32Chemicals - an industry focus on the impact of IFRS 16

adobe_pdf_file_icon_32x32Airlines - an industry focus on the impact of IFRS 16

adobe_pdf_file_icon_32x32Communications - an industry focus on the impact of IFRS 16

adobe_pdf_file_icon_32x32Real estate - an industry focus on the impact of IFRS 16


At a glance

In January 2016 the International Accounting Standards Board (IASB) issued IFRS 16, ‘Leases’, and thereby started a new era of lease accounting – at least for lessees! Whereas, under the previous guidance in IAS 17, Leases, a lessee had to make a distinction between a finance lease (on balance sheet) and an operating lease (off balance sheet), the new model requires the lessee to recognise almost all lease contracts on the balance sheet; the only optional exemptions are for certain short-term leases and leases of low-value assets. For lessees that have entered into contracts classified as operating leases under IAS 17, this could have a huge impact on the financial statements.

At first, the new standard will affect balance sheet and balance sheet-related ratios such as the debt/equity ratio. Aside from this, IFRS 16 will also influence the income statement, because an entity now has to recognise interest expense on the lease liability (obligation to make lease payments) and depreciation on the ‘right-of-use’ asset (that is, the asset that reflects the right to use the leased asset). Due to this, for lease contracts previously classified as operating leases the total amount of expenses at the beginning of the lease period will be higher than under IAS 17. Another consequence of the changes in presentation is that EBIT and EBITDA will be higher for companies that have material operating leases.

The new guidance will also change the cash flow statement. Lease payments that relate to contracts that have previously been classified as operating leases are no longer presented as operating cash flows in full. Only the part of the lease payments that reflects interest on the lease liability can be presented as an operating cash flow (depending on the entity’s accounting policy regarding interest payments). Cash payments for the principal portion of the lease liability are classified within financing activities. Payments for short-term leases, leases of low-value assets and variable lease payments not included in the measurement of the lease liability remain presented within operating activities.

Although accounting remains substantially the same for lessors, the changes made by the new standard are still relevant. In particular, lessors should be aware of the new guidance on the definition of a lease, subleases and the accounting for sale and leaseback transactions. The changes in lessee accounting might also have an impact on lessors as lessee’s needs and behaviours change and they enter into negotiations with their customers.

For both, lessees and lessors IFRS 16 adds significant new, enhanced disclosure requirements.

Lease accounting was a joint project of the IASB and the US-standard setter (the FASB). Although initially the two Boards intended to develop a converged standard, ultimately only the guidance on the definition of a lease and the principle of recognising all leases on the lessee’s balance sheet are expected to be aligned. In other areas, differences remain or will even increase. We provide a summary of the main differences between IFRS 16 and the expected new guidance in US GAAP in the Appendix.

Scope

Publication date: 15 Apr 2014

IFRS 16 will apply to all lease contracts except for:

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

Aside from this, a lessee may choose to apply IFRS 16 to leases of intangible assets other than those mentioned above.

Identifying a lease - Definition of a lease

Publication date: 15 Apr 2014

IFRS 16 defines a lease as a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. At first sight, the definition looks straightforward. But, in practice, it can be challenging to assess whether a contract conveys the right to use an asset or is, instead, a contract for a service that is provided using the asset.

For example, an entity might want to transport a specified quantity of goods, in accordance with a stated timetable, for a period of five years from A to B by rail. To achieve this, it could either rent a number of rail cars or it could contract to buy the transport service from a freight carrier. In both cases, the goods will arrive at B – but the accounting might be quite different!

PwC observation:

In future, there is likely to be a greater focus on identifying whether a contract is or contains a lease, given that all leases (except short-term leases and leases of low-value assets) will be recognised on the balance sheet of the lessee. Currently, many companies that have contracts which include both an operating lease and a service do not separate the operating lease component. This is because the accounting for an operating lease and a service/supply arrangement is the same (that is, there is no recognition on the balance sheet and straight-line expense is recognised in profit or loss over the contract period). Under the new standard, the treatment of the two components will differ. A lessee may decide as a practical expedient by class of underlying asset not to separate non-lease components (services) from lease components. If the lessee decides to apply this exemption each lease component and any associated non-lease component is accounted for as a single lease component. So the service component will either be separated or the entire contract will be treated as a lease.  

Leases are different from service contracts: a lease provides a customer with the right to control the use of an asset; whereas, in a service contract, the supplier retains control. IFRS 16 states that a contract contains a lease if:

  • there is an identified asset; and
  • the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.

What is an identified asset?

An asset can be identified either explicitly or implicitly. If explicit, the asset is specified in the contract (for example, by a serial number or a similar identification marking); if implicit, the asset is not mentioned in the contract (so the entity cannot identify the particular asset) but the supplier can fulfil the contract only by the use of a particular asset. In both cases there may be an identified asset.

In any case, there is no identified asset if the supplier has a substantive right to substitute the asset. Substitution rights are substantive where the supplier has the practical ability to substitute an alternative asset and would benefit economically from substituting the asset.

The term ‘benefit’ is interpreted broadly. For example, the fact that the supplier could deploy a pool of assets more efficiently, by substituting the leased asset from time to time, might create a sufficient benefit as long as there are no significant costs. It is important to note that ‘significant’ is assessed with reference to the related benefits (that is, costs must be lower than benefits, it is not sufficient if the costs are low or not material to the entity as a whole). Significant costs could occur, in particular, if the underlying asset is tailored for use by the customer. For example, a leased aircraft might have specific interior and exterior specifications defined by the customer. In such a scenario, substituting the aircraft throughout the lease term could create significant costs that would discourage the supplier from doing so.

The assessment whether a substitution right is substantive depends on the facts and circumstances at inception of the contract and does not take into account circumstances that are not considered likely to occur.

A right to substitute an asset if it is not operating properly, or if there is a technical update required, does not prevent the contract from being dependent on an identified asset. The same is true for a supplier’s right or obligation to substitute an underlying asset for any reason on or after a particular date or on the occurrence of a specified event because the supplier does not have the practical ability to substitute alternative assets throughout the period of use.

If the customer cannot readily determine whether the supplier has a substantive substitution right, it is presumed that the right is not substantive (that is, that the contract depends on an identified asset).

Portion of an asset

An identified asset can be a physically distinct portion of a larger asset, such as one floor of a multi-level building or physically distinct dark fibres within a cable.

A capacity portion (that is, a portion of a larger asset that is not physically distinct) is not an identified asset unless it represents substantially all of the capacity of the entire asset. So, for example, a capacity portion of a fibre-optic cable that does not represent substantially all of the capacity of the cable would not qualify as an identified asset.

When does the customer have the right to control the use of an identified asset?

A contract conveys the right to control the use of an identified asset if the customer has both the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset throughout the period of use.

Substantially all of the economic benefits from use of the asset throughout the period of use

Economic benefits can be obtained directly or indirectly (for example, by using, holding or subleasing the asset). Benefits include the primary output and any by-products (including potential cash flows derived from these items), as well as payments from third parties that relate to the use of the identified asset. Economic benefits relating to the ownership of the asset are ignored.

The example below illustrates under which circumstances payments from third parties should be taken into account:

Example

A customer rents a solar farm from the supplier. The supplier receives tax credits relating to the ownership of the solar farm, whereas the customer receives renewable energy credits from the use of the farm. In this scenario, only the renewable energy credits are taken into account in the analysis, because the tax credits relate not to the use of the solar farm but, instead, to ownership of the asset.  

Right to direct the use of an asset throughout the period of use

When assessing whether the customer has the right to direct the use of the identified asset, the key question is which party (that is, the customer or the supplier) has the right to direct how and for what purpose the identified asset is used throughout the period of use.  

The standard gives several examples of relevant decision-making rights:

  • Right to change what type of output is produced.
  • Right to change when the output is produced.
  • Right to change where the output is produced.
  • Right to change how much of the output is produced.

The relevance of each of the decision-making rights depends on the underlying asset being considered. If both parties have decision-making rights, an entity considers the rights that are most relevant to changing how and for what purpose the asset is used. Decision-making rights are relevant when they affect the economic benefits to be derived from the use of the asset.

To illustrate the concept, the table below provides some questions to consider when evaluating which party has the relevant decision-making rights:

 

Which party decides …

Lease of trucks/aircraft/rail cars etc.

Which goods are transported?
When the goods are transported and to where?
How often the asset is used/how full it needs to be to run?
Which route is taken?

Fibre-optic cable

When and whether to light the fibres?
What and how much data the cable will transport?
How to run the cable?
Through which routes the data will be delivered?

Retail unit

Which goods will be sold?
The prices at which the goods will be sold?
Where and how the goods are displayed?

Power plant

How much power will be delivered and when?
When to turn the power plant on/off?

However, there are several rights that are not taken into account:

  • Protective rights: In many cases, a supplier might limit the use of an asset by a customer in order to protect its personnel or to ensure compliance with relevant laws and regulations (for example, a customer who has hired a ship is prevented from sailing the ship into waters with a high risk of piracy or transporting hazardous materials). These protective rights do not affect the assessment of which party to the contract has the right to direct the use of the identified asset.
  • Maintaining/operating the asset:Decisions about maintaining and operating an asset do not grant the right to direct the use of the asset. They are only taken into account if the decisions about how and for what purpose the asset is used are predetermined (see below).
  • Decisions made before the period of use:Decisions madebefore the period of use are not taken into account unless they are made in the context of the design of the asset by a customer (see below).

In some scenarios, the decisions about how and for what purpose the underlying asset is used are already predetermined before the inception of the lease. If this is the case, the customer has the right to direct the use of an asset if it either:

  • has the right to operate the identified asset throughout the period of use without the supplier having the right to change those operating instructions, or
  • has designed the identified asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

 

PwC observation:

The new concept of “pre-determined” introduced by IFRS 16 can be very complex and judgmental where decisions are made before the inception of the lease. When analysing these decisions, there are several questions to be considered, such as:

  • Do any decisions that are not predetermined have a significant effect on how and for what purpose the asset is used?
  • To what extent are decisions about how and for what purpose the asset is used predetermined?
  • Do the decisions predetermine how and for what purpose the identified asset is used or do they only establish protective rights?
  • Which party to the contract has made the decisions?

Sometimes, an identified asset is incidental to a service but has no specific use to the customer by itself.  In these cases, the customer often does not have the right to direct the use of the asset.

Example

A customer enters into a contract with a telecommunications company for network services. To supply the services, it is necessary to install a server at the customer’s premises. The supplier can reconfigure or replace the server, when needed, to continuously provide the network services; the customer does not operate the server, nor does it make any significant decisions about its use. The telecommunication company determines the speed and the quality of data transportation in the network using the servers.  

The telecommunication company has the right to control the use of the server because it makes all the relevant decisions about the use of the server throughout the period of use. It decides how the data is transported, whether to reconfigure the servers and whether to use the servers for another purpose. The customer only decides about the level of network services (that is the output of the servers) before the period of use.

This arrangement does not contain a lease.

Summary overview

The flowchart below summarises the analysis to be made to evaluate whether a contract contains a lease:

Determining whether a contract contains a lease

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PwC observation:

The definition of a lease is now much more driven by the question of which party to the contract controls the use of the underlying asset for the period of use. A customer no longer needs only to have the right to obtain substantially all of the benefits from the use of an asset (‘benefits’ element), but must also have the ability to direct the use of the asset (‘power’ element).

This conceptual change becomes obvious when looking at a contract to purchase substantially all of the output produced by an identified asset (for example, a power plant). If the price per unit of output is neither fixed nor equal to the current market price, the contract would be classified as a lease under IAS 17 and IFRIC 4, Determining whether an Arrangement contains a Lease.

IFRS 16, however, requires not only that the customer obtains substantially all of the economic benefits from the use of the asset but also an additional ‘power’ element, namely the right of the customer to direct the use of the identified asset (for example, the right to decide the amount and timing of power delivered).

Comprehensive example

A customer enters into a contract that conveys the right to use an explicitly specified retail unit for a period of five years. The property owner can require the customer to move into another retail unit; there are several retail units of similar quality and specification available.

As the property owner has to pay for any relocation costs it can benefit economically from relocating the customer only if there is a new tenant that wants to occupy a large amount of retail space at a rate that is sufficient to cover the relocation costs. Those circumstances may arise, but they are not considered likely to occur.

The contract requires the customer to sell his goods during the opening hours of the larger retail space. The customer decides on the mix of goods sold, the pricing of the goods sold and the quantities of inventory held. He further controls physical access to the retail unit throughout the five-year period of use.

The rent that the customer has to pay includes a fixed amount plus a percentage of the sales from the retail unit.

Is there an identified asset?

The retail unit is explicitly specified in the contract. The property owner has a right to substitute the asset. But, because it would benefit from the exercise of the right only under certain circumstances that are not considered likely to occur, the substitution right is not substantive.

Hence, the retail unit is an identified asset.

Has the customer the right to obtain substantially all of the economic benefits from the use of the retail unit?

The customer has the exclusive use of the retail unit throughout the period of use. The fact that a part of the cash flows received from the use are passed to the property owner as consideration does not prevent the customer from having the right to substantially all of the economic benefits from the use of the retail unit.

Has the customer the right to direct the use of the retail unit?

During the period of use, all decisions on how and for what purpose the retail unit is used are made by the customer. The restriction that goods can only be sold during the opening hours of the larger retail space defines the scope of the contract, but it does not limit the customer’s right to direct the use of the retail unit.

Conclusion

The contract contains a lease of retail space.

Identifying a lease - Separating components of a contract

Publication date: 15 Apr 2014

Contracts often combine different kinds of obligations of the supplier, which might be a combination of lease components or a combination of lease and non-lease components. For example, the lease of an industrial area might contain the lease of land, buildings and equipment, or a contract for a car lease might be combined with maintenance.

Where such a multi-element arrangement exists, IFRS 16 requires each separate lease component to be identified (based on the guidance on the definition of a lease) and accounted for separately.

The right to use an asset is a separate lease component if both of the following criteria are met:

  • the lessee can benefit from use of the asset either on its own or together with other resources that are readily available to the lessee; and
  • the underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract.

PwC observation:

IFRS 15 contains guidance on how to evaluate whether a good or service promised to a customer is distinct for lessors. The question arises of how IFRS 16 interacts with IFRS 15.

For a multi-element arrangement that contains (or might contain) a lease, the lessor has to perform the assessment as follows:

  • Apply the guidance in IFRS 16 to assess whether the contract contains one or more lease components.
  • Apply the guidance in IFRS 16 to assess whether different lease components have to be accounted for separately.
  • After identifying the lease components under IFRS 16, the non-lease components should be assessed under IFRS 15 for separate performance obligations.

The criteria in IFRS 16 for the separation of lease components are similar to the criteria in IFRS 15 for analysing whether a good or service promised to a customer is distinct.

If the analysis concludes that there are separate lease and non-lease components, the consideration must be allocated between the components as follows:

  • Lessee: The lessee allocates the consideration on the basis of relative stand-alone prices. If observable stand-alone prices are not readily available, the lessee shall estimate the prices, and should maximise the use of observable information.
  • Lessor: The lessor allocates the consideration in accordance with IFRS 15 (that is, on the basis of relative stand-alone selling prices).

As a practical expedient, lessees are allowed not to separate lease and non-lease components and, instead, account for each lease component and any associated non-lease components as a single lease component. This accounting policy choice has to be made by class of underlying asset. Because not separating a non-lease component would increase the lessee’s lease liability, the Board expects that a lessee will use this exemption only if the service component is not significant.

Identifying a lease - Combination of contracts

Publication date: 15 Apr 2014

Often, several contracts with the same counterparty are entered into at or near the same time and in contemplation of another. IFRS 16 requires an entity to combine contracts entered into at or near the same time with the same counterparty (or related parties of the counterparty) before assessing whether they contain a lease and account for them as a single contract if one or more of the following conditions are met:

  • the contracts are negotiated as a package with an overall commercial objective;
  • the consideration in one contract depends on the price/performance of the other contract; or
  • the assets involved are a single lease component.

Identifying a lease - Lease term

Publication date: 15 Apr 2014

Similar to IAS 17, the new standard defines the lease term as the non-cancellable period of the lease plus periods covered by an option to extend or an option to terminate if the lessee is reasonably certain to exercise the extension option or not exercise the termination option.

The interpretation of the term ‘reasonably certain’ has been a source of long and controversial discussions, under IAS 17, that led to diversity in practice. To address this, the standard states the principle that all facts and circumstances creating an economic incentive for the lessee to exercise the option must be considered, and provides some examples of such factors:

  • Contractual terms and conditions for optional periods compared with market rates: It is more likely that a lessee will not exercise an extension option if lease payments exceed market rates. Other examples of terms that should be taken into account are termination penalties or residual value guarantees.
  • Significant leasehold improvements undertaken (or expected to be undertaken): It is more likely that a lessee will exercise an extension option if a lessee has made significant investments to improve the leased asset or to tailor it for its special needs.
  • Costs relating to the termination of the lease/signing of a replacement lease: It is more likely that a lessee will exercise an extension option if doing so avoids costs such as negotiation costs, relocation costs, costs of identifying another suitable asset, costs of integrating a new asset and costs of returning the original asset in a contractually specified condition or to a contractually specified location.
  • The importance of the underlying asset to the lessee’s operations: It is more likely that a lessee will exercise an extension option if the underlying asset is specialised or if suitable alternatives are not available.
  • If an option is combined with one or more other features such as for example a residual value guarantee with the effect that the cash return for the lessor is the same regardless of whether the option is exercised an entity shall assume that the lessee is reasonably certain to exercise the option to extend the lease, or not to exercise the option to terminate the lease.

When the option can only be exercised if one or more conditions are met the likelihood that those conditions will exist should also be taken into account.

Aside from this, lessee’s past practice regarding the period over which it has typically used particular types of assets, and its economic reasons for doing so, may also provide helpful information.

PwC observation:

One of the primary reasons for including extension options (and not limiting the accounting to the non-cancellable lease term) is to avoid the potential for structuring opportunities. For example, one could theoretically structure a 20-year lease as a daily lease with 20 years’ worth of daily renewals.

There is no guidance in the standard on how to weight the individual factors when determining whether it is ‘reasonably certain’ that a lessee will exercise an option. For example, consider a flagship store that in a prime and much sought-after location. Significant judgement would be needed to determine whether the prime geographical location of the store or other factors (for example termination penalties, lease hold improvements, etc.) indicate that it is reasonably certain whether or not the lessee will renew the store lease.

The lease term is reassessed in only limited circumstances:

  • where the lessee exercises or does not exercise an option in a different way than the entity had previously determined was reasonably certain;
  • where an event occurs that contractually obliges the lessee to exercise an option (prohibits the lessee from exercising an option) not previously included in the determination of the lease term (previously included in the determination of the lease term); or
  • where a significant event or change in circumstances occurs that is within the control of the lessee and affects whether it is reasonably certain to exercise an option. This trigger is only relevant for the lessee (and not the lessor).

Example

An entity leases a building for a ten-year period, with the option to extend for five years. At the commencement date, the entity concludes that it is not reasonably certain that it will exercise the extension option. It determines the lease term to be ten years. After using the building for five years, the entity decides to sublease the building to another party, and it enters into a sublease contract with a term of ten years.

Entering into a sublease is a significant event that is within the control of the lessee, and it affects the entity’s assessment of whether it is reasonably certain to exercise the extension option. Accordingly, the lessee has to reassess the lease term of the head lease upon the occurrence of the significant event.

This requirement can be seen as a compromise: on the one hand, the IASB believes that a regular reassessment of the lease term would provide more relevant information to users of the financial statements; on the other hand, the Board acknowledges that such a requirement could be very costly.

Accordingly, the IASB decided to develop an approach similar to the one for impairment testing – a reassessment is only made if there are indicators that it would result in a different outcome.

Identifying a lease - Recognition and measurement exemptions

Publication date: 15 Apr 2014

The standard contains two recognition and measurement exemptions. Both exemptions are optional and they only apply to lessees. If one of these exemptions is applied, the leases are accounted for in a way that is similar to current operating lease accounting (that is, payments are recognised on a straight-line basis or another systematic basis that is more representative of the pattern of the lessee’s benefit):

  • Short-term leases: Short-term leases are defined as leases with a lease term of 12 months or less. The lease term also includes periods covered by an option to extend or an option to terminate if the lessee is reasonably certain to exercise the extension option or not exercise the termination option. A lease that contains a purchase option is not a short-term lease. If a lessee elects this exemption, it has to be made by class of underlying asset.
    If an entity applies the short-term lease exemption it shall treat any subsequent modification or change in lease term as resulting in a new lease.
  • Leases for which the underlying asset is of low value: The standard does not define the term ‘low value’, but the Basis for Conclusions explains that the Board had in mind assets of a value of USD5,000 or less when new. Examples of assets of low value are IT equipment or office furniture. For certain assets (such as assets that are dependent on, or highly interrelated with, other underlying assets), the exemption is not applicable.

The election can be made on a lease-by-lease basis. It is important to note that the analysis does not take into account whether low-value assets in aggregate are material. Accordingly, although the aggregated value of the assets captured by the exemption may be material the exemption is still available.

IFRS 16 also clarifies that both a lessee and a lessor can apply the standard to a portfolio of leases with similar characteristics if the entity reasonably expects that the resulting effect is not materially different from applying the standard on a lease-by-lease basis. 

Lessee accounting - Initial recognition and measurement

Publication date: 15 Apr 2014

The new lessee accounting model within IFRS 16 is the most important change to current guidance.

Under IFRS 16, lessees will no longer distinguish between finance lease contracts (on balance sheet) and operating lease contracts (off balance sheet), but they are required to recognise a right-of-use asset and a corresponding lease liability for almost all lease contracts. This is based on the principle that, in economic terms, a lease contract is the acquisition of a right to use an underlying asset with the purchase price paid in instalments.

The effect of this approach is a substantial increase in the amount of recognised financial liabilities and assets for entities that have entered into significant lease contracts that are currently classified as operating leases.

The lease liability is initially recognised at the commencement day and measured at an amount equal to the present value of the lease payments during the lease term that are not yet paid; the right-of-use asset is initially recognised at the commencement day and measured at cost, consisting of the amount of the initial measurement of the lease liability, plus any lease payments made to the lessor at or before the commencement date less any lease incentives received, the initial estimate of restoration costs and any initial direct costs incurred by the lessee. The provision for the restoration costs is recognised as a separate liability.

Initial measurement of a right-of-use asset and a lease liability

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Lease payments

Lease payments consist of the following components:

  • fixed payments (including in-substance fixed payments), less any lease incentives receivable;
  • variable lease payments that depend on an index or a rate;
  • amounts expected to be payable by the lessee under residual value guarantees
  • the exercise price of a purchase option (if the lessee is reasonably certain to exercise that option); and
  • payments of penalties for terminating the lease (if the lease term reflects the lessee exercising the option to terminate the lease).

IFRS 16 distinguishes between three kinds of contingent payments, depending on the underlying variable and the probability that they actually result in payments:

  1. Variable lease payments based on an index or a rate: Variable lease payments based on an index or a rate (for example, linked to a consumer price index, a benchmark interest rate or a market rental rate) are part of the lease liability. From the perspective of the lessee, these payments are unavoidable, because any uncertainty relates only to the measurement of the liability but not to its existence. Variable lease payments based on an index or a rate are initially measured using the index or the rate at the commencement date (instead of forward rates/indices). This means that an entity does not forecast future changes of the index/rate; these changes are taken into account at the point in time in which lease payments change. The accounting for variable lease payments that depend on an index or a rate is illustrated in the example on page 18.
  2. Variable lease payments based on any other variable: Variable lease payments not based on an index or a rate are not part of the lease liability. These include payments linked to a lessee’s performance derived from the underlying asset, such as payments of a specified percentage of sales made from a retail store or based on the output of a solar or a wind farm. Similarly payments linked to the use of the underlying asset are excluded from the lease liability, such as payments if the lessee exceeds a specified mileage. Such payments are recognised in profit or loss in the period in which the event or condition that triggers those payments occurs.
  3. In-substance fixed payments: Lease payments that, in form, contain variability but, in substance, are fixed are included in the lease liability. The standard states that a lease payment is in-substance fixed if there is no genuine variability (for example, where payments must be made if the asset is proven to be capable of operating, or where payments must be made only if an event occurs that has no genuine possibility of not occurring). Furthermore, the existence of a choice for the lessee within a lease agreement can also result in an in-substance fixed payment. If, for example, the lessee has the choice either to extend the lease term or to purchase the underlying asset, the lowest cash outflow (that is, either the discounted lease payments throughout the extension period or the discounted purchase price) represents an in-substance fixed payment. In other words, the entity cannot argue that neither the extension option nor the purchase option will be exercised.

If payments are initially structured as variable lease payments linked to the use of the underlying asset but the variability will be resolved at a later point in time, those payments become in-substance fixed payments when the variability is resolved. 

IAS 17 does not contain any specific guidance on in-substance fixed payments. However, the Board believes that current practice already follows this approach.

PwC observation:

Determining whether a contingent payment is a ‘disguised’ or in-substance fixed lease payment will require a significant judgement, particularly as the standard includes only limited guidance on how to interpret the term.

A residual value guarantee captures any kind of guarantee made to the lessor that the underlying asset will have a minimum value at the end of the lease term. The Board indicated it believed that a residual value guarantee could be interpreted as an obligation to make payments based on variability in the market price for the underlying asset and is similar to variable lease payments based on an index or a rate.

PwC observation:

The Basis for Conclusions notes that the measurement of a residual value guarantee should reflect the entity’s reasonable expectation of the amount that will be paid. However, the standard is silent about whether expectation should be based on a probability-weighted approach or interpreted as the most likely outcome.

Aside from this, it is worth noting that the requirement to recognise only amounts expected to be payable is a change compared to the guidance in IAS 17. Under IAS 17 the maximum amount guaranteed by the lessee had to be included in the lease liability (in case of a finance lease).

Discount rate

The lessee uses as the discount rate the interest rate implicit in the lease - this is the rate of interest that causes the present value of (a) 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. Determining the interest rate implicit in the lease is a key judgement that can have a significant impact on an entity’s financial statements. 

If this rate cannot be readily determined, the lessee should instead use its incremental borrowing rate.

The incremental borrowing rate is defined as 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 cost of the right-of-use asset in a similar economic environment.

Restoration costs

In many cases, the lessee is obliged to return the underlying to the lessor in a specific condition or to restore the site on which the underlying asset has been located. To reflect this obligation, the lessee recognises a provision in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets. The initial carrying amount of the provision, if any, (that is, the initial estimate of costs to be incurred) should be included in the initial measurement of the right-of-use asset. This corresponds to the accounting for restoration costs in IAS 16 Property, Plant and Equipment.

Any subsequent change in the measurement of the provision, due to a revised estimation of expected restoration costs, is accounted for as an adjustment of the right-of-use asset as required by IFRIC 1, Changes in Existing Decommissioning, Restoration and Similar Liabilities.

Initial direct costs

The standard defines initial direct costs as incremental costs that would not have been incurred if a lease had not been obtained. Such costs include commissions or some payments made to existing tenants to obtain the lease. All initial direct costs are included in the initial measurement of the right-of-use asset.

Lessee accounting - Subsequent measurement

Publication date: 15 Apr 2014

The lease liability is measured in subsequent periods using the effective interest rate method. The right-of-use asset is depreciated in accordance with the requirements in IAS 16, ‘Property, Plant and Equipment’ which will result in a depreciation on a straight-line basis or another systematic basis that is more representative of the pattern in which the entity expects to consume the right-of-use asset. The lessee must also apply the impairment requirements in IAS 36,‘Impairment of assets’, to the right-of-use asset.

PwC observation:

The combination of a straight-line depreciation of the right-of-use asset and the effective interest rate method applied to the lease liability results in a decreasing ‘total lease expense’ throughout the lease term. This effect is sometimes referred to as ‘frontloading’.

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Many stakeholders believe that the ‘frontloading’ effect creates artificial volatility in the income statement that does not properly reflect the economic characteristics of a lease contract, particularly if the risk and rewards incidental to ownership stay with the lessor (operating lease). Others believe that in economic terms, a lease contract is the acquisition of a right to use an underlying asset with the purchase price paid in instalments and that ‘frontloading’ reflects this.

It should be noted, however, that, if the lessee has a portfolio of similar lease assets that are replaced on a regular basis, the effect should even out.

The carrying amount of the right-of-use asset and the lease liability will no longer be equal in subsequent periods. Due to the ‘frontloading’ effect described above, the carrying amount of the right-of-use asset will, in general, be below the carrying amount of the lease liability.

Subsequent measurement of lease liability and right-of-use asset

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Reassessment

As actual lease payments can differ significantly from lease payments incorporated in the lease liability on initial recognition, the standard specifies when the lease liability is to be reassessed. It is important to note that a reassessment only takes place if the change in cash flows is based on contractual clauses that have been part of the contract since inception. Any changes that result from renegotiations are discussed under ‘Modification of a lease’ below.

The requirements for reassessment are summarised below:

Component of the lease liability

Reassessment

Lease term and associated extension and termination payments

When? – If there is a change in the lease term.

How? – Reflect the revised payments using a revised discount rate

(the interest rate implicit in the lease for the remainder of lease term (if that rate can be readily determined); otherwise: incremental borrowing rate at the date of reassessment).

 

Exercise price of a purchase option

When? – If a significant event or change in circumstances occurs that is within the control of the lessee and affects whether the lessee is reasonably certain to exercise an option.

How? – Reflect the revised payments using a revised discount rate

(the interest rate implicit in the lease for the remainder of lease term (if that rate can be readily determined); otherwise: incremental borrowing rate at the date of reassessment).

Amounts expected to be payable under a residual value guarantee

When? – If there is a change in the amount expected to be paid.

How? – Include the revised residual payment using the unchanged discount rate.

Variable lease payment dependent on an index or a rate

When? – If a change in the index/rate results in a change in cash flows.

How? – Reflect the revised payments based on the index/rate at the date when the new cash flows take effect for the remainder of the term using the unchanged discount rate. (Exception: the discount rate has to be updated if the change results from a change in floating interest rates).

 

Example
An entity operating in an inflationary environment entered into a ten-year lease contract with annual lease payments of CU 50,000, payable at the beginning of each year. Every two years, lease payments will be adjusted to reflect changes in the Consumer Price Index for the preceding 24 months. At the commencement date, the Consumer Price Index was 125. At the beginning of the third year CPI is 135.

When is the lease liability reassessed?
On initial recognition, the lease liability is calculated based on the contractual lease payments of CU 50,000 p.a. Even if the Consumer Price Index may change the entity will not remeasure its lease liability before the beginning of the third year because until then the change in CPI does not result in a change in cash flows. At the beginning of the third year, however, the lease liability has to be adjusted because the contractual cash flows have changed.

How is the lease liability reassessed?
The revised measurement of the lease liability is at the present value of the revised payments, based on the Consumer Price Index at the date of change for the remainder of the term using the unchanged discount rate (that is CU 50,000 × 135 / 125 = CU 54,000).

Aside from this, the lease liability shall be remeasured if payments initially structured as variable payments become in-substance fixed lease payments because the variability is resolved at some point after the commencement date.

Any remeasurement of the lease liability results in a corresponding adjustment of the right-of-use asset. If the carrying amount of the right-of-use asset has already been reduced to zero, the remaining remeasurement is recognised in profit or loss.

Reassessment of a lease liability

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The right-of-use asset is also remeasured if the carrying amount of the provision for restoration costs has changed due to a revised estimate of expected costs. In that instance, the change in the carrying amount of the right-of-use asset is equal to the change in the carrying amount of the provision. If adjustments result in an addition the entity shall consider whether this is an indication that the new carrying amount of the right-of-use asset may not be fully recoverable.

Lessee accounting - Modification of a lease

Publication date: 15 Apr 2014

There are many different reasons why the parties to a contract might decide to renegotiate and modify an existing lease contract during the lease term. One objective might be to extend or shorten the term of an existing contract (with or without changing the other contractual terms); another reason might be to change the underlying asset (for example, a lessee already leases two floors of a building and the parties agree to add a third one). If the lessee is in financial difficulties, the lessor might agree to reduce lease payments as a concession to support a restructuring.

IFRS 16 defines a modification as a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions of the lease. Any change that is triggered by a clause that is already part of the original lease contract (including changes due to a market rent review clause or the exercise of an extension option) is not regarded as a modification.

The accounting for the modification of a lease depends on how the contract is modified. The standard distinguishes between three different scenarios:

Modification of a lease

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An example for a renegotiation that would result in a change of the scope of the lease would be adding an additional floor to the existing lease of a building for the remaining lease term. The effective date of the modification is the date on which the parties agree to the modification of the lease.  

In cases where the modification is not accounted for as a separate lease the lessee shall, in a first step, allocate the consideration in the modified contract between separate lease and non-lease components and determine the lease term of the modified lease (that is, reassess the previous estimation of the lease term).

Decrease in scope

If the lease is modified to terminate the right of use of one or more underlying assets (for example, a lessee already leases three floors of a building and the parties agree to reduce the lease by one floor for the remaining contractual term) or to shorten the contractual lease term, the lessee remeasures the lease liability at the effective date of the modification using a revised discount rate. The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term (or, if not readily determinable, the lessee’s incremental borrowing rate at that time). Furthermore, it decreases the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease. Any gain or loss relating to the partial or full termination is recognised in profit or loss.

Example

A lessee enters into a lease for 5,000 square metres of office space for ten years. The lease payments are fixed at CU 50,000 p.a. After five years, the parties amend the contract to reduce the office space by 2,500 square metres. From year 6 onwards, the annual lease payments will be CU30,000. At the beginning of year 6, the lessee’s incremental borrowing rate is 5% (assume that the rate implicit in the lease at that date is not readily determinable).

The carrying amounts of the lease liability and right-of-use asset before modification are as follows:

Carrying amount of the right-of-use asset before the modification CU184,002
Carrying amount of the lease liability before the modification CU210,618

The value of the lease liability after the modification is CU129,884
(= CU30,000/1.05 + CU30,000/1.052 + CU30,000/1.053 + CU30,000/1.054 + CU30,000/1.055).

In a first step, the right-of-use asset and the lease liability are reduced by 50%, because the original office space is reduced by 50%. The difference between these two amounts is recognised as a gain in profit or loss:

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In a second step, the right-of-use asset has to be adjusted to reflect the updated discount rate and the change in the consideration. Accordingly, the difference between the remaining lease liability (CU105,309) and the modified lease liability (CU129,884) is recognised as an adjustment to the right-of-use asset:

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Increase in scope with a corresponding increase in the lease consideration

If there has been an increase in the scope of the lease and the consideration for the lease increase is commensurate with the stand-alone price for the increase in scope, the modification is accounted for as a separate lease. To be commensurate, the increase in the consideration does not need to be equal to the stand-alone price of the increase in scope. The standard makes clear that any ‘appropriate adjustments’ to reflect the circumstances of the particular contract are still in line with the assumption that a change in the consideration is commensurate. So for example a discount that reflects the costs the lessor would have incurred when looking for a new lessee (such as marketing costs), may be an appropriate adjustment.

It is important to note that an increase in the scope of the lease only arises if the parties add the right to use one or more underlying assets. The extension of an existing right of use (for example, by a change in the lease term) is not an increase in scope and, therefore, always results in the continuation of the existing lease. However, it is still accounted for as a modification of a lease.

PwC observation:

In practice, it might be difficult to decide whether an increase in consideration is commensurate with an increase in scope of the lease. According to IFRS 16, a change in consideration will still be commensurate with the change in the scope of the lease if it includes appropriate adjustments to reflect the circumstances of the particular contract. However, the assessment of whether an adjustment is appropriate will be highly judgmental. 

Increase in scope without a corresponding increase in the lease consideration

If the consideration paid for the increase in the scope of the lease does not increase by a commensurate amount (that is, the stand-alone price for the increase in scope and any appropriate adjustments), the lessee remeasures the lease liability at the effective date of the modification using a revised discount rate and makes a corresponding adjustment to the right-of-use asset. The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term (or, if not readily determinable, the lessee’s incremental borrowing rate at that time).

Example

A lessee enters into a lease for 5,000 square metres of office space for ten years. The lease payments are fixed at CU100,000 p.a. After five years, the parties amend the contract for an additional 5,000 square metres. The annual lease payments increase to CU150,000. The market rent for the additional 5,000 square metres is CU100,000. At the beginning of year 6, the lessee’s incremental borrowing rate is 7% (assume that the interest rate implicit in the lease at that date is not readily determinable).

The parties decided to add an additional right of use (that is, for 5,000 square metres of office space) and increase the scope of the lease. However, the additional lease payments are not commensurate with the stand-alone price for the additional office space and any appropriate adjustments. Accordingly, the modification is not accounted for as a separate lease but as an adjustment to the original lease. The modified lease liability is calculated as the present value of the five remaining lease payments (CU150,000 each) discounted using the lessee’s incremental borrowing rate at the effective date of the lease modification (7%). This results in a (revised) lease liability of CU615,030. The difference between this amount and the carrying amount of the lease liability immediately before the modification of the lease is recognised as an adjustment to the right-of-use asset.  

If, however, the consideration for the additional office space is increased by CU100,000 p.a. to CU200,000 p.a. (that is, by an amount equal to the stand-alone price for the additional right of use), the modification is instead accounted for as a second, separate lease for 5,000 square metres of office space over a five-year period. 

Change in the lease consideration

If the parties to the contract change the consideration of the lease without increasing or decreasing the scope of the lease, the lessee remeasures the lease liability using the interest rate implicit in the lease for the remainder of the lease term (or, if not readily determinable, the lessee’s incremental borrowing rate at the effective date of modification) and makes a corresponding adjustment to the right-of-use asset.

PwC observation:

IAS 17 did not contain guidance on accounting for modifications. Accordingly, although the guidance in IFRS 16 requires the application of judgement (for example, in assessing whether the increase in the consideration for the lease is commensurate with the stand-alone price for the additional right of use and any appropriate adjustments), it is expected that this will improve consistency in the accounting for lease modifications.

Lessee accounting - Other measurement models

Publication date: 15 Apr 2014

Aside from the cost model described above, IFRS 16 contains two alternative measurement models that can impact measurement for certain right-of-use assets:

  • A right-of-use asset must be subsequently measured in accordance with the fair value model in IAS 40 if the right-of-use asset meets the definition of investment property and the lessee has elected the fair value model in IAS 40.
  • A right-of-use asset can be subsequently measured at the revalued amount in accordance with IAS 16 if it relates to a class of property, plant and equipment and the lessee applies the revaluation model to all assets in that class.

Lessee accounting - Presentation and disclosures

Publication date: 15 Apr 2014

On the balance sheet, the right-of-use asset can be presented either separately or in the same line item in which the underlying asset would be presented. The lease liability can be presented either as a separate line item or together with other financial liabilities. If the right-of-use asset and the lease liability are not presented as separate line items, an entity discloses in the notes the carrying amount of those items and the line item in which they are included.
In the statement of profit or loss and other comprehensive income, the depreciation charge of the right-of-use asset is presented in the same line item/items in which similar expenses (such as depreciation of property, plant and equipment) are shown. The interest expense on the lease liability is presented as part of finance costs. However, the amount of interest expense on lease liabilities has to be disclosed in the notes.
In the statement of cash flows, lease payments are classified consistently with payments on other financial liabilities:

  • The part of the lease payment that represents cash payments for the principal portion of the lease liability is presented as a cash flow resulting from financing activities.
  • The part of the lease payment that represents interest portion of the lease liability is presented either as an operating cash flow or a cash flow resulting from financing activities (in accordance with the entity’s accounting policy regarding the presentation of interest payments).
  • Payments on short-term leases, for leases of low-value assets and variable lease payments not included in the measurement of the lease liability are presented as an operating cash flow.

To provide users with information that allows them to assess the amount, timing and uncertainty of lease payments, IFRS 16 includes enhanced disclosure requirements. The most important disclosures are shown in the Appendix to this publication.

Lessor accounting

Publication date: 15 Apr 2014

IFRS 16 does not contain substantial changes to lessor accounting compared to IAS 17. The lessor still has to classify leases as either finance or operating, depending on whether substantially all of the risk and rewards incidental to ownership of the underlying asset have been transferred. For a finance lease, the lessor recognises a receivable at an amount equal to the net investment in the lease which is the present value of the aggregate of lease payments receivable by the lessor and any unguaranteed residual value. If the contract is classified as an operating lease, the lessor continues to present the underlying assets.
There are, however, some changes to current requirements worth mentioning.

Lessor accounting - Subleases

Publication date: 15 Apr 2014

Structure of a sublease

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Under IAS 17, a sublease was classified with reference to the underlying asset. IFRS 16 now requires the lessor to evaluate the sublease with reference to the right-of-use asset. Because, typically, the fair value of the right-of-use asset is below the fair value of the underlying asset, subleases are now more likely to be classified as finance leases. Aside from this, since the lessor of the sublease is, at the same time, the lessee with respect to the head lease, it will in any case have to recognise an asset on its balance sheet – as a right-of-use asset with respect to the head lease (if the sublease is classified as an operating lease) or a lease receivable with respect to the sublease (if the sublease is classified as a finance lease).

If the head lease is a short-term lease, the sublease shall be classified as an operating lease. For a sublease that results in a finance lease, the intermediate lessor is not permitted to offset the remaining lease liability (from the head lease) and the lease receivable (from the sublease). The same is true for the lease income and lease expense relating to head lease and sublease of the same underlying asset.

Lessor accounting - Manufacturer/dealer lessor

Publication date: 15 Apr 2014

The guidance regarding when and to what extent a manufacturer/dealer lessor should recognise profit or loss remains almost unchanged. According to IFRS 16:

  • revenue is the fair value of the underlying asset, or, if lower, the present value of the lease payments accruing to the lessor, discounted using a market rate of interest;
  • cost of sale is the cost, or carrying amount if different, of the underlying asset less the present value of the unguaranteed residual value; and
  • selling profit or loss is the difference between revenue and the cost of sale recognised in accordance with an entity’s policy for outright sales to which IFRS 15 applies.

A manufacturer or dealer lessor shall recognise selling profit or loss on a finance lease at the commencement date, regardless of whether the lessor transfers the underlying asset as described in IFRS 15.

Aside from this, the new guidance on identifying a lease (as described at the beginning of this In depth) also affects the lessor.

Lessor accounting - Modification of a lease

Publication date: 15 Apr 2014

IAS 17 is silent about how to account for the modification of a lease for lessors. To avoid diversity in practice, IFRS 16 includes specific rules:

Modification of an operating lease

The modification of an operating lease should be accounted for as a new lease by the lessor. Any prepaid or accrued lease payments are considered to be payments for the new lease (that is, they will be spread over the new term of the modified lease).

Modification of a finance lease

A lessor accounts for the modification of a finance lease as a separate lease if:

  • the modification increases the scope of the lease; and
  • the consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that price to reflect the circumstances of the particular contract.

This mirrors the guidance for lessees.

If one of the above criteria is not met, the lessor has to assess whether the modification would have resulted in either an operating or a finance lease if it had been in effect at inception of the lease:

  • If the lease would have been classified as an operating lease, the lessor accounts for the modification as a new lease (operating lease). The carrying amount of the underlying asset that has to be recognised is measured as the net investment in the original lease immediately before the lease modification.
  • If the lease would have been classified as a finance lease, the lessor accounts for the lease modification in accordance with IFRS 9

Sale and leaseback transactions - Determining whether the transfer is a sale

Publication date: 15 Apr 2014

Aside from lessee accounting, the accounting for sale and leaseback transactions is one of the main areas in which the new lease standard changes the current guidance. The accounting for sale and leaseback transactions under IAS 17 mainly depended on whether the leaseback was classified as a finance or an operating lease. Under IFRS 16 the determining factor is whether the transfer of the asset qualifies as a sale in accordance with IFRS 15. An entity shall apply the requirements for determining when a performance obligation is satisfied in IFRS 15 to make this assessment.  

Structure of a sale and leaseback

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Sale and leaseback transactions - Transfer of the asset is a sale

Publication date: 15 Apr 2014

If the buyer-lessor has obtained control of the underlying asset and the transfer is classified as a sale in accordance with IFRS 15, the seller-lessee measures a right-of-use asset arising from the leaseback as the proportion of the previous carrying amount of the asset that relates to the right of use retained. The gain (or loss) that the seller-lessee recognises is limited to the proportion of the total gain (or loss) that relates to the rights transferred to the buyer-lessor.

If the consideration for the sale is not equal to the fair value of the asset, any resulting difference represents either a prepayment of lease payments (if the purchase price is below market terms) or an additional financing (if the purchase price is above market terms). The same logic applies if the lease payments are not at market rates. The buyer-lessor accounts for the purchase in accordance with applicable standards (such as IAS 16 if the underlying asset is property, plant or equipment), and for the leaseback in accordance with IFRS 16.

Example (from the perspective of the seller-lessee)

A seller-lessee sells a building to an unrelated buyer-lessor for cash of CU2,000,000. The fair value of the building at that time is CU1,800,000; the carrying amount immediately before the transaction is CU1,000,000.

At the same time, the seller-lessee enters into a contract with the buyer-lessor for the right to use the building for 18 years, with annual payments of CU120,000 payable at the end of each year. The interest rate implicit in the lease is 4.5%, which results in a present value of the annual payments of CU1,459,200.

The transfer of the asset to the buyer-lessor has been assessed as meeting the definition of a sale under IFRS 15.

Financing transaction

Since the consideration (CU2,000,000) exceeds the fair value (CU1,800,000) of the building, the agreement contains a financing transaction:

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Sale and Leaseback

The seller-lessee initially recognises a right-of-use asset as the proportion of the previous carrying amount (CU1,000,000) that reflects the right of use retained. The proportion is calculated by dividing the present value of the lease payment (CU 1,459,200) less the part of the lease payments that is just a repayment of the financing granted to the seller-lessee (CU 200,000) [= CU1,259,200] by the fair value of the asset (CU1,800,000).

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The gain on sale is calculated as a proportion of the total gain of CU 800,000 (purchase price less financing element less carrying amount of the building), representing the ratio between the rights effectively transferred to the buyer (= Fair value of the building less the right-of-use asset obtained by the seller-lessee) and the fair value of the building:

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The final accounting entries are as follows:

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Sale and leaseback transactions - Transfer of the asset is not a sale

Publication date: 15 Apr 2014

If the transfer is not a sale (that is, the buyer-lessor does not obtain control of the asset in accordance with IFRS 15), the seller-lessee does not derecognise the transferred asset and accounts for the cash received as a financial liability. The buyer-lessor does not recognise the transferred asset and, instead, accounts for the cash paid as a financial asset (receivable).

Transition

Publication date: 15 Apr 2014

IFRS 16 is effective for reporting periods beginning on or after 1 January 2019 (for entities within the EU this is subject to EU endorsement). Earlier application is permitted, but only in conjunction with IFRS 15. This means that an entity is not allowed to apply IFRS 16 before applying IFRS 15. The date of initial application is the beginning of the annual reporting period in which an entity first applies IFRS 16.

Transition - Definition of a lease

Publication date: 15 Apr 2014

Entities are not required to reassess existing lease contracts but can elect to apply the guidance regarding the definition of a lease only to contracts entered into (or changed) on or after the date of initial application (‘grandfathering’). This applies to both contracts that were not previously identified as containing a lease applying IAS 17/IFRIC 4 and those that were previously identified as leases in IAS 17/IFRIC 4. If an entity chooses this expedient it shall be applied to all of its contracts.

Acknowledging the potentially significant impact of the new lease standard on a lessee’s financial statements, IFRS 16 does not require a full retrospective application in accordance with IAS 8 but allows a ‘simplified approach’. Full retrospective application is optional.

Transition - Simplified approach – lessee accounting

Publication date: 15 Apr 2014

If a lessee elects the ‘simplified approach’, it does not restate comparative information. Instead, the cumulative effect of applying the standard is recognised as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of initial application.

Balance sheet item

Measurement

Leases previously classified as operating leases

Lease liability

Remaining lease payments, discounted using lessee’s incremental borrowing rate at the date of initial application.

Right-of-use asset

Retrospective calculation, using a discount rate based on lessee’s incremental borrowing rate at the date of initial application.
or
Amount of lease liability (adjusted by the amount of any previously recognised prepaid or accrued lease payments relating to that lease).
(Lessee can choose one of the alternatives on a lease-by-lease basis.)

Leases previously classified as finance leases

Lease liability

Carrying amount of the lease liability immediately before the date of initial application.

Right-of-use asset

Carrying amount of the lease asset immediately before the date of initial application.

A lessee is not required to apply the new lessee accounting model to leases for which the lease term ends within 12 months after the date of initial application.

A lessee is not required to apply the new lessee accounting model to leases for which the lease term ends within 12 months after the date of initial application.

Transition - Simplified approach – lessor accounting

Publication date: 15 Apr 2014

Lessor accounting stays largely the same as under IAS 17. The only significant change is that, under IFRS 16, subleases must be classified either as finance or as operating leases, with reference to the right-of-use asset resulting from the head lease.

Hence, the lessor is not required to make any adjustments on transition except for the reassessment of operating subleases ongoing at the date of initial application. The analysis is made on the basis of the remaining contractual terms and conditions of the head lease and the sublease. If operating subleases are now classified as finance leases, the lessor accounts for the sublease as a new finance lease entered into on the date of initial application.

Transition - Simplified approach – sale and leaseback

Publication date: 15 Apr 2014

Sale and leaseback transactions entered into before the date of initial application are not reassessed. In the case of a finance leaseback, the seller-lessee continues to amortise any gain on sale over the term of the lease. In the case of an operating leaseback, any deferred gain or loss due to off-market terms is accounted for as an adjustment to the leaseback right-of-use asset.

Transition - Retrospective application

Publication date: 15 Apr 2014

If an entity chooses not to use the simplified approach, it has to apply IFRS 16 retrospectively to each prior reporting period in accordance with IAS 8, ‘Accounting Policies, Changes in Accounting Estimates and Errors’.

Appendix - Disclosure requirements for lessees

Publication date: 15 Apr 2014

*

Right-of-use asset                           

Depreciation charge (by class of underlying asset)

Carrying amount (by class of underlying asset)

Additions

Lease liabilities

Interest expense

Maturity analysis in accordance with paragraph 39 and B11 of IFRS 7

Recognition and measurement exemptions                                            

Expense relating to short-term leases

Expense relating to leases of low-value assets

Other disclosures relating to income statement

Expense relating to variable lease payments not included in lease liabilities

Income from subleasing right-of-use assets

Gains or losses arising from sale and leaseback transactions

Total cash outflow for leases

Future cash outflows from …

Variable lease payments
(includes key variables on which payments depend and how they affect them)

Extension options and termination options

Residual value guarantees

Leases not yet commenced to which the entity is committed

Short-term lease commitments

Qualitative disclosures

Nature of the lessee’s leasing activities

Restrictions or covenants imposed by leases

Sale and leaseback transactions

*  This table covers the major disclosure requirements; depending on the particular facts and circumstances, additional disclosures might be necessary.

Appendix - Disclosure requirements for lessors

Publication date: 15 Apr 2014

*

Finance lease                                    

Selling profit or loss

Finance income on the net investment in the lease

Lease income relating to variable lease payments not included in the measurement of the lease receivable

Qualitative and quantitative explanation of the significant changes in the carrying amount of the net investment in the lease

Maturity analysis of lease receivable for a minimum of each of the first five years plus a total amount for the remaining years; reconciliation to the net investment in the lease

Operating lease

Lease income, separately disclosing income relating to variable lease payments that do not depend on an index or rate

Maturity analysis of lease payments for a minimum of each of the first five years plus a total amount for the remaining years  

Disclosure requirements in IAS 36, IAS 38, IAS 40 and IAS 41 for assets subject to operating leases

Disclosure requirements in IAS 16 for items of property, plant and equipment subject to an operating lease

Qualitative disclosures for all leases

Nature of the lessor’s leasing activities

Management of the risk associated with any rights that the lessor retains in underlying assets

Relevant requirements of IFRS 7

*  This table covers the major disclosure requirements; depending on the particular facts and circumstances, additional disclosures might be necessary.

Appendix - Comparison of IFRS 16 and IAS 17/IFRIC 4 – overview of the main differences

Publication date: 15 Apr 2014

Issue

IFRS 16

IAS 17/IFRIC 4

Definition of a lease

Right to use an asset, that is:

  • identified asset, and
  • right to control the use

In general similar to IFRS 16, but different detailed guidance

Separating lease components

Separate component, if:

  • separate benefit for lessee, and
  • not highly dependent on, or highly interrelated with, other component

No specific guidance
(except for lease of land and building)

Combination of contracts

Combine contracts if certain criteria are met

No comprehensive guidance
(see SIC 27)

Exemptions

 

 

Short-term lease (lessee)

Lease term 12 months
(provided there is no purchase option)

No

Low-value assets (lessee)

ValueUSD5,000

No

Lessee accounting

 

 

Balance sheet

Right-of-use asset and lease liability for almost every lease

Operating lease:
No asset or liability recognised (only accruals or prepayments)
Finance lease: Leased asset and lease liability

Variable lease payments

Part of the lease liability if they depend on index/rate

Not part of the lease liability

Income statement

Single approach

  • Right-of-use asset: depreciation
  • Lease liability: effective interest rate method
  • Variable lease payments not included in lease liability (that is, not depending on index/rate)

Operating lease: Lease payments on a straight-line basis
Finance lease:
Leased asset: depreciation
Lease liability: effective interest rate method
Variable lease payments not included in lease liability

Cash flow statement

Part of lease payment that represents principal portion:
Cash flow resulting from financing activities
Part of lease payment that represents interest portion:
operating cash flow or cash flow resulting from financing activities (depending on entity’s policy)

Payments for short-term leases, for lease of low-value assets and variable lease payments not included in lease liability:
operating cash flow

Operating lease: operating cash flow
Finance lease: Similar to IFRS 16

Lessor accounting

 

 

Balance sheet
  • Classification as finance or operating lease
  • Finance lease: derecognition of the underlying asset, recognition of a lease receivable at amount equal to the net investment in the lease
  • Operating lease: continue to recognise the underlying asset
Income statement

Finance lease: interest measured using the effective interest rate method
Operating lease: lease payments on straight-line basis

Subleases

Classification of sublease refers to right-of-use asset

Classification of sublease refers to leased asset

Modifications
  • Adjustment of existing lease, or
  • accounted for as a separate lease,

depending on kind of modification

No specific guidance

Sale and leaseback

Distinction based on whether transfer is sale

Distinction based on classification of leaseback

Appendix - Comparison of IFRS 16 and “revised”* US GAAP - overview of the main differences

Publication date: 15 Apr 2014

(*The publication takes into account decisions of the FASB as at 31 December 2015).


Issue

IFRS 16

US-GAAP

Definition of a lease

Right to use an asset, that is:

  • identified asset, and

  • right to control the use

Same as IFRS 16

Exemptions

 

 

Short-term lease (lessee)

Yes
(Lease term ≤ 12 months; no purchase option)

Yes

Low-value assets (lessee)

Yes
(Value ≤ USD5,000)

No

Lessee accounting

 

 

Balance sheet

Right-of-use asset and lease liability for almost every lease

Income statement

Single approach

  • Right-of-use asset: depreciation

  • Lease liability: effective interest rate method

  • Variable lease payments not included in lease liability (that is, not depending on index/rate)

Dual approach

Depending on the characteristics of the lease:

  • Similar to IFRS 16 or
  • Recognising a single lease expense typically on a straight-line basis over the lease term

Lessor accounting

Previous guidance is substantially carried forward

Subleases

Classification of sublease refers to right-of-use asset

Classification of sublease refers to underlying asset

Sale and leaseback

Gain or loss on sale is limited to the amount that relates to the rights transferred  

Gain or loss on sale is accounted for consistently with guidance that would apply to any other sale of assets

Reassessment of variable lease payments

Required for variable lease payments that depend on index/rate (when there is a change in cash flows)

In general no reassessment (however, remeasurement is required if the lease is reassessed for another reason)

Appendix - Impact on lessee’s key performance indicators

Publication date: 15 Apr 2014

KPI

Calculation

Effect of IFRS 16

Gearing (debt to equity ratio)

Liabilities/equity

Increase
(because most leases previously accounted for as operating leases will now be on balance sheet)

EBIT

Earnings before interest and tax

Increase
(because the depreciation added is lower than the lease expense eliminated from operating income)

EBITDA

Earnings before interest, tax and amortisation

Increase
(because lease expense is eliminated from EBITDA)

Operating cash flow

Increase
(because some or all of the operating lease payments are moved to financing)

Asset turnover

Sales/total assets

Decrease because lease assets are part of total assets

ROCE

EBIT/Equity plus financial liabilities

Depends on the characteristics of the lease portfolio (EBIT as well as financial liabilities will increase)

Leverage

Net debt/EBITDA

Depends on the characteristics of the lease portfolio (EBITDA as well as net debt will increase)

 

Authored by:

Jessica Taurae
Phone: +44 207 212 5700
Email: jessica.taurae@uk.pwc.com

Holger Meurer
Phone: +44 207 212 3073
Email: holger.m.meurer@uk.pwc.com

 

Derek Carmichael
Phone: +44 207 804 6475
Email: derek.j.carmichael@uk.pwc.com

 


Banking & Capital Markets industry supplement

Publication date: 15 Apr 2014

At a glance

The IASB has issued a new standard, IFRS 16, on leasing, under which lessees will be required to bring substantially all leases onto their balance sheets. Some changes could also impact certain lessors. The new guidance is likely to introduce some level of change for all entities that are party to a lease.

In depth INT2016-01 provides a summarised analysis of the new standard. In addition, chapter 15 (Leases) of PwC’s Manual of Accounting contains a comprehensive overview of the new leases standard and its related implications.

This supplement highlights some of the areas that could create the most significant challenges for entities in the Banking & Capital Markets sector as they transition to the new standard.

Banking & Capital Markets industry supplement - Overview

Publication date: 21 Nov 2018

Leases are common in the Banking & Capital Markets sector. Entities are generally lessees (for example, of banking branches and IT equipment, and inter-company leases between operating companies and trading companies) and, at times, lessors of assets (for example, of aircraft and properties).

Banking & Capital Markets industry supplement - Impact

Publication date: 21 Nov 2018

Lessees

IFRS 16 requires lessees to capitalise (that is, recognise a right-of-use asset and a lease liability in relation to) virtually all leases; the only optional exemptions are for certain short-term leases and leases of low-value assets. Expense recognition will be similar to a finance lease today (that is, depreciation of the right-of-use asset and interest expense on the lease liability).

The financial reporting effects are just some of the most obvious impacts that the new standard will have on companies in the Banking & Capital Markets sector. Financial institutions will also need to analyse how the new model will affect current business activities, contract negotiations, budgeting, and key metrics. The identification of a complete inventory of leases, including embedded and inter-company leases, will be critical to effective capital planning.

On 6 April 2017, the Basel Committee on Banking Supervision issued a ‘frequently asked questions’ press release related to lease accounting. The press release made it clear that right-of-use assets related to underlying tangible assets should not be deducted from regulatory capital; they are not akin to intangible assets, and they should be included in risk-based capital and leverage denominators at 100% risk weighting, similar to the treatment for tangible assets.

For regulated banking institutions, the recognition of right-of-use assets on the balance sheet might impact the calculation of regulatory capital ratios by increasing the assets in the denominator of the risk-based capital ratios (risk-weighted assets) and leverage capital ratio (adjusted asset). All other things being equal, a higher denominator will result in lower capital ratios for the financial institution. 

Financial institutions with a large portfolio of leases will need to evaluate their ability to gather the required information on existing leases, which will be critical to an orderly transition to the new standard. This could result in the need for new systems, controls and processes, which will take time to identify, design, implement and test.

Lessors

The accounting model for lessors remains broadly consistent with existing IFRS, because lessors will classify leases as operating or financing based on the same guidance that is currently in IAS 17. To the extent that financial institutions have arrangements with customers which contain lease and non-lease components, the lessor will need to consider the interaction of IFRS 16 with IFRS 15, which could result in certain components of the arrangement being accounted for as other revenue, rather than as part of the lease.

The new rules could impact the financial metrics of customers and borrowers, causing some to re-evaluate whether to buy an asset instead of leasing it or to reconsider certain terms of a lease. For example, when underwriting new loans, bank personnel will need to understand the impact of the new accounting on the financial statements of potential borrowers, and they will need to understand the impact that the standard might have on how lending covenants have been traditionally structured.

Banking & Capital Markets industry supplement - Effective date and transition

Publication date: 21 Nov 2018

The effective date of the new standard is for annual reporting periods beginning on or after 1 January 2019. Early adoption is permitted for all entities, provided that they have already adopted IFRS 15. IFRS 16 has also been endorsed for use in the European Union.

The new standard permits two transition methods. Acknowledging the potentially significant impact of the new lease standard on a lessee’s financial statements, IFRS 16 does not require a full retrospective application in accordance with IAS 8, but it allows a ‘simplified approach’. Full retrospective application is optional. If a lessee elects the ‘simplified approach’, it does not restate comparative information; instead, the cumulative effect of applying the standard is recognised as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of initial application. In addition, there are a number of practical expedients.

Banking & Capital Markets industry supplement - Identifying leases

Publication date: 21 Nov 2018

Regardless of how an arrangement is structured, the lease accounting guidance in IFRS 16 applies to any arrangement that conveys control over an identified asset to another party. The arrangement or agreement does not need to be called a lease or be a lease in its entirety. An arrangement is a lease or contains a lease if (1) there is an explicitly or implicitly identified asset, and (2) use of the asset is controlled by the customer (that is, the user of the asset or taker of the output from the asset). 

IFRS 16 In Depth BCM for BIAG

Banking & Capital Markets industry supplement - Identified asset

Publication date: 21 Nov 2018

An identified asset can be specified explicitly (such as a computer, by its serial number) or implicitly. However, in all cases, the asset is not identified if the supplier has a substantive contractual right to substitute such asset (for example, if the server provider can substitute the server available to the bank). A substitution right is substantive if (a) the supplier can practically use another asset to fulfil the arrangement throughout the term of the arrangement, and (b) it is economically beneficial for the supplier to do so. The supplier’s right or obligation to substitute an asset for repairs, maintenance, malfunction or technical upgrade does not preclude the asset from being considered an identified asset.  

An identified asset must be physically distinct. A physically distinct asset could be an entire asset or a portion of an asset. For example, a building is generally considered physically distinct, but one floor within the building could also be considered physically distinct if it can be used independently of the other floors (for example, with its own point of entry or exit, and access to lavatories). However, a capacity or other portion of an asset is not an identified asset if (1) it is not physically distinct (such as an arrangement permitting use of a portion of the capacity of a server), and (2) the customer does not have the right to substantially all of the economic benefits from the use of the asset (for example, even though several parties share the use of the server, no customer has substantially all of the capacity).

Example 1 – Whether a contract contains a lease: outsourced information technology function

Facts: Commercial Bank (‘Customer’) enters into a three-year IT contract with a service provider (‘Supplier’) for IT-related services. Under this arrangement, Supplier installs a dedicated server at Customer’s premises to be used by Customer during the term of the arrangement. The server is explicitly identified in the contract, and Supplier is permitted to substitute the server only if it malfunctions. Customer decides which data to store on or delete from the server and how to integrate the server within its operations throughout the contract term. Supplier provides maintenance and other support services, such as nightly data back-up and software upgrades. Supplier does not have any right to decide the deployment of the server during the term of the arrangement (that is, it cannot make any decisions about the use of the server during the period of use, it does not have the right to decide how data is transported using the server, it cannot decide whether to reconfigure the server, and it cannot decide whether to use the server for another purpose).

Question: Does the contract contain an identified asset?

Discussion:Based on the facts in this example, the contract contains an identified asset.

The contract explicitly identifies a server that Supplier can substitute only in the event of malfunction. Therefore, the arrangement contains identified property, plant or equipment (that is, the server). Since the contract has an identified asset, it is now necessary to consider who controls the use of that identified asset, to determine whether the arrangement contains a lease.

Banking & Capital Markets industry supplement - Right to control the use of the identified asset

Publication date: 21 Nov 2018

A customer controls the use of the identified asset by possessing (1) the right to obtain substantially all of the economic benefits (for example, output) from the asset (the ‘economics’ criterion) and (2) the right to direct the use of the identified asset throughout the period of the arrangement (the ‘power’ criterion). The economics criterion might sound similar to the current model, under which an arrangement is deemed to meet the economics criterion if it is remote that any other party will take more than a minor amount of the output. However, under current guidance, if the customer has the right to substantially all of the output, there is a pricing exception that precludes the economics criterion from being met. That is, under current guidance, having substantially all of the output is not enough to satisfy the criterion if the price that the customer will pay for the output is either contractually fixed per unit or equal to the current market price per unit at the time of delivery.

A customer meets the ‘power’ criterion if it holds the right to make decisions that have the most significant impact on the economic benefits derived from the use of the asset. In some cases, the use of the asset is predetermined in the contract (for example, a piece of equipment). If decisions that have the most impact on the economic benefits to be derived from the use of the underlying asset are predetermined, the customer might still have control if (a) it has the right to direct the operations of the asset without the supplier having the right to change those operating instructions, or (b) it has designed the asset (or specific aspects of the asset) in a manner that predetermines how and for what purpose the asset will be used. Sometimes, terms that are protective in nature might be included in the contract to protect the supplier’s asset and supplier’s personnel and to comply with regulations. For example, a contract might restrict usage of a piece of equipment up to a maximum number of hours per period, based on the piece of equipment’s design constraints. The existence of such protective rights, in and of itself, does not prevent a customer from having the right to direct the use of an asset.

In the context of Example 1 above, Customer has the right to control the use of the server, because it has (a) the right to obtain all of the economic benefits from the use of the identified server, based on its exclusive access and use of the server during the three-year term, and (b) the right to direct the use of the identified server because of its ability to determine which data is stored, and the nature and timing of the content placed on the server. Maintenance and support activities ensure that the server operates as it should, but they do not impact how and for what purpose the server is used, because they do not affect the economic benefits derived from use of the server.

PwC observation:

Financial institutions might have data for leases related to their head office and branch networks, but ensuring a complete inventory of leases will mean evaluating all types of arrangement for embedded leases. For example, there has been a trend for many financial institutions to outsource business operations and support functions such as IT – in some cases, on a global scale – to leverage and drive expertise. Financial institutions will need to assess such contractual arrangements, to determine if they contain embedded leases. Common examples of arrangements that might contain an embedded lease are the outsourcing of data centres and hosting arrangements. Banks might also have leases associated with their ATMs or other assets. Arrangements that are considered to be leases might or might not qualify for the exemption available for short-term leases.

Banking & Capital Markets industry supplement - Inter-company arrangements

Publication date: 21 Nov 2018

Inter-company arrangements designed to allocate overhead and other costs, such as rent, to different business and legal entities are common in the financial services sector. Companies will need to analyse such arrangements, to determine if they are leases or contain embedded leases. While these types of arrangement exist in many industries, the impact of the new leases standard might be significant to financial services companies, because they tend to have a large number of subsidiaries and legal entities through which they conduct business that prepare stand-alone financial statements.

While inter-company leases would be eliminated for the purposes of consolidated reporting, some legal entities might be required to prepare stand-alone financial statements. The recording of a right-of-use asset and a lease liability in the stand-alone financial statements, on application of the new lease accounting model, might impact a number of regulatory reporting and capital calculations for such entities.

Under the new leases standard, a lessee could, by class of underlying asset, elect to not reflect a right-of-use asset and a lease liability on the lessee’s balance sheet for leases with a term of 12 months or less (the ‘short-term exemption’). The standard also stipulates that leases between related parties should be accounted for based on the enforceable terms and conditions of the lease.

It is common for an entity to enter into an agreement with its parent company, or another member of the consolidated group, under which the entity pays a fee in return for the use of space (such as a floor in the building), equipment, and other services, such as maintenance. These types of agreement might contain a lease. However, if the legally enforceable term of such an agreement is 12 months or less, the lessee entity could elect the short-term exemption and not reflect a right-of-use asset and a lease liability on its balance sheet.

Interpretation of ‘legally enforceable’

The question that arises is how ‘legally enforceable’ should be interpreted in connection with related-party leases. Some related-party transactions might not be documented and/or the terms and conditions are not at arm’s length. Therefore, in order to operationalise the short-term exemption, we believe that a lessee should first focus on what the legally enforceable lease term is, based on the written agreement. However, if the economics of the written agreement do not align with the economics of other related transactions (for example, the lease term is one year but the lessee is installing expensive leasehold improvements that have an economic life of greater than one year) or there is no written agreement, the lessee should determine if there is a binding oral agreement or understanding. The lessee might need to solicit input from legal counsel about whether the terms and conditions of the oral agreement or understanding are legally enforceable. 

PwC observation:

Even though a lessee could, by class of underlying asset, elect to not reflect a right-of-use asset and a lease liability on its balance sheet for leases with a term of 12 months or less, entities are still subject to the disclosure requirements for related-party transactions under IAS 24, ‘Related Party Disclosures’. This includes disclosing information necessary to understand the effects of the related-party transactions on the entity’s financial statements, such as a description of the relationships and the transactions.

Banking & Capital Markets industry supplement - Components, contract consideration, and allocation

Publication date: 21 Nov 2018

An arrangement might contain lease and non-lease components. Components are those items or activities in the arrangement that transfer a good or service to a customer/lessee (for example, maintenance of bank branches provided by the landlord of a shopping centre within which the branch is located). A right to use an underlying asset is a separate lease component from other lease components if (a) the lessee can benefit from the right-of-use either on its own or together with other resources that are readily available to the lessee, and (b) the right-of-use is neither highly dependent on nor highly interrelated with the other rights to use underlying assets in the contract.

Non-lease components are subject to other GAAP outside the new leases standard (for example, non-lease components might be lessor performance obligations under the new revenue standard). Property taxes and insurance that do not represent separate goods or services are not components. Any fixed payments by the lessee for these items are considered part of overall contract consideration, to be allocated among the lease and non-lease components.

Maintenance costs, on the other hand, involve delivery of a separate service, and so they are considered a non-lease component if provided by the lessor to the lessee. In leases containing land, the land is a separate lease component unless the accounting effect of separately accounting for the land component is insignificant (for example, the amount recognised for the land lease component would be insignificant, or separating the land lease component would not impact the lease classification of any lease component).

Once the lease and non-lease components are identified, contract consideration is allocated to each component.

A lessee should allocate the contract consideration to each lease and non-lease component based on its relative stand-alone price. Any variable payments that are not based on a rate or an index are excluded from the calculation of the overall contract consideration. The standard provides a practical expedient under which a lessee can, as an accounting policy election by class of underlying asset, choose to not separate non-lease components from the associated lease component, and instead account for them all together as part of the applicable lease component.

The impact of property taxes and insurance paid by the lessee depends on whether they are fixed or variable. If a lessee pays the actual amount of property taxes and insurance that are not, in substance, fixed, and the payments are not based on an index or a rate, they should be accounted for similarly to other variable lease payments (that is, excluded from contract consideration and excluded from lease payments used for classification and initial measurement) by both the lessee and the lessor. On the other hand, if a lessee pays a fixed amount of property taxes and insurance as part of rent payments, such payments should be included in contract consideration and allocated to the lease and non-lease components by the lessee and lessor. The effect of doing so, consistent with the notion that property taxes and insurance are not separate goods that are transferred, is that such payments are subject to allocation to the components, and the amounts allocated to the lease component are included in the classification and measurement of the lease. Lessor accounting is discussed at the end of the document.

Banking & Capital Markets industry supplement - Lessee accounting model

Publication date: 21 Nov 2018

Lessees will be required to recognise a right-of-use asset and liability for virtually all of their leases (other than short-term leases or leases of low-value assets). For income statement purposes, leases will produce a front-loaded expense pattern (similar to current finance leases), where a higher interest expense is recognised in earlier reporting periods. Depreciation of the right-of-use asset is on a straight-line basis (similar to current finance lease expense recognition).

Example 2 – Lessee accounting: initial and subsequent measurement

Facts: Commercial Bank enters into a lease of equipment with Lessor Corp. The following is a summary of information about the lease and the leased asset:

Lease commencement date 1 January 20X1
Lease term 5 years, with no renewal option
Remaining economic life of the equipment 6 years
Purchase option None
Annual lease payments $525,000
Payment date Annually in advance on 1 January (first lease payment is due on lease commencement date)
Fair value of the equipment at lease commencement date $2,500,000
Commercial Bank’s incremental borrowing rate 5%
Residual value guarantee None
Initial direct costs None

Other information:

  • The interest rate implicit in the lease that Lessor Corp charges Commercial Bank is not readily determinable by Commercial Bank.
  • Title to the equipment remains with Lessor Corp throughout the period of the lease and on lease expiration.
  • Commercial Bank does not guarantee the residual value of the equipment.
  • Commercial Bank pays for insurance and maintenance of the equipment separately from lease payments.
  • The lease commencement date does not fall at or near the end of the economic life of the equipment.
  • The right-of-use asset is not impaired.


Question 1: How should Commercial Bank account for the lease at the lease commencement date?

Discussion: Commercial Bank should measure the lease liability by calculating the present value of the unpaid annual fixed lease payments of $525,000 discounted at Commercial Bank’s incremental borrowing rate of 5% ($1,861,625). The right-of-use asset would be equal to the lease liability, plus $525,000 rent paid on lease commencement date ($2,386,625).

Although not included in the example, the right-of-use asset would be reduced by any lease incentives received from Commercial Bank on or before the lease commencement date and increased by initial direct costs incurred by Commercial Bank or lease payments made to Lessor Corp before the commencement date.

Question 2: How should Commercial Bank subsequently measure the right-of-use asset and lease liability during the lease term?

Discussion: Commercial Bank would subsequently account for the lease liability and right-of-use asset as follows. The right-of-use asset would be amortised on a straight-line basis over the lease term, because the remaining economic life of the leased equipment is greater than the lease term consistent with the principles in IAS 16, ‘Property, Plant and Equipment’.

  Payment Principal* Interest expense** Lease liability Right-of-use asset amortisation Right-of-use asset
Commencement $525,000*** $525,000   $1,861,625   $2,386,625
Year 1 $525,000 $431,919 $93,081 $1,429,706 $477,325 $1,909,300
Year 2 $525,000 $453,515 $71,485 $976,191 $477,325 $1,431,975
Year 3 $525,000 $476,190 $48,810 $500,001 $477,325 $954,650
Year 4 $525,000 $500,001 $24,999 $ - $477,325 $477,325
Year 5 $ - $ - $ - $ - $477,325 $ -
  $2,625,000 $1,861,625 $238,375 $ - $2,386,625 $ -


This would be classified as a financing outflow on the statement of cash flows.
**   This would be classified as an operating or financing outflow on the statement of cash flows.
***  Initial payment was due at the lease commencement date; therefore, the entire payment is a reduction of principal.


PwC observation:

The incremental borrowing rate is 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. When calculating the incremental borrowing rate, a lessee should consider the following:

  • The rate calculated should be the rate at which the entity could borrow. The rate should not reflect the cost of equity finance and, as such, it would be inappropriate to use a WACC (or any other rate including a component ‘cost of capital’ alongside the cost of debt). Similarly, it would be inappropriate to use a transfer pricing rate (used for tax transfer pricing adjustments), because these are typically ‘risk-free’. However, there might be scenarios in which these rates can be used as a starting point, provided that appropriate adjustments are made.
  • The rate should reflect the amount that the entity could borrow over the term of the lease. It should be the rate at which an entity would borrow to acquire an asset of similar value to the right-of-use asset, rather than to acquire the entire underlying asset. An exception would be where the lease term is for substantially all of the life of the underlying asset.
  • The rate should reflect that of a secured borrowing for a similar asset (being the right-of-use asset, not the underlying asset), rather than an unsecured borrowing or general line of credit.
  • The rate should reflect the credit standing of the entity and the rate at which it would borrow in a similar economic environment. For example, if a company has GBP functional currency and typically borrows in GBP, but it enters into a US dollar lease, the incremental borrowing rate will reflect the cost of borrowing US dollars.


Example 3 – Lease of space for installation of ATMs

Facts: Commercial Bank has automated teller machines (ATMs) for the purpose of providing a self-service option to its depositors and customers. While Commercial Bank places many of its ATMs at its branches, it also enters into leases with third parties to place its ATMs in shopping centres and other strategic locations. The ATMs are built securely into the premises. The leases for space often have a non-cancellable term of 12 months, with a one-year renewal option. The rent during the renewal period would be the market rent at the time of exercise of the renewal option by Commercial Bank. Commercial Bank has exercised its renewal option for a majority of such leases in the past.

Question: How should Commercial Bank determine the lease term?

Discussion: In IFRS 16, a lessee can elect to not apply the recognition requirements of the standard to short-term leases (that is, a lease that, at the commencement date, has a lease term of 12 months or less). This election should be made by class of underlying asset. If a lessee elects this short-term lease exemption, it should recognise the lease payments in net income on a straight-line basis over the lease term, along with appropriate disclosures.

In evaluating whether or not the lease would be considered ‘short term’, at the lease commencement date, Commercial Bank should consider the factors that create an economic incentive for exercise of the renewal option, including factors based on the contract, the asset, the entity or the market. Commercial Bank should compare the renewal rents with the expected market rents for equivalent property under similar terms and conditions. In general, a renewal option with renewal rents that are equal to or greater than the rents in the initial lease term is not considered to be reasonably certain of exercise; however, this presumption could be overcome if the economic penalties that the lessee would suffer by not exercising the renewal option are significant. For example, if Commercial Bank determines that there would be significant economic losses incurred if a lease is not renewed, such as the costs to relocate the ATM to another location (since it would be costly to uninstall a built-in ATM and re-install it in another location) or lost economic benefits due to losing a strategic ATM location, Commercial Bank might conclude that exercise of the renewal option is reasonably certain. Although not determinative in isolation, the historical pattern of renewing its leases might indicate that there are factors that would commercially compel Commercial Bank to renew the lease.

If Commercial Bank is reasonably certain to exercise the renewal option, the lease term is 24 months (the initial lease term plus the one-year renewal option term) and, consequently, the exemption for short-term leases cannot be applied.

PwC observation:

Short-term leases are leases with a lease term of 12 months or less. The lease term also includes periods covered by an option to extend, or an option to terminate, if the lessee is reasonably certain to exercise the extension option, or not to exercise the termination option. A lease that contains a purchase option is not a short-term lease. The exemption for short-term leases must be applied by class of underlying asset.


Example 4 – Lease of computers and photocopiers

Facts: Commercial Bank leases desktop and laptop computers from IQ Technologies for a period of three years, for staff to use in the head office and branches. The desktop computers have an average value of £1,500, and the laptop computers have an average value of £2,000.

IQ Technologies also leases photocopier machines for a period of five years to Commercial Bank, and these are also used in the head office. The photocopiers have an average value of £800, and the photocopiers which also have in-built fax machines have an average value of £1,000.

Question: Can Commercial Bank apply the low-value exemption to these leases?

Discussion: The analysis of low-value leases does not require the lessee to determine whether low-value assets in aggregate are material. The exemption is still available, even if the aggregate value of low-value leases is material to the lessee – that is, Commercial Bank can assess the value of the desktop computers (£1,500), laptop computers (£2,000) and photocopiers (£800 and £1,000) individually, rather than the total value of each of those portfolios which could be material to Commercial Bank.

The standard does not define the term ‘low value’, but its Basis for Conclusions explain that the IASB had in mind assets of a value of US$5,000 or less when new. The amount of US$5,000 is not a quantitative threshold, but an example that the IASB has used to illustrate a general principle.

Commercial Bank can apply the low-value asset exemption to the leased desktop computers, laptop computers and photocopiers. The desktop computers, laptop computers and photocopiers are not highly dependent on, or highly interrelated with, each other. Although, in practice, some of the desktop computers/laptop computers/photocopiers are used together within the head office/branches, Commercial Bank could remove one of the items from the head office/branches and still operate the head office/branches. Furthermore, Commercial Bank can benefit from each of the leased assets on their own.

PwC observation:

The low-value exemption allows lessees to recognise the associated lease payments as an expense on either a straight-line basis over the lease term or another systematic basis. The lessee should apply another systematic basis if that basis is more representative of the pattern of the lessee’s benefit. Appropriate disclosure should be made if the exemption is taken.

In order to assess whether a leased asset qualifies for the low-value asset exemption, an entity should focus on the nature of the asset. Examples of assets of low value can include certain IT equipment (tablets and standard personal computers), office furniture, or telephones. Cars would not qualify as low-value assets, because a new car would typically not be of low value. The types of asset that qualify for the low-value asset exemption might change over time if, due to technological or market developments, the price of a particular type of asset changes. A change in the US dollar foreign currency exchange rate or the inflation rate does not, by itself, affect whether an asset is within the scope of the exemption.

A lease does not qualify as a lease of a low-value asset if a lessee sub-leases, or expects to sub-lease, the leased asset.

Banking & Capital Markets industry supplement - Initial direct costs

Publication date: 21 Nov 2018

Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained, except for such costs incurred by a manufacturer or dealer lessor in connection with a finance lease. For example, when a lessee and lessor execute a legally binding lease commitment prior to drafting the lease agreement, incremental legal fees for drafting the legally binding lease commitment might qualify as initial direct costs. However, incremental external legal fees would be excluded from the initial direct costs, if the lessee would be required to pay its attorneys for negotiating the lease even if the lease were not executed.

The definition of ‘initial direct costs’ has narrowed under the new leases standard, compared to current guidance. The new definition might not align with current practices or with similar definitions used in other areas of IFRS, such as transaction costs under IFRS 9, ‘Financial Instruments’. Under the new standard, only incremental direct costs associated with executing the lease, such as broker commissions, would be deferred. Payroll costs would generally not qualify for deferral.

Many banks are evaluated on their cost:income ratio, which compares expenses to income and is a measure of cost containment. Under IAS 17, payroll costs for originating a lease could be deferred by a lessor, included in the yield calculation of a finance lease, and recognised as a reduction of return over its lease term. Under the new model, such costs are no longer deferred, but will need to be expensed as incurred directly through non-interest expense. In some cases, this might impact the bank’s cost:income ratio. This will also have the effect of increasing net interest income over future periods for lessor portfolios.

Banking & Capital Markets industry supplement - Accounting for initial direct costs in a failed sale and leaseback transaction

Publication date: 21 Nov 2018

An example of a sale and leaseback arrangement for a bank might be that a company sells an asset (such as a vehicle or aircraft) to the bank, and then the bank leases that asset back to the seller. Under the new sale and leaseback model applicable to both lessees and lessors, a sale and leaseback transaction will qualify as a sale only if control of the asset sold has transferred to the buyer, according to the guidance in IFRS 15. For example, if the seller-lessee has a repurchase option, the IFRS 15 guidance on repurchase agreements will have to be applied, to decide whether control of the asset has transferred to the buyer-lessor.

If a transaction does not qualify as a sale, (1) the seller-lessee would not derecognise the transferred asset and would reflect the proceeds from the sale and leaseback transaction as a borrowing, and (2) the buyer-lessor (that is, the bank) would reflect its cash payment as a loan and apply the general loan guidance under IFRS 9 which would then allow the broader definition of transaction costs to be used.

PwC observation:

Lessors should assess how application of the new standard will impact line items such as interest income and non-interest expense when evaluating profitability and other metrics. They should also assess the impact that the narrowing of the definition of ‘initial direct costs’ might have on the cost:income ratio.

Banking & Capital Markets industry supplement - Lessor accounting model

Publication date: 21 Nov 2018

The accounting for leases by lessors has not significantly changed under IFRS 16; as under the current guidance, lessors will continue to determine whether a lease is a finance or operating lease.

IFRS 16 has clarified how lessors should account for lease agreements which have lease and non-lease components. Further details about components can be found above. Contracts often combine different kinds of obligations of the supplier, which might be a combination of lease components or a combination of lease and non-lease components. For example, the lease of a property might contain the lease of a property and the provision of maintenance services. In a multi-element arrangement, an entity has to identify each separate lease component (based on the guidance on the definition of a lease) and account for it separately.

A lessor should allocate the contract consideration to each lease and non-lease component in accordance with the transaction price allocation guidance in the new revenue standard (IFRS 15). Any variable payments not based on an index or rate (or which are not, in substance, fixed) that relate to a lease component are excluded from the calculation of the overall contract consideration. This includes elements of variable consideration that would otherwise be included under the new revenue standard. The practical expedient available to a lessee for lease and non-lease components is not available to a lessor.

Banking & Capital Markets industry supplement - About PwC’s Banking practice

Publication date: 21 Nov 2018

The Banking & Capital Markets industry faces challenging markets, new regulatory reform measures, and competition for clients and talent – all against a backdrop of heightened expectations from investors, regulators, industry partners and other stakeholders. Our Banking & Capital Markets partners and staff can assist in meeting these key industry challenges.

PwC helps organisations and individuals to create value. We are a network of firms in 157 countries with more than 223,000 people who are committed to delivering quality in assurance, tax and advisory services.

For more information, please contact your local PwC banking partner. 

Authored by:

Jessica Taurae
Partner
Email: Jessica.taurae@pwc.com

Sandra Thompson
Partner
Email: Sandra.thompson@pwc.com

Richard Brown
Manager
Email: richard.brown@pwc.com

 
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