IFRS 16 Leases introduces dramatic changes to accounting for leases, particularly for lessees in their financial statements.
By David Hardidge and Ram Subramanian
After more than a decade’s development, the new accounting standard for leases IFRS 16 (AASB 16 in Australia) – operative from 1 January 2019 – will impact what the International Accounting Standards Board (IASB) estimates is around US$2 trillion in leased assets that do not appear on the balance sheets of listed companies using IFRS or US GAAP.
The sheer size of the off-balance sheet assets and liabilities, combined with lack of transparency around them, has been a key driver behind IFRS 16 and its US equivalent.
Indeed, former chair of the IASB Sir David Tweedie quipped in 2008 that one of his greatest ambitions was to fly on an aircraft that actually was on an airline’s balance sheet.
When operative, many lease arrangements that were previously off-balance sheet will have to be included on-balance sheet. The new standard no longer distinguishes between finance and operating leases for lessees.
IFRS 16 will require the capitalisation of future operating lease payments on balance sheet as a right-of-use (ROU) lease asset and lease liability. The lease asset has to be depreciated, while interest will need to be recognised on the lease liability, over the lease term.
Although the changes appear similar to accounting for finance leases, the detailed calculations involved can be very different, particularly for rent variations, such as those arising from CPI increases.
Given these changes and the need for close scrutiny of the choice of transitional provisions that will affect future profits, intheblack.com recently hosted a live online chat on the subject. The following is an edited version of that discussion.
What impact will IFRS 16 have on profit?
The combination of the lease liability interest expense and right-of-use lease asset depreciation will usually be higher than the lease rental expense at the start of the lease.
Consequently, net profit will be relatively lower. Then it flips during the lease term, so there is a lower interest expense as the lease liability is repaid. Consequently, net profit will be relatively higher. This is known as the “financing effect”.
Are there any exemptions?
There are exemptions from the new accounting for those leases defined as short-term (less than 12 months) and those with low value. A low-value exemption threshold is not specifically defined in the standard. It is given in the guidance (USD $5000) as an indicator and not intended to be a hard and fast bright-line. You do not have to do your own materiality assessment. Low value leases are simply excluded from the standard. The threshold was expressed in USD because most people around the world can relate to it.
Generally, the low value test is applied to individual assets and not collectively. So for a situation of a lease for, say 100 computers at $4000 each, it is likely the low value exemption is available for all the individual computers.
Will accounting software be able to cope?
Working out discounted cash flows and lease liabilities will almost certainly require specialised software. While a spreadsheet model can be developed relatively easily for an individual lease, it becomes far more complicated when trying to aggregate a series of leases with different starting dates. Accounting for rental adjustments like CPI is complex, and it is possible that many current asset registers will not adequately deal with calculations required under the new standard.
Software vendors are already promoting new solutions for calculating CPI adjustments, but beware there are differences between IFRS 16 and the US version (ASC 842) of the standard, so the methodology that works in the US is unlikely to work in Australia or another jurisdiction that follows IFRS.
How do I account for CPI changes?
When projecting future rentals, you do not have to forecast CPI increases or conduct “true-ups” to actuals. This would have been a burden on preparers to calculate, and then account for. Instead, the intention is to forecast future cash flows based on known and fixed payments.
When rentals change, it is necessary to recalculate discounted cash flows, i.e., the lease liability. However, you stay with the original discount rate. The difference between the discounted cash flows before the rental change and the discounted amount after the change is recognised as an adjustment to the lease liability. There is also a corresponding change to the lease asset. Subsequently the financial statements will need to reflect interest expense on the adjusted liability and depreciation on the adjusted asset.
Let’s take an example where your rent over a 10 year lease is adjusted for CPI increases annually. In this scenario, your leased right-of-use asset will comprise the original right-of-use asset depreciated over 10 years, the CPI adjustment after year 1 depreciated over 9 years, the CPI adjustment in year 2 depreciated over 8 years, and so on. We do not expect many current asset registers can easily handle these calculations.
How do I account for other types of variable payments?
Using an example of retail space at a shopping centre of $5000 per month plus 5 per cent of sales, the lease liability is determined using the known rentals (i.e., the $5000 per month) that are projected over the lease term (defined in the standard). The 5 per cent of sales is a contingent variable lease payment and is recognised when the cash flows change (i.e. when incurred).
So retailers will still have an operating lease expense in their P&L for such payments.
When calculating the right-of-use asset and liability values, only the payments for the right to use asset should be included. Items such as electricity and maintenance should be excluded. However, if your rental payments are fixed and include extras, then either you make estimates to exclude that portion, or you are allowed to include them in the capitalised lease rentals – though that increases the lease liability and right-to-use asset – and gives a different expense profile than if the electricity costs etc. were accounted for separately.
Accounting for Leases. In this course, you will cover the scope of the new lease standard and the principles of lease accounting for both lessee and lessor.
How will you calculate the take-on (transition) values?
The transition provisions can be complicated. While there is an option to retrospectively apply the standard and include comparatives, many preparers may choose to apply the modified retrospective approach which does not require comparatives. Under this approach the lease liability will be based on future rentals as determined under the standard, based on the term of the lease, and usually with a transition date discount rate. Calculating the asset depends on a further choice under this approach.
For entities with a 30 June year end, and a financial year starting 1 July 2019, any transactions from 1 January 2019 to 30 June 2019 will be recognised in the 30 June 2019 financial statements based on the old rules. On 1 July 2019, the new rules apply.
How should the interest rate for deductions be calculated?
The new accounting standard does not change the tax deductibility of lease payments (or asset purchases), which remain subject to local tax legislation. However, in terms of accounting, an interest expense on a new lease liability will be recognised. This will be either the interest rate implicit in the lease (can be difficult to work out), or an incremental borrowing rate.
Are there new implications for employers on salary-packaged novated leases?
Novated leases can be complex, but commonly if an employee ceases employment with any particular organisation the lease is cancelled or re-novated back to the employee. In such circumstances, all obligations assumed by the employer under the novation agreement often revert to the employee. The lease can, of course, be novated to a new employer.
With respect to the new standard, a lease must be an asset controlled by the employer. Therefore, if an employee can take a lease for a motor vehicle elsewhere, it can be argued the current employer does not control the motor vehicle and as a result, the lease is not caught by the standard.
How will peppercorn leases in the not-for-profit sector be accounted for?
Not-for-profit (NFP) organisations are subject to special rules that require peppercorn (nominal payment) leases to be recognised as though they paid market rentals. So, for example, in the case where a NFP might have a 30-year lease over a property provided to it by a council or government department and is only paying $100 per annum in rent, the right-of-use asset is fair valued (based on market rents) and recognised in the balance sheet. The corresponding credit is the liability for future cash payments ($100 per annum), and the difference usually recognised as a contribution from the council or government department.
In a situation such as where a sports team might lease a facility shared by other entities, it would be first necessary to determine whether the facility is in the scope of the standard and gets capitalised – again, a lease has to be over an asset you control. If this lack of control over an asset can be established, it is unlikely the sports team would be caught by the standard, as capacity sharing is not deemed sufficient to constitute control.
How will revaluation of land and buildings in the public sector be affected?
The standard allows you to revalue the right-of-use asset, like it is property, plant & equipment. The standard requires that if you do revalue the right-of-use asset, that you also revalue the related class. However, it seems that if you revalue buildings, you are not forced to revalue right-of-use building leased assets. The ultimate decision will probably be determined by who sets your financial reporting requirements.
Is the right-of-use asset presented with tangible or intangible assets?
The right-of-use asset will be classified under the applicable property, plant and equipment class as a tangible asset. However, there is likely to be further note disclosure distinguishing between owned and leased assets. Also, the standard does optionally allow for the application of the standard to intangible assets that are not scoped out.
Need to learn more about the standard?
In anticipation of IFRS 16 / AASB 16 coming into effect, CPA Australia has been engaged in resources development to assist stakeholders prepare for its new requirements.
This includes a podcast that provides an overview of the standard, as well as a half-day workshop that was held in Melbourne and Sydney late last year.
More information on these and other resources can be found at the CPA Australia website.
The standard is available from the AASB website or IFRS website, with links to supplementary material.
Because the effect of the standard may be dramatic, preparers should study the standard and accompanying material to gain a full understanding of impending requirements.
David Hardidge is Director – Technical and Treasury Products at Queensland Audit Office. Ram Subramanian is Policy Adviser – Reporting at CPA Australia.
The authors have provided their responses to the questions raised during the live online chat using examples and other scenarios to demonstrate how some of the key requirements within IFRS 16 Leases are applicable. This article is an edited version of that discussion.
It should be noted that the application of the requirements within IFRS 16 is subject to the exercise of professional judgment and interpretation, and the requirements may vary depending on the specific circumstances.
This article and the Q&A transcript are provided as general guidelines only for readers to obtain a better understanding of the key requirements within the standard. Readers must always ensure they read and understand the requirements in IFRS 16 Leases and accompanying guidance when applying it to their own specific circumstances.
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