As we discussed here, the IASB has issued IFRS 16 Leases, effective for annual reporting periods beginning on or after January 1, 2019.
Here’s the summary of the approach to lessee accounting:
- “IFRS 16 introduces a single lessee accounting model and requires a lessee to recognize assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. A lessee is required to recognize a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.
- A lessee measures right-of-use assets similarly to other non-financial assets (such as property, plant and equipment) and lease liabilities similarly to other financial liabilities. As a consequence, a lessee recognises depreciation of the right-of-use asset and interest on the lease liability, and also classifies cash repayments of the lease liability into a principal portion and an interest portion and presents them in the statement of cash flows applying IAS 7 Statement of Cash Flows.
- Assets and liabilities arising from a lease are initially measured on a present value basis. The measurement includes non-cancellable lease payments (including inflation-linked payments), and also includes payments to be made in optional periods if the lessee is reasonably certain to exercise an option to extend the lease, or not to exercise an option to terminate the lease.”
The first step in this process is to identify at inception of a contract whether that contract is a lease, or contains a lease. This is the case “if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.” For this purpose, a period of time may be described in terms of the amount of use of an identified asset – for example, the number of production units an item of equipment will be used to produce. Once the assessment is made, it’s only reassessed if the contract’s terms and conditions change.
The assessment requires determining whether, throughout the period of use, 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. It’s immediately clear how this drives differences from the current approach. For example, under IAS 17, a lease of a single floor in a large building for a period of a few years would be an operating lease, because it doesn’t transfer substantially all the risks and rewards of owning that space to the lessee. But if the lessee has the right to use that floor space as it wishes for the period of the contract, then it provides a basis under IFRS 16 for recognizing a right-of-use asset. It’s key to this determination that something like a floor of a building is physically distinct from the other floors in the building. The standard notes: “A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fibre optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.”
A customer controls the use of an identified asset when it has the right to obtain substantially all of the economic benefits from using the asset throughout the period of use – this could be by using, holding or sub-leasing it. As in other aspects of IFRS, this concept interacts with the concept of protective rights – contractual terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure compliance with laws or regulations. For example, a contract might specify the maximum amount of use of an asset or limit where or when the customer can use it, such as by limiting it to a particular territory. This doesn’t mean the customer lacks the right to direct the use of an asset, as long as it obtains substantially all of the economic benefits from using the asset within the agreed parameters. This might differ from, say, a situation where a customer only has access to an asset when it’s not being used by someone else, or has to respond to other kinds of unpredictable constraints outside its control.
In a similar vein, a right of use asset doesn’t exist when the supplier has the substantive right to substitute the asset throughout the period of use. For a lease of a piece of machinery for example, this might be the case where the customer can’t prevent the supplier from removing it and replacing it with another machine (and other such machines are readily available to the supplier, or could be), and the supplier would benefit economically from exercising its right to substitute the asset. This evaluation is also based on the facts and circumstances at inception of the contract, and so doesn’t take into account (say) how possible changes in future technology or future market prices might influence the supplier’s thinking in this regard.
More on this next time…
The opinions expressed are solely those of the author