As we discussed here, the IASB has issued IFRS 16 Leases, effective for annual reporting periods beginning on or after January 1, 2019.
We’ve already discussed some of the issues arising in identifying at inception of a contract whether that contract is a lease, or contains a lease and in determining the lease term, as well as the standard’s major scope exemption. Here now is what the standard has to say about initially measuring the lease liability:
- “At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate.
- At the commencement date, the lease payments included in the measurement of the lease liability comprise the following payments for the right to use the underlying asset during the lease term that are not paid at the commencement date:
- (a) fixed payments (including in-substance fixed payments…), less any lease incentives receivable;
- (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date;
- (c) amounts expected to be payable by the lessee under residual value guarantees;
- (d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option…;
- (e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.”
There are numerous concepts to dissect here. First of all, for the most straightforward leases it will often be obvious what constitutes a fixed payment – simply the (say) defined monthly charges for using the leased asset. But the concept also includes payments “that may, in form, contain variability but that, in substance, are unavoidable.” This may include payments that depend on events with no genuine possibility of not occurring, or situations where “there is more than one set of payments that a lessee could make, but only one of those sets of payments is realistic.”
Variable lease payments that depend on an index or a rate include, for example, payments linked to a consumer price index, payments linked to a benchmark interest rate (such as LIBOR) or payments that vary to reflect changes in market rental rates. The IASB reasons that these payments meet the definition of liabilities for the lessee because they’re unavoidable and don’t depend on any future activity of the lessee. The lessee measures such payments using the index or rate at the commencement date (using lease payments that assume no inflation over the remainder of the lease term). The IASB decided that requiring the use of forward rates when available would lead to reduced comparability.
In the basis for conclusions document, the IASB also addresses the treatment of variable payments linked to future performance or use of an underlying asset (for example, payments arising only when the underlying asset is used, or a sale is made). They decided to exclude these kinds of variable payments from the measurement of lease liabilities (although it sounds like different Board members came to that conclusion in different ways).
Even these aspects of the lease liability alone ((a) and (b) in the definition above) might sometimes generate differences from the current IAS 17 in identifying what should or shouldn’t be included within the lease liability. IAS 17 defines the core portion of minimum lease payments as “the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services, and taxes to be paid by and reimbursed to the lessor…” The concept of payments that the lessee “is or can be required to make” wouldn’t necessarily always get to the same place as the new notion of in-substance fixed payments. Then, as just noted, IAS 17 excludes “contingent rent” from the minimum lease payments. Some of what’s regarded as contingent rent under IAS 17 would be excluded under IFRS as well (such as amounts based on percentages of future sales) but other items (such as amounts based on future price indices) would be included, in the way set out above.
Residual values guaranteed to the lessor by the lessee (item (c) above) are also treated as part of the minimum lease payments under both IAS 17 and IFRS 16. The new standard specifies that “the measurement of a residual value guarantee should reflect an entity’s reasonable expectation of the amount that will be paid.” The IASB considered whether such guarantees should be recognized separately, in that they may meet the concept of a derivative, but concluded this might “diminish the relevance and faithful representation of the information provided,” as well as being costly to apply.
In assessing whether a lessee is reasonably certain to exercise a purchase option, or the likelihood of it exercising a termination option (items (d) and (e) above), it “considers all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, the option, including any expected changes in facts and circumstances from the commencement date until the exercise date of the option.” The relevant factors here align with those considered in assessing the lease term, as we discussed here.
More to come…
The opinions expressed are solely those of the author