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, in determining the lease term, and in measuring the lease liability, as well as the standard’s major scope exemption. Here now is what the standard has to say on initially measuring the lease asset:
- The cost of the right-of-use asset shall comprise:
- (a) the amount of the initial measurement of the lease liability (as described previously);
- (b) any lease payments made at or before the commencement date, less any lease incentives received;
- (c) any initial direct costs incurred by the lessee; and
- (d) an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period.
A lessee recognizes individual items as part of the right-of-use asset’s cost when it incurs an obligation for those items.
The IASB considered whether a lessee should initially measure the right-of-use asset instead at fair value, which might provide more relevant information about the economic benefits to be derived from using the underlying asset. But they concluded that among other things, initially measuring the asset at cost is consistent with the measurement of many other non-financial assets, such as assets within the scope of IAS 16 and IAS 38, as well as being less complex and less costly. Likewise, including initial direct costs in the measurement of the right-of-use asset is consistent with the treatment of costs associated with acquiring other non-financial assets such as property, plant and equipment.
After the lease commencement date, most issuers will measure the right-of-use asset applying a cost model (unless the asset meets the definition of investment property to which the issuer applies a fair value model under IAS 40, or relates to a class of property, plant and equipment to which the issuer elects to apply the IAS 16 revaluation model). In other words, the issuer measures the asset at cost less any accumulated depreciation and any accumulated impairment losses; and adjusted for any remeasurement of the lease liability (as discussed here). The approach to depreciation follows the requirements of IAS 16, with the specification that if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, then the lessee depreciates the right-of-use asset from the commencement date to the end of the underlying asset’s overall useful life (i.e. without being limited by the end of the lease term). In other cases, the lessee depreciates the right-of-use asset from the commencement date to the earlier of the end of the asset’s useful life or the end of the lease term. The approach to impairment follows the requirements of IAS 36.
In its effects analysis document, the IASB sums up the expected net overall effect of this model on the balance sheet:
- ” Applying IFRS 16 to an individual lease, the carrying amount of the lease asset would typically reduce more quickly than the carrying amount of the lease liability.
- This is because, in each period of the lease, the lease asset is typically depreciated on a straight-line basis, and the lease liability is (a) reduced by the amount of lease payments made and (b) increased by the interest— reducing over the life of the lease. Consequently, although the amounts of the lease asset and lease liability are the same at the start and end of the lease, the amount of the asset would typically be lower than that of the liability throughout the lease term. Because this effect is expected for each individual lease, it is also expected when considering the ‘portfolio effect’ of companies holding a mix of leases with different remaining lease terms.
- Accordingly, assuming that all other factors that might affect equity are constant, for companies with material off balance sheet leases, applying IFRS 16 will typically reduce reported shareholders’ equity compared to IAS 17. The reduction in reported equity is expected to occur when a company first implements IFRS 16—ignoring other factors, reported equity would then remain constant thereafter to the extent that the company’s lease portfolio remains constant. However, the timing of the reduction in equity depends on the decisions made by a company when first implementing IFRS 16.”
The big question is how much this might affect investors’ perception of any particular entity. But we’ll have to wait (quite a while) to get any sense of that…
The opinions expressed are solely those of the author.