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 covered the main aspects of the accounting model for lessees in various previous posts. Let’s look now at the mechanics of making the transition to the new standard.
As a practical expedient, an entity isn’t required to reassess whether a contract is, or contains, a lease at the date of initial application (although it can choose to do so). Instead, the entity is permitted:
- (a) to apply IFRS 16 to contracts it previously identified as leases applying IAS 17 Leases and IFRIC 4 Determining whether an Arrangement contains a Lease.
- (b) not to apply IFRS 16 to contracts that it hadn’t previously identified as containing a lease applying IAS 17 and IFRIC 4.
If the entity chooses either of these routes, it discloses that fact and applies either (a) or (b) to all of its contracts. As a result, it applies the aspects of the standard relating to identifying a lease (as discussed here) only to contracts entered into (or changed) on or after the date of initial application.
This reflects feedback from preparers that it could be costly for them to reassess all of their existing contracts using the definition of a lease requirements in IFRS 16. The IASB envisages “only a limited number of scenarios in which application of the lease definition requirements in IFRIC 4 would result in a different outcome from the application of the lease definition guidance in IFRS 16…(and) expects that the consequence of an entity not reassessing its existing contracts applying the lease definition requirements in IFRS 16 would be the recognition of slightly more leases on transition to IFRS 16 than would otherwise be the case. On this basis, the IASB concluded that the costs of requiring entities to reassess existing contracts applying the lease definition guidance in IFRS 16 would not be justified.”
With that choice made, the entity applies IFRS 16 retrospectively to each prior reporting period presented; or else applies it retrospectively while recognizing the cumulative effect of initial adoption at the date of initial application, using a methodology we’ll get into below. Here too, the lessee applies the election consistently to all of its leases in which it’s a lessee. The balancing act here is a fairly standard one:
- “The IASB decided not to require a full retrospective approach for all lessees because the costs of such an approach could be significant and would be likely to outweigh the benefits. A full retrospective approach would require entities to determine the carrying amounts of all leases in existence at the earliest comparative period as if those leases had always been accounted for applying IFRS 16 and to restate comparative information. That could be impracticable for entities that have thousands of leases. Nonetheless, the IASB did not wish to prohibit entities from applying a full retrospective approach, because that approach would provide better information to users of financial statements than other approaches. Consequently, the IASB decided to permit entities to choose to apply IFRS 16 fully retrospectively with restatement of comparative information.”
The IASB also rejected a prospective approach, of applying IFRS 16 only to leases commencing after the date of transition – given the length of some operating lease terms, this would have meant waiting decades to obtain fully comparable lease accounting.
For an entity electing to recognize the cumulative effect of initial adoption at the date of initial application, and for the leases it previously classified as finance leases applying IAS 17, the carrying amount of the right-of-use asset and the lease liability at the date of initial application is the carrying amount of the lease asset and lease liability immediately before that date as measured applying IAS 17. For those leases, a lessee accounts for the right-of-use asset and the lease liability applying IFRS 16 from the date of initial application. The thinking here is that the lessee accounting model in IFRS 16 is similar enough to the model for finance leases in IAS 17 that more detailed transition requirements aren’t necessary.
For leases previously classified as operating leases, the transition mechanics for entities applying a cumulative catch-up approach are more complicated, especially on the asset side. First of all, such an entity recognizes a lease liability at the date of initial application, measured at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate at the date of initial application. On a lease by lease basis, the entity can choose to apply a single discount rate to a portfolio of leases with reasonably similar characteristics (such as leases with a similar remaining lease term for a similar class of underlying asset in a similar economic environment). The IASB expects this choice will provide cost savings to lessees without having a significant effect on reported information.
We’ll continue next time with how the transition mechanics apply in initially recognizing a right-of-use asset…
The opinions expressed are solely those of the author