This Accounting Alert is issued to provide key concepts about IFRS 16, Leases, in anticipation of its mandatory adoption beginning January 1, 2019.
Definition of a Lease
Under IFRS 16, a lease is defined as 'a contract, or part o a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration'.
With this new definition from IFRS 16, some contracts that do not contain a lease today may meet the definition of a lease, and vice versa. Using the new definition, we can use the following three key evaluations to assess whether a contract is a lease or not:
- Is there an identified asset?
asset is explicitly identified in the contract (unless the supplier has substantive substitution right throughout the period of use) or is implicitly specified by being identified at the time that the asset is made available for use by the customer
- Does the customer have the right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use?
whether the customer has the right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use such as by using, holding or sub-leasing the asset
- Does the customer have the right to direct the use of the identified asset throughout the period of use?
whether the customer has the right to direct the use of an identified asset such as when the customer has the right to direct 'how and for what purpose' the asset is being used throughout the period of use
If all of these key questions are satisfied, such contract falls under the definition of a lease, hence, IFRS 16 should be applied.
Understanding the Discount Rate
In applying IFRS 16, it is important to determine the appropriate discount rates. This is required to determine the present value of the lease payments used to measure a lessee's lease liability and to determine the lease classification for a lessor and to measure a lessor's net investment in a lease.
For lessees, the lease payments are required to be discounted using either of the following (as defined in IFRS 16):
- implicit interest rate in the lease (if can be readily determined) - the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor
- lessee's incremental borrowing rate - the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment
A lessee will need to determine a discount rate for virtually every lease to which it applies the lessee accounting model in IFRS 16. However, discount rate may not need to be determined for a lease if:
- a lessee applies the recognition exemption for either a short-term or a low-value asset lease
- all lease payments are made on (or prior to) the commencement date of the lease, or
- all lease payments are variable and not dependent on an index or rate
For lessors, the discount rate will always be the interest rate implicit in the lease.
Applying IFRS 16 in Interim Financial Statements
IFRS 16 must first be applied to accounting periods beginning on or after January 1, 2019 including interim periods on or after that date. The application of IFRS 16 to those interim periods will broadly follow the requirements of IFRS 16 except in one key respect - variable lease payments.
The new standard requires a variable lease payment, provided it is not in-substance fixed or based on an index or rate, to be recognized in profit or loss in the period in which the triggering event or condition occurs. In other words, a variable lease payment would only be recognized in the interim period in which the event that crystallizes the payment occurs.
*Point of conflict:
The requirement of the new standard may be construed as in direct conflict with the requirement of IAS 34, Interim Financial Reporting, which requires a variable lease payment to be recognized if it is expected that the event will occur before the end of the current annual reporting period.
*Our view
When preparing a set of interim financial statements under IAS 34, the IAS 34 approach should be taken to ensure the interim financial statements are compliant with IAS 34. However, given the evident conflict, it is not possible to entirely rule out an IFRS 16 approach. Hence, the preparers should exercise careful judgment in selecting the appropriate accounting policy.
