IFRS 16: When is a lease not a lease?
While IFRS 16 is widely seen as an improvement on its predecessor, there are a number of areas of judgement in the standard which will require vigilance from auditors, users and preparers of financial statements. Robert McCracken CA explains.
The new accounting standard on leasing, IFRS 16, issued by the IASB, will be effective for annual periods beginning on or after 1 January 2019.
The standard will have the greatest impact on lessees – almost all leases will be recognised as ‘right of use’ assets and corresponding financing liabilities on the balance sheet – whereas lessor accounting will remain largely unchanged.
Under the existing standard, IAS 17, leases which meet the definition of operating leases are not recognised on the balance sheet. Only leases meeting the definition of finance leases are recognised at present, and the distinction between operating and finance leases can be arbitrary and prone to structuring.
Reform on the cards
Many users of financial statements had been critical of lease accounting standards for some time, hence its reform had been on the agendas of both the IASB and the FASB.
Sir David Tweedie, former chairman of the IASB, once famously said that it was his ambition before he died to travel in an aircraft that was recognised on the balance sheet of the airline concerned. It was considered that leasing is primarily a means of financing the use of a wide range of assets and that off-balance sheet lease accounting masks the true extent of indebtedness of lessees.
The new standard should alleviate such concerns to a large degree, nevertheless, there are a number of areas in the new standard which will require judgement and may present structuring opportunities to preparers eager to minimise the extent of additional liabilities recognised on their balance sheets.
Definition of a lease
Under IFRS 16, a lease is a contract, or part of a contract, that conveys the right to use an identified asset for a period of time in exchange for consideration. A contract conveys such right if, throughout the period of use, the customer has the right to:
- obtain substantially all of the economic benefits from the use of the asset; and
- direct the use of the asset.
Determining whether there is an identified asset may require judgement, in some cases.
There will be no such asset (and therefore no lease) if the supplier has the substantive right to substitute the asset throughout the period of use. IFRS 16indicates that a supplier’s substitution right is substantive if it has the practical ability to substitute alternative assets throughout the period of use and would benefit economically from doing so.
IFRS 16 has clearly been written in this way to minimise the possibility of abuse. Substitution rights could be inserted, for example, into vehicle leasing contracts, but it seems unlikely that the supplier would benefit economically from such an arrangement. Nevertheless, there may be some temptation to try to avoid the new lease accounting rules by inserting non-genuine substitution rights into contracts for the use of assets.
Separating lease and non-lease components
If the right to use an identified asset or assets is bundled together with agreements to provide other goods or services, the non-lease components will need to be identified and accounted for separately under the relevant accounting standards.
An example of a non-lease component would be servicing or maintenance arrangements for items of plant or machinery. This distinction will become much more important under IFRS 16 than it is under the existing standard.
For operating leases, in particular, it currently makes little difference in accounting terms whether a component meets the definition of a lease or not. Preparers may therefore be tempted to assign as high a value as possible to the non-lease components in order to minimise the recorded lease liability.
The IASB has tried to anticipate this by specifying carefully how the contract consideration is to be allocated between the lease and non-lease components. This allocation is required to be done on the basis of the stand-alone prices of each component, with maximum use of observable information where stand-alone prices are not readily available. However, this process is likely to require significant judgement in cases where observable price information is limited.
Variable lease payments
IFRS 16 excludes variable lease payments from the calculation of lease assets and liabilities, unless they depend on an index or rate (such as an interest or inflation rate) or are, in substance, fixed payments.
For example, the consideration for a lease of retail premises may include a variable element linked to the sales performance of the retailer. This element would not be included in the initial measurement of the lease asset and liability. There may, therefore, be a temptation to structure lease agreements in order to maximise the variable element of the lease payments and so minimise the recognition of lease liabilities.
The IASB has anticipated this as far as possible by clarifying that payments which are ‘in substance’ fixed, do not constitute variable payments. Thus payments which appear variable or contingent but which in practice are unavoidable would need to be included in the measurement of the lease asset and liability.
This will potentially be an area requiring significant judgement and may require close analysis of the underlying facts and circumstances. Consider, for example, a lease of premises to a retailer where a significant proportion of the lease payments depends on the retailer’s sales exceeding a very undemanding threshold.
IFRS 16 contains two principal exemptions from its requirements, for low-value assets and short term leases with a term of 12 months or less.
These exemptions were sought by many constituents during the development of the standard in order to ensure that the costs of implementation do not outweigh the benefits. This seems to raise the possibility of creating a lease with a term of 12 months or less but which can effectively be renewed to result in a longer lease term in practice.
The standard requires renewal to be ‘reasonably certain’ before optional lease periods can be included in the lease calculations. It provides guidance on the factors to consider in this respect, mostly relating to the economic imperative or attraction of renewal. Again, this is an area where significant judgement may be required.
IFRS 16: judgement required
IFRS 16 is widely regarded as an improvement on its predecessor and a fairer reflection of the financing arrangements created by leases.
However, there are a number of areas of judgement in the standard, as indicated above, which will require vigilance on the part of auditors, users and preparers of financial statements.