First Impressions: IFRS 16, Leases

First Impressions: IFRS 16, Leases

The International Accounting Standards Board (IASB), on 13 January 2016, issued a new accounting standard, IFRS 16 Leases. This will replace the current guidance and represents a fundamental shift in the accounting treatment for leases, specifically for lessees.

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Background

The International Accounting Standards Board (IASB), on 13 January 2016, issued a new accounting standard, IFRS 16 Leases. This will replace the current guidance and represents a fundamental shift in the accounting treatment for leases, specifically for lessees. It is anticipated to increase transparency and comparability of published financial information as analysts and investors will be able to see a company’s own assessment of its lease liabilities, calculated using a prescribed methodology under IFRS.

The new standard is effective internationally from 1 January 2019, an early application is permitted (as long as the recently issued revenue standard, IFRS 15, Revenue from Contracts with Customers is also applied).

In India, companies are currently transitioning to Indian Accounting Standard (Ind AS) 17, Leases which is based on IAS 17, Leases. However, companies (especially with large lease portfolio) may find it useful to start assessing the impact of IFRS 16, both on current and prospective leasing arrangements, to ensure that they are well prepared to adopt the new standard when it becomes notified and applicable in India.

Key guidance 

Change in the definition of a lease

IFRS 16 states that a contract is or contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. While this definition is similar to the current guidance, there is additional guidance and illustrative examples on how the definition is to be applied. This presents certain differences from the current practice and may lead to some arrangements that are currently accounted for as leases falling outside the new guidance. The lease definition is now the determining factor for whether an arrangement will be on or off balance sheet.

IFRS 16 provides additional guidance on the following aspects:

Identified asset and substitution rights

A contract contains a lease only if it relates to an identified asset. While an asset may continue to be explicitly or implicitly specified in a contract, a lessee would not have control over the use of an identified asset if the lessor has a substantive right to substitute the asset for an alternative asset during the lease term. IFRS 16 provides more clarity on the lessor’s substitution rights to determine if a lessee has control over the use of the asset.

A lessor’s substitution right is considered to be substantive if throughout the period of use, the lessor:

  • Has the practical ability to substitute the asset, and
  • Would benefit economically from exercising its right to substitute the asset.

Evaluation of the substitution rights is likely to be a key area of focus in determining whether a lease exists, especially in equipment leasing contracts, transportation contracts and real estate leases.

Right to direct the use of an asset

IFRS 16 has detailed application guidance on determining if a lessee has control over the right to direct the use of an asset. It effectively divides these rights into three categories:

  • Right to direct ‘how and for what purpose’ the asset is used throughout the period of use: if the customer holds this right then the contract contains a lease. The decisions about how and for what purpose an asset is used are more important in determining control of the use of an asset than other decisions to be made about use, including decisions about operating and maintaining the asset. This is because decisions about how and for what purpose an asset is used determine how, and what, economic benefits are derived from use. How and for what purpose an asset is used is a single concept, i.e. 'how' an asset is used is not assessed separately from 'for what purpose' an asset is used. Decisions regarding operating an asset are generally about implementing the decisions about how and for what purpose an asset is used and are dependent upon (and subordinate to) those decisions.
  • Operating decisions: The approach to determining whether a customer has the right to direct the use of an identified asset changes if the decisions about how and for what purpose an asset is used are predetermined. IFRS 16 clarifies that, if decisions about how and for what purpose an asset is used are predetermined, a customer can still direct the use of an asset if it has the right to operate the asset, or if it designed the asset in a way that predetermines how and for what purpose the asset will be used. In either of these cases the customer controls rights of use that extend beyond the rights of a customer in a typical supply or service contract (i.e. the customer has rights that extend beyond solely ordering and receiving output from the asset). In these cases, the customer has the right to make (or has made in the case of design) decisions that affect the economic benefits to be derived from use of the asset throughout the period of use. Although according to IASB each of these cases represents a scenario in which the customer directs the use of an asset, it expects that, for most leases, the assessment of whether a customer directs the use of an asset would be based on identifying the party that decides how and for what purpose an asset is used.
  • Protective rights held by the lessor: IFRS 16 provides application guidance on protective rights for example, terms and conditions included in the contract to protect the supplier's interest in the underlying asset or other assets, to protect its personnel or to ensure the supplier's compliance with applicable laws and regulations. In IASB's view, such protective rights define the scope of the rights obtained by a customer without preventing a customer from having the right to direct the use of that asset. Accordingly, protective rights may affect the price paid for the lease (i.e. a lessee may pay less for the use of the asset if it is more restricted in its use of that asset). However, protective rights generally would not affect the existence of the customer's right to direct the use of the asset.

Accounting by lessees

A lessee is required to apply a single lease accounting model under which it recognises all major leases (except those eligible under the practical expedient exemptions) on balance sheet. A detailed guidance is available on the recognition of related lease assets and liabilities and the method to be used for their initial measurement as well as subsequent recognition. Key impacts are:

  • There will be an increase in reported assets as well as liabilities for lessees. This will have an impact on key financial ratios (including gearing), affect compliance with existing covenants and may also affect their future borrowing ability.
  • Lessees will have a front-loaded pattern of expenses for most leases despite paying constant rentals. This is due to a higher interest charge on the lease liabilities in initial years based on the effective interest rate as well as a higher depreciation charge on the recognised lease assets. This will adversely affect Earnings per Share (EPS) but would have a positive impact on financial ratios that are based on Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA).

Accounting by lessors

The accounting treatment for lessors remains largely unchanged as compared with the current guidance on leases. They will continue to classify leases as finance or operating leases and account for them in a manner similar to the current guidance. There are a few areas of differences with reference to the definition of a lease, guidance on sale and leaseback transactions as well as some disclosure requirements. The retention of the existing accounting model for lessors has resulted in a lack of consistency and symmetry with the new lessee accounting model.

More extensive disclosures by lessees

Generally, lessees would have to provide extensive disclosures than those for finance leases under IAS 17. A lessee would have provide a description of how liquidity risk related to lease liabilities is managed, future cash outflows to which the lessee is potentially exposed that are not reflected in the measurement of lease liabilities e.g. variable lease payments, extension options and termination options, residual value guarantees, etc. In addition, lessees would need to assess whether additional information is necessary to meet the overall objective. Therefore, more effort and judgement would be needed in the preparation of disclosures.

Our comments

In India, we expect the new lease accounting requirements to affect a wide variety of sectors, notably

  • Airlines
  • Retail
  • Power generation companies
  • Companies that seek large volumes of equipment financing and Any other companies with large lease portfolios, especially those that use leasing as an off-balance sheet mode of financing.

The larger the lease portfolio, the greater the impact on key reporting metrics and financial ratios.

We also think that certain types of arrangements will need detailed evaluation to determine if they are or continue to be leases, including IT outsourcing contracts, third party manufacturing contracts (toll manufacturing), power purchase contracts (including thermal, wind, solar and others), equipment leases and transportation arrangements. Also, companies that are in the process of negotiating long-term leases should keep the implication of this standard into consideration.

KPMG IFRG Limited has released its publication First Impressions: IFRS 16 Leases which is expected to help you assess the impact of IFRS on your business. It explains key requirements of the new standard, highlights areas that may result in a change in practice, and features KPMG insights on the new lease accounting.

To read more about KPMG’s First Impressions on IFRS 16 Leases please click here.

© 2016 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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