IFRS 16 – Leases

IFRS 16 is effective for annual periods beginning on or after 1 January 2019 with earlier application permitted for entities that apply IFRS 15 Revenue from Contracts with Customers at or before the date of initial application of IFRS 16.

IFRS 16 supersedes the following standards and interpretations:

1. IAS 17 Leases;
2. IFRIC 4 Determining whether an Arrangement contains a Lease;
3. SIC-15 Operating Leases—Incentives; and
4. SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.

Why the need for a new Standards on Leases

Leasing is an important activity for many entities. It is a means of gaining access to assets, of obtaining finance and of reducing an entity’s exposure to the risks of asset ownership. The prevalence of leasing means that it is important that users of financial statements have a complete and understandable picture of an entity’s leasing activities.

The accounting model of IAS 17 Leases, required lessees and lessors to classify their leases as either finance leases or operating leases and account for those two types of leases differently. That model was criticized for failing to meet the needs of users of financial statements because it did not always provide a faithful representation of leasing transactions. In particular, it did not require lessees to recognize assets and liabilities arising from operating leases.

The International Accounting Standards Board (IASB) and the US national standard-setter, the Financial Accounting Standards Board (FASB), initiated a joint project to develop a new approach to lease accounting that requires a lessee to recognize assets and liabilities for the rights and obligations created by leases. This approach will result in a more faithful representation of a lessee’s assets and liabilities and, together with enhanced disclosures, will provide greater transparency of a lessee’s financial leverage and capital employed.

IASB and FASB decided that a lessee should be required to recognize assets and liabilities for all leases (with limited exceptions), and both IASB and FASB have defined leases in the same way. IASB and FASB reached similar decisions regarding the measurement of lease liabilities, and how to account for leases that were formerly classified as finance leases. In addition, both IASB and FASB decided not to substantially change lessor accounting.

However, IASB and FASB reached different decisions for leases that were formerly classified as operating leases with respect to the recognition of lease expenses and the reporting of lease-related cash flows. IASB decided to adopt a single lessee accounting model whereby a lessee accounts for all leases in the same way. FASB decided to adopt a dual lessee accounting model, classifying leases in a similar manner to the previous requirements in US GAAP for distinguishing between operating leases and capital leases, and to account for those two types of leases differently.

The main feature of IFRS 16

Lessee Accounting

IFRS 16 introduces a single lessee accounting model and requires a lessee to recognize assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. A lessee is required to recognize a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

A lessee measures right-of-use assets similarly to other non-financial assets (such as property, plant and equipment) and lease liabilities similarly to other financial liabilities. As a consequence, a lessee recognizes depreciation of the right-of-use asset and interest on the lease liability, and also classifies cash repayments of the lease liability into a principal portion and an interest portion and presents them in the statement of cash flows applying IAS 7 Statement of Cash Flows.

Assets and liabilities arising from a lease are initially measured on a present value basis. The measurement includes non-cancellable lease payments (including inflation-linked payments), and also includes payments to be made in optional periods if the lessee is reasonably certain to exercise an option to extend the lease, or not to exercise an option to terminate the lease.

IFRS 16 contains disclosure requirements for lessees. Lessees will need to apply judgment in deciding upon the information to disclose to meet the objective of providing a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee.

Lessor Accounting

IFRS 16 substantially carries forward the lessor accounting requirements in IAS 17. Accordingly, a lessor continues to classify its leases as operating leases or finance leases, and to account for those two types of leases differently.

IFRS 16 also requires enhanced disclosures to be provided by lessors that will improve information disclosed about a lessor’s risk exposure, particularly to residual value risk.