Athens, January 2019
Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.
IASB and FASB have been considering for quite some time the lack of complete information with regards to long-term, in-substance unavoidable liabilities that most entities are committed to.
The new accounting standard IFRS 16 Leases, which is applicable for financial reporting periods beginning on, or after 1/1/2019, sets the record straight in that respect, as it obliges entities to recognize these liabilities, as opposed to the previous standard IAS 17 Leases.
The standard relates to all non-current assets subject to lease agreements, as properties, cars, equipment. For the sake of clarity, we will examine in this series of articles, the treatment of lease contracts related to properties. The same treatment however, is applicable to any leased asset.
Why is there a need for a different approach?
The driver for introducing the new standard is very simple. Entities leasing properties as part of their operating activities, (i.e. without necessarily intending to purchase the property at some stage during or at the end of the lease term), do so for a long period. Think of banks, apparel retailers (Burberry, Benetton, Zara, H&M), or consumer electronics retailers as Curry’s, Dixons, Media Markt. Would they enter into a lease agreement, with the aim of vacating the property soon? They strategically select a location that suits their exposure to their clientele, and their intention is to honour the lease agreement by not vacating the leased space before the end of the lease agreement.
Therefore, it is not deemed appropriate to allow avoiding recognizing a liability, for which the reporting entity has undertaken an existing obligation which is unlikely not to be honoured.
The driver of change is thus, the necessity of recognizing an existing long-term liability by the lessees, that went practically unnoticed by the previous standard.
Which contracts are subject to the standard?
The standard introduces a single lessee model, there is no distinction between finance and operating lease, anymore.
As long as the lease agreement relates to:
A specified asset; and
The use of this asset is determined at will by the lessee or the lease agreement does not allow the lessor to alter the terms of the use;
… the lease agreement contains a lease and IFRS 16 is applicable.
IFRS 16 allows entities not to apply the treatment described below, for
Lease of low-value assets, an indication of which is a maximum of $5,000, a test which is to be performed on a lease-by-lease basis.
Short-term leases, i.e. less than 12 months.
These are simply expensed according to the accruals principle.
IFRS 16 on the contrary, obliges entities to recognize the present value of the lease liability, at the inception of the lease. This liability will be amortized during the lease period, and finance cost will be recognized based on the actuarial method.
The rate to be used will be the rate implicit in the lease. When not available, entities are to apply the incremental borrowing rate of the lessee, which is the rate 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”.
These issues are clarified in Part II of this series.
Lessees undertake these long-term lease obligations, with the aim of securing economic benefits, in the form of net cash flows that will arise in the future from their primary operating activities, as selling of inventory, rendering of services, etc., by using the leased asset(s).
Therefore, entities will also recognize for the same amount as the non-current liability, a non-current asset, a right-of-use asset. This asset will also include initial direct costs incurred by the lessee.
This asset reflects the minimum expected benefits to be earned by the lessee, who has undertaken the long-term lease obligation.
The asset is subject to amortization, impairment, as any other non-current asset. The standard provides entities with alternative options, outside the scope of this article.
The asset is presented in the statement of financial position either as such (a right-of-use asset), or in the same line as that within which, the corresponding assets would be presented if they were owned, e.g. property, plant and equipment.
Queries, comments, are welcome at [email protected]