International Financial Reporting Standard 16 – Leases
What is a lease?
Leases are among the most common transactions in modern business. A lease is a contract under which the lessor conveys to the lessee, in exchange for consideration, the right to use an identified asset for an agreed period of time. Leases are often colloquially called rentals. They are very common for vehicles, ships, aircraft and real estate.
How are leases viewed from the lessee’s perspective?
From the lessee’s perspective, leases are essentially a form of financing provided by the lessor. Typically, the lessee pays lease payments over the lease term rather than a single upfront payment. Economically, the lessor provides credit to the lessee to acquire a right-of-use (ROU) asset over the lease term.
How are leases accounted for by the lessee under IFRS 16?
Under IFRS 16, lessee accounting reflects the substance of leases being a financing transaction: at commencement, the lessee recognises a right-of-use asset and a lease liability. Over the lease term, the lessee recognises depreciation of the right-of-use asset and interest expense on the lease liability (with a few specified exceptions).
Why are operating leases recognised on the statement of financial position?
The rationale for bringing operating leases onto the lessee’s statement of financial position is that the lessee obtains control of the right to use the underlying asset at lease commencement. At that point the lessee can unilaterally make relevant decisions about how the asset is used, e.g., nature and cost of leasehold improvements. Consequently, the lessee has a non-cancellable obligation to pay lease payments from the inception date.
How is lessor accounting treated under IFRS 16?
Lessor accounting is not symmetrical with lessee accounting. For cost-benefit reasons, IFRS 16 retains the previous model for lessors. Lessor accounting follows substance over form, classifying leases as either finance or operating leases:
What is a finance lease?
A finance lease transfers substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee, even if legal title does not pass (often called a capital lease).
What is an operating lease?
An operating lease is any lease other than a finance lease.
When is a lease typically classified as a finance lease?
For example, if the lease term covers the major part of the underlying asset’s economic life, the lease is typically classified as a finance lease, as risks and rewards effectively pass to the lessee.
How are finance and operating leases accounted for by the lessor?
Economically, a finance lease resembles a sale of the underlying asset on credit. Therefore, the lessor accounts for it akin to a financed sale. Under an operating lease, the lessor retains the underlying asset on its statement of financial position and recognises lease income over the lease term.
Does IFRS 16 include bright-line thresholds for lease classification?
IFRS 16 provides examples that typically indicate a finance lease, but, unlike US GAAP, does not prescribe bright-line quantitative thresholds. Classification of leases requires judgment.
How are leases typically classified in practice?
In practice, vehicle leasing companies usually classify most contracts with customers as operating leases. Where the leased asset is real estate with a significant land component, the lessor assesses the building and land components separately for classification. For long-term arrangements, a lessor might classify the building component as a finance lease (risks and rewards transferred) but the land component as an operating lease.
How is a lease identified under IFRS 16?
Identifying whether an arrangement contains a lease is critical, as IFRS 16 applies only to transactions that are defined as leases. The Standard defines a lease and provides guidance to identify those transactions. Some agreements that are named “leases” do not meet the definition, while other service-style contracts do contain a lease component. Distinguishing leases from service contracts is sometimes challenging and requires judgment.
How are sale and leaseback transactions accounted for?
The Standard also addresses sale and leaseback transactions (a sale of an asset combined with a leaseback). These are often used as a financing alternative. The accounting for sale and leaseback transactions depends on whether the transfer qualifies as a sale under IFRS 15, as follows:
What happens if the transfer qualifies as a sale?
If the transfer is a sale, the seller-lessee recognises only the gain related to the rights transferred to the buyer-lessor, not the portion relating to the rights retained via the leaseback.
What happens if the transfer does not qualify as a sale?
If the transfer is not a sale, the seller-lessee recognises no immediate gain. The transaction is accounted for as a financing (a loan secured by the transferred asset).
What are the effects of recognising leases on the financial statements?
Effects of bringing operating leases onto the lessee’s financial statements
Recognising right-of-use assets and lease liabilities generally leads to the following reporting impacts compared with the previous “straight-line rent” model (which ignored the time value of money):
How do leases affect leverage and return metrics?
Leverage and return metrics: Higher assets and liabilities typically worsen leverage ratios (debt/total assets) and reduce the return on assets and the dividend yield.
How do leases affect working capital and current ratio?
Working capital/current ratio: Often worsens because current portions of lease liabilities are presented as current liabilities, while the right-of-use asset is presented wholly as non-current.
What is the expense profile under IFRS 16?
Front-loaded total expense profile: Total expense (depreciation and interest) is typically higher in early periods and lower later. This is because depreciation is usually recognised on a straight-line basis, whereas interest declines over time as the liability diminishes. Hence, at any point during the lease term, the carrying amount of the right-of-use asset is generally lower than the corresponding lease liability.
How do leases affect cost of inventory?
Cost of inventory: Where leased facility/equipment is used to produce inventory that is not a qualifying asset under IAS 23 Borrowing Costs (e.g., no substantial period needed to get it ready for sale), only the depreciation component of the lease costs is capitalised as part of the cost of inventory. The interest component is expensed as incurred.
How do leases affect EBITDA and operating profit?
Higher EBITDA and operating profit: Lease depreciation and interest are excluded from EBITDA, and interest is excluded from operating profit. Under the previous model, rent expense reduced both EBITDA and operating profit.
How do leases affect cash flows?
Improved operating cash flows: Cash paid for the principal component of the lease payments is classified as financing activities, and interest is classified as operating or financing activities, in accordance with the accounting policy. Thus, operating cash flows and Free Cash Flows often improve, compared with classifying all rent payments as operating cash outflows.
Are the effects of IFRS 16 permanent?
Some effects are permanent, e.g., leverage, working capital, EBITDA and operating cash flow. Other effects reverse over time at the individual-lease level, e.g., the front-loaded expense pattern. For entities with many leases that start and end on a rolling basis, the aggregate income statement effect may be muted. However, for growing businesses with a rising volume of new leases, total expenses (depreciation and interest) may increase versus straight-line rent, reducing profit in the growth phase.