AASB 16 comparision with IFRS 16

AASB 16 Leases incorporates IFRS 16 Leases issued by the International Accounting Standards Board (IASB). Australian-specific paragraphs (which are not included in IFRS 16) are identified with the prefix “Aus”. Paragraphs that apply only to not-for-profit entities begin by identifying their limited applicability.

Impact of IFRS/AASB 16 on Lessee and Lessor

Leasing is an important and widely used financing solution. It enables companies to access and use propertyand equipment without incurring large cash outflows at the start. It also provides flexibility and enables lessees to address the issue of obsolescence and residual value risk. In fact sometimes, leasing is the only way to obtain the use of a physical asset that is not available for purchase.

Changes on Lesses perspective

  • The new standard will affect virtually all commonly used financial ratios and performance metrics such as gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows. These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes. These impacts may compel many organisations to reassess certain ‘lease versus buy’ decisions.
  • Balance sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will also be a change to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (acceleration of lease expense relative to the recognition pattern for operating leases today).
  • Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships, and technology – are expected to be greatly affected. The impact for entities with numerous small leases, such as tablets and personal computers, small items of office furniture and telephones might be less as the IASB offers an exemption for low value assets (assets with a value of $5,000 or less when new). Low value assets meeting this exemption do not have to be recognised on the balance sheet.
  • The cost to implement and continue to comply with the new leases standard could be significant for most lessees.Particularly if they do not already have an in-house lease information system.

Changes on Lessor perspective

  • Lessees and lessors may need to consider renegotiating or restructuring existing and future leases.
  • Business and legal structures supporting leases should also be reassessed to evaluate whether these continue to be effective (for example, joint ventures and special purpose entities).
  • Lessor accounting remains largely unchanged from IAS 17 however, lessors are expected to be affected due to the changed needs and behaviours from customers which impacts their business model and lease products.

Objective and Scope of IFRS 16

IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases. The objective is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of an entity.
IFRS 16 requires an entity to consider the terms and conditions of contracts and all relevant facts and circumstances, and to apply the standard consistently to contracts with similar characteristics and in similar circumstances.

IFRS 16 is effective for annual periods beginning on or after 1 January 2019. Early application is permitted, provided the new revenue standard, IFRS 15 Revenue from Contracts with Customers, has been applied, or is applied at the same date as IFRS 16.

Scope of IFRS 16

An entity shall apply this Standard to all leases, including leases of right-ofuse assets in a sublease, except for:
(a) leases to explore for or use minerals, oil, natural gas and similar nonregenerative resources;
(b) leases of biological assets within the scope of IAS 41 Agriculture held by a lessee;
(c) service concession arrangements within the scope of IFRIC 12 Service Concession Arrangements
(d) licences of intellectual property granted by a lessor within the scope of IFRS 15 Revenue from Contracts with Customers; and
(e) rights held by a lessee under licensing agreements within the scope of IAS 38 Intangible Assets for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

A lessee may, but is not required to, apply this Standard to leases of
intangible assets other than those described in paragraph 3(e).

Recognition Exemption

IFRS 16 allows a lessee to elect not to apply the recognition requirements to:
a) Short-term leases (Less than 12 months including intention to exercisable option); and
b) Leases for which the underlying asset is of low value (New Asset Valued US$5,000 or less).

What is Lease?

A lease is a contract (i.e., an agreement between two or more parties that creates enforceable rights and obligations), or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
IFRS 16 requires an entity to determine whether a contract is a lease or contains a lease at the inception of the contract.The assessment of whether a contract is or contains a lease will be straightforward in most arrangements. However, judgement may be required in applying the definition of a lease to certain arrangements. For example, in contracts that include significant services, we believe that determining whether the contract conveys the right to direct the use of an identified asset may be challenging.

To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:
(a) the right to obtain substantially all of the economic benefits from use of the identified asset and
(b) the right to direct the use of the identified asset

If the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term.

What is identified Asset?

An asset is typically identified by being explicitly specified in a contract. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer.
A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fibre optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.

Substantive substitution rights

Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
(a) the supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
(b) the supplier would benefit economically from the exercise of its right to substitute the asset (ie the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event,the supplier’s substitution right is not substantive because the supplier does not have the practical ability to substitute alternative assets throughout the period of use.
An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts and circumstances at inception of the contract and shall exclude consideration of future events that, at inception of the contract, are not considered likely to occur. Examples of future events that, at inception of the contract, would not be considered likely to occur and, thus, should be excluded from the evaluation include:

(a) an agreement by a future customer to pay an above market rate for use of the asset;
(b) the introduction of new technology that is not substantially developed at inception of the contract;
(c) a substantial difference between the customer’s use of the asset, or the performance of the asset, and the use or performance considered likely at inception of the contract; and
(d) a substantial difference between the market price of the asset during the period of use, and the market price considered likely at inception of the contract.
If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier’s premises and, therefore, are more likely to exceed the benefits associated with substituting the asset.
The supplier’s right or obligation to substitute the asset for repairs and maintenance, if the asset is not operating properly or if a technical upgrade becomes available does not preclude the customer from having the right to use an identified asset.
If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.

Scenario A
Assume that an electronic data storage provider (supplier) provides services through a centralised data centre, that involve the use of a specified server (Server No. 10). The supplier maintains many identical servers in a single accessible location and determines, at inception of the contract, that it is permitted to and can easily substitute another server without the customer’s consent throughout the period of use. Further, the supplier would benefit economically from substituting an alternative asset, because doing this would allow the supplier to optimise the performance of its network at only a nominal cost. In addition, the supplier has made clear that it has negotiated this right of substitution as an important right in the arrangement, and the substitution right affected the pricing of the arrangement.
Analysis: The customer does not have the right to use an identified asset because, at the inception of the contract, the supplier has the practical ability to substitute the server and would benefit economically from such a substitution. However, if the customer could not readily determine whether the supplier had a substantive substitution right (e.g., there is insufficient transparency into the supplier’s operations), the customer would presume the substitution right is not substantive and conclude that there is an identified asset.
Scenario B
Assume the same facts as in Scenario A except that Server No. 10 is customised, and the supplier does not have the practical ability to substitute the customised asset throughout the period of use. Additionally, it is unclear whether the supplier would benefit economically from sourcing a similar alternative asset.
Analysis: Because the supplier does not have the practical ability to substitute the asset and there is no evidence of economic benefit to the supplier for substituting the asset, the substitution right is non-substantive, and Server No. 10 would be an identified asset. In this case, neither of the conditions of a substitution right is met. As a reminder, both conditions must be met for the supplier to have a substantive substitution right.

Key Concepts

Inception of Contract

IFRS 16 requires customers and suppliers to determine whether a contract is or contains a lease at the inception of the contract. The inception date of a lease is the earlier of the date of a lease agreement and the date of commitment by the parties to the principal terms and conditions of the lease.

Commencement Date of Lease

The commencement date is the date on which the lessor makes an underlying asset (i.e., the asset that is subject to the lease) available for use by the lessee. In some cases, the commencement date of the lease may be before the date stipulated in the lease agreement (e.g., the date on which rents become due and payable). This often occurs when the leased space is modified by the lessee prior to commencing operations in the leased space (e.g., during the period a lessee uses the leased space to construct its own leasehold improvements). If a lessee takes possession of, or is given control over, the use of the underlying asset before it begins operations or making lease payments under the terms of the lease, the lease term has commenced even if the lessee is not required to pay rent or the lease arrangement states the lease commencement date is a later date. The timing of when lease payments begin under the contract does not affect the commencement date of the lease. For example, a lessee (except for a lessee applying the short-term lease or low-value asset exemption) initially recognises a lease liability and related right-of-use asset on the commencement date and a lessor (for finance leases) initially recognises its net investment in the lease on the commencement date.

Lease term and purchase option

The lease term begins at the lease commencement date and is determined on that date based on the non-cancellable term of the lease, together with both of the following:

  • The periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
  • The periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option

The phrase ‘reasonably certain’ which was also used in IAS 17 is generally interpreted as a high threshold. Therefore, the IASB does not anticipate a change in practice. Purchase options should be assessed in the same way as options to extend the lease term or terminate the lease. The IASB indicated in the Basis for Conclusions (BC173) that an option to purchase an underlying asset is economically similar to an option to extend the lease term for the remaining economic life of the underlying asset.

Example

Scenario A
Entity W enters into a lease for equipment that includes a non-cancellable term of four years and a two-year fixed-priced renewal option with future lease payments that are intended to approximate market rates at lease inception. There are no termination penalties or other factors indicating that Entity W is reasonably certain to exercise the renewal option.
Analysis:
At the lease commencement date, the lease term is four years.
Scenario B
Entity X enters into a lease for a building that includes a non-cancellable term of four years and a two-year, market-priced renewal option. Before it takes possession of the building, Entity Q pays for leasehold improvements. The leasehold improvements are expected to have significant value at the end of four years, and that value can only be realised through continued occupancy of the leased property.
Analysis:
At lease commencement, Entity X determines that it is reasonably certain to exercise the renewal option because it would suffer a significant economic penalty if it abandoned the leasehold improvements at the end of the initial non-cancellable period. At lease commencement, Entity X concludes that the lease term is six years.
Scenario C
Entity Y enters into a lease for an identified retail space in a shopping centre. The retail space will be available to Entity Y for only the months of October, November and December during a non-cancellable term of five years. The lessor agrees to provide the same retail space for each of the five years.
Analysis:
At the lease commencement date, the lease term is 15 months (three months per year over the five annual periods specified in the contract).

Reassessment of the lease term and purchase options- lessees

After lease commencement Commencement date of the lease, IFRS 16 requires lessees to monitor leases for significant changes that could trigger a change in the lease term. Lessees are required to reassess the lease term upon the occurrence of either a significant event or a significant change in circumstances that:

  • Is within the control of the lessee
  • Affects whether the lessee is reasonably certain to exercise an option not previously included in its determination of the lease term, or not to exercise an option previously included in its determination of the lease term

Examples of significant events or significant changes in circumstances within the lessee’s control include:

  • Constructing significant leasehold improvements that are expected to
    have significant economic value for the lessee when the option becomes
    exercisable
  • Making significant modifications or customisations to the underlying asset
  • Making a business decision that is directly relevant to the lessee’s ability to exercise, or not to exercise, an option (e.g., extending the lease of
  • a complementary asset or disposing of an alternative asset)

Subleasing the underlying asset for a period beyond the exercise date of the option Changes in market-based factors (e.g., a change in market rates to lease or purchase a comparable asset) are not within the lessee’s control, and they therefore do not trigger a reassessment by themselves.
IFRS 16 also requires lessees to revise the lease term when the lessee either exercises an option that it previously deemed it was not reasonably certain to exercise or does not exercise an option that it previously deemed it was reasonably certain to exercise. Furthermore, the lease term is revised if an event occurs that contractually obliges the lessee to exercise an option not previously
included in the entity’s determination of the lease term or an event occurs that contractually prohibits the lessee from exercising an option previously included in the entity’s determination of the lease term.

As the lessee is required to reassess the lease term upon the occurrence of either a significant event or a significant change in circumstances that is within the control of the lessee, the revision of the lease term often happens before the actual exercise of the option in these circumstances. Additionally, if the reassessment of lease term or the exercise of a purchase option results in a change, the lessee would remeasure the lease liability, using revised inputs (e.g., discount rate,) at the reassessment date, and would adjust the right-of- use asset. However, if the right-of-use asset is reduced to zero, the lessee would recognise any remaining amount in profit or loss.

Lease Payments

Lease payments are payments, made by a lessee to a lessor, relating to the right to use an underlying asset during the lease term and include the following amounts:

  • Fixed (including in-substance fixed) payments, less any lease incentives receivable from the lessor
  • Variable lease payments that depend on an index or a rate
  • Variable payments that depend on an index or rate
  • The exercise price of a purchase option if the lessee is reasonably certain to exercise that purchase option
  • The exercise price of a purchase option
  • Payments for penalties for terminating a lease, if the lease term reflects the lessee exercising an option to terminate the lease
  • Payments for penalities for terminating a lease
  • Amounts expected to be payable by the lessee under residual value guarantees (lessee only)
  • Amounts expected to be payable under residual value guarantees – lessees only
  • Residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee (lessor only)

Lease payments do not include payments allocated to non-lease components of a contract, unless the lessee elects to combine non-lease components with a lease component and to account for them as a single lease component.

Lease Incentive

A lease agreement with a lessor might include incentives for the lessee to sign the lease, such as an upfront cash payment to the lessee, payment of costs for the lessee (such as moving expenses) or the assumption by the lessor of the lessee’s pre-existing lease with a third party.

For lessees, lease incentives that are received by the lessee at or before the lease commencement date reduce the initial measurement of a lessee’s right-of-use asset. Lease incentives that are receivable by the lessee at lease commencement date reduce a lessee’s lease liability (and therefore, the right- of-use asset as well).


For lessors, lease incentives that are paid or payable to the lessee are also deducted from lease payments and affect the lease classification test. For finance leases, lease incentives that are payable to the lessee reduce the expected lease receivables at the commencement date and, thereby, the initial measurement of the lessor’s net investment in the lease. For operating leases,
lessors should defer the cost of any lease incentives paid or payable to the lessee and recognise that cost as a reduction to lease income over the lease term.

Modification of Lease

If a finance lease is modified (i.e., there is a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and condition of the lease), the modified lease is evaluated to determine whether it is or contains a lease.
Determining whether an arrangement contains a lease. If a lease continues to exist, a modification to a finance lease may result in:

  • A separate lease
  • A change in the accounting for the existing lease (i.e., not a separate lease)

If an operating lease is modified, it is treated as a new lease from the effective date of the modification.

Disclosure

The objective of the disclosures is for lessors to disclose information that gives 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 lessor. IFRS 16 requires a lessor to disclose quantitative and qualitative information about its leases, the significant judgements made in applying IFRS 16 and
the amounts recognised in the financial statements related to the leases.

Lessors may need to exercise judgement to determine the appropriate level at which to aggregate, or disaggregate, disclosures so that meaningful information is not obscured by insignificant details or by grouping items with different characteristics.

Sale and Leaseback Transactions

A sale and leaseback transaction involves the transfer of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of the same asset by the seller-lessee. Because IFRS 16 requires lessees to recognise most leases on the balance sheet (i.e., all leases except for leases of low-value assets and short-term leases depending on the lessee’s accounting policy election), sale and leaseback transactions no longer provide lessees with a source of off-balance sheet financing. Both the seller-lessee and the buyer lessor are required to apply IFRS 15 to determine whether to account for a sale and leaseback transaction as a sale and purchase of an asset.

Example of Sale and Leaseback Transaction

An entity (Seller-lessee) sells a building to another entity (Buyer-lessor) for cash of CU2,000,000. Immediately before the transaction, the building is carried at a cost of CU1,000,000. At the same time, Seller-lessee enters into a contract with Buyer-lessor for the right to use the building for 18 years, with annual payments of CU120,000 payable at the end of each year. The terms and conditions of the transaction are such that the transfer of the building by Seller-lessee satisfies the requirements for determining when a performance

obligation is satisfied in IFRS 15 Revenue from Contracts with Customers.

Accordingly, Seller-lessee and Buyer-lessor account for the transaction as a sale and leaseback. This example ignores any initial direct costs.

The fair value of the building at the date of sale is CU1,800,000. Because the consideration for the sale of the building is not at fair value, Seller-lessee and Buyer-lessor make adjustments to measure the sale proceeds at fair

value. The amount of the excess sale price of CU200,000 (CU2,000,000 — CU1,800,000) is recognised as additional financing provided by Buyer-lessor to Seller-lessee. 

The interest rate implicit in the lease is 4.5 per cent per annum, which is readily determinable by Seller-lessee. The present value of the annual payments (18 payments of CU120,000, discounted at 4.5 per cent per annum) amounts to CU1,459,200, of which CU200,000 relates to the additional financing and CU1,259,200 relates to the lease—corresponding to 18 annual payments of CU16,447 and CU103,553, respectively.

Buyer-lessor classifies the lease of the building as an operating lease.

Seller-lessee

At the commencement date, Seller-lessee measures the right-of-use asset arising from the leaseback of the building at the proportion of the previous carrying amount of the building that relates to the right-of-use retained by Seller-lessee, which is CU699,555. This is calculated as: CU1,000,000  (the carrying amount of the building) ÷ CU1,800,000 (the fair value of  the building) x CU1,259,200 (the discounted lease payments for the 18-year right-of-use asset). 

Seller-lessee recognises only the amount of the gain that relates to the rights transferred to Buyer-lessor of CU240,355 calculated as follows. The gain on sale of building amounts to CU800,000 (CU1,800,000 – CU1,000,000), of which:

(a) CU559,645 (CU800,000 ÷ CU1,800,000 x CU1,259,200) relates to the right to use the building retained by Seller-lessee; and

(b) CU240,355 (CU800,000 ÷ CU1,800,000 x (CU1,800,000 -CU1,259,200)) relates to the rights transferred to Buyer-lessor.

At the commencement date, Seller-lessee accounts for the transaction, as

follows:

Cash                                        CU2,000,000

Right-of-use asset                 CU699,555

Building                                                                                  CU1,000,000

Financial liability                                                                   CU1,459,200

Gain on rights transferred                                  CU240,355

Buyer-lessor

At the commencement date, Buyer-lessor accounts for the transaction, as follows:

Building CU                            1,800,000 

Financial asset                       CU200,000 (18 payments of CU16,447,discounted at 4.5 per cent per annum)

Cash                                                                        CU2,000,000

After the commencement date, Buyer-lessor accounts for the lease by treating CU103,553 of the annual payments of CU120,000 as lease payments. The remaining CU16,447 of annual payments received from Seller-lessee are accounted for as (a) payments received to settle the financial asset of CU200,000 and (b) interest revenue.

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