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IFRS 16 working paper

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IFRS 16 in brief
Initial measurement and accounting
Modifications
Transition to IFRS 16
Adopting IFRS 16

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IFRS 16 working paper

  1. 1. IFRS 16 for a Lessee Measuring and accounting for a lease agreement 1 Antonello Dessanti dessanti@live.com
  2. 2. IFRS 16 in brief  IFRS 16 is a new standard that replaces IAS 17, IFRIC 4, SIC-15 and SIC-27  IFRS 16 is effective for annual reporting periods beginning on or after 1 January 2019. Earlier application is permitted for entities that apply IFRS 15 Revenue from Contracts with Customers at or before the date of initial application of this Standard.  Significant changes are applicable for a lessee, namely the measurement and recognition of the right of use (asset) and the lease obligations (liability).  Recognition exemptions are available for short-term leases and leases for which the underlying asset is of low value (paragraphs 5 – 8).  A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value (paragraph B.6).  The exemptions have to be adopted by the reporting entity, individually or for by class of underlying asset to which the right of use relates. 2
  3. 3. IAS 17 vs. IFRS 16 IAS 17  IAS 17 required an assessment to determine whether the lease is an operating or a finance lease.  No recognition in the balance sheet for the operating leases.  Future commitments of operating leases(undiscounted) are disclosed in the financial statements for future commitments.  Lease installments are recognized in the income statement within the operating expenses and classified in the statement of cash flows as cash used for operating activities. IFRS 16  The right of use and of the lease obligation are recognized at the commencement date of the lease agreement.  Depreciation charge of the right of use and interest expenses of the lease obligation are recognized in the income statement.  Lease installments reduce the lease obligations and are classified in the statement of cash flows as cash used for financing activities (lease components) and as cash used for operating activities (non-lease components). 3
  4. 4. Effect analysis IFRS 16  On January 2016, IASB estimated that the present value of lease payments for 1,145 worldwide IFRS reporting entities will increase the total assets by US$1.83 Trillion.  On February 2016, a PWC study based on 3,199 worldwide IFRS reporting entities (excluding United States) estimated an increase in debt by 25%.  Industries likely to experience most significant impact on financial ratios are Retail, Airlines, Professional Services, Health Care, Textile & Apparels, and Wholesale.  Median increase in debt: 22%  Median increase in EBITDA: 13%  Median increase in leverage ratio (debt / EBITDA): 2.03 – 2.14 4
  5. 5. Impact on financial statements5 Balance Sheet Example Total assets Increase 3-years lease with a present value of $60,000 Net assets Decrease Working capital Decrease Balance Sheet Asset turnover ratio Decrease IAS 17 IFRS 16 Gearing ratio Increase Current assets $45,000 $45,000 Income Statement Fixed assets $15,000 $75,000 EBITDA Increase Total assets $60,000 $120,000 EBIT Increase Current liabilities $30,000 $50,000 Interest coverage ratio Decrease Long-term liabilities $10,000 $50,000 EPS (*) Decrease Total liabilities $40,000 $100,000 Net income (*) Decrease Net assets $20,000 $20,000 Statement of cash flows Cash used for operating activities Decrease Working capital $15,000 -$5,000 Cash used for financing activities Increase Working capital ratio 1.5 0.9 Debt $10,000 $50,000 (*) Higher costs during the early years of the Debt to Equity 0.5 2.5 lease
  6. 6. Definition of a lease  The guidance for determining whether an agreement contains a lease is based on who does control the use of the asset  At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration (paragraph 9).  The asset must be identified (paragraphs B13.B20).  Controls occurs directing the use and obtaining the benefits from the use: Customer controls the use of the asset = Lease agreement Supplier controls the use of the asset = Service agreement  Refer to IASB “IFRS 16 Illustrative examples” issued in January 2016 for more guidance on determining whether an agreement contains a lease. 6
  7. 7. Key judgements, exemptions and policy choices Judgements IFRS 16 ref. Identifying a lease based on the definition of a lease Para 9.12 B9-B33 Determining whether it is reasonably certain that an extension or a termination option will be exercised Para 18 B34-41 Identifying the appropriate rate to discount the lease payments Para 26 Exemptions Short-term leases (by class of asset) or low value asset leases (lease by lease basis) Para 5.8 B3-B8 Policy choices Applying IFRS 16 to a portfolio of similar leases B1 Separation of non-lease components from lease components by class of assets Para 15 Applying IFRS to leases of intangible assets Para 4 Transition choice (full retrospective or cumulative catch-up) C5-C13 7
  8. 8. Case study: renting a retail space  This case study is for renting a retail space with three different types of modifications.  The lease agreement is for 1,500 sq. feet with a term of 10 years and no option to renew.  The annual lease is $20 per sq. foot (net rent) and $2.0 per sq. foot for common area maintenance (CAM) costs. The lease installments will increase annually by 2% (consumer price index).  The reporting entity determined that net rent is a lease component and CAM costs are non-lease components. The increase for inflation adjustment is included in the measurement of the lease liability.  The gross annual rental cost in the 1st year is $33,000, of which $30,000 are for lease components and $3,000 for non-lease components.  There is no interest rate implicit in the lease and the lessee's incremental borrowing rate is 5% per annum at commencement date. 8
  9. 9. Initial measurement and accounting Year Lease components Non-lease components Annual Payments 1 $30,000.00 $3,000.00 $33,000.00 2 $30,600.00 $3,060.00 $33,660.00 3 $31,212.00 $3,121.20 $34,333.20 4 $31,836.24 $3,183.62 $35,019.86 5 $32,472.96 $3,247.30 $35,720.26 6 $33,122.42 $3,312.24 $36,434.67 7 $33,784.87 $3,378.49 $37,163.36 8 $34,460.57 $3,446.06 $37,906.63 9 $35,149.78 $3,514.98 $38,664.76 10 $35,852.78 $3,585.28 $39,438.05 Year Commitment Present Value 1 30,000.00$ 28,571.43$ 2 30,600.00$ 27,755.10$ 3 31,212.00$ 26,962.10$ 4 31,836.24$ 26,191.75$ 5 32,472.96$ 25,443.42$ 6 33,122.42$ 24,716.46$ 7 33,784.87$ 24,010.28$ 8 34,460.57$ 23,324.27$ 9 35,149.78$ 22,657.86$ 10 35,852.78$ 22,010.50$ Lease liability 251,643.17$ Initial measurement Debit Right of use (ROI) asset 251,643.17$ Credit Current portion lease obligation 30,000.00$ Credit Long-term lease obligation 221,643.17$ Journal entries Year 1 Debit Depreciation ROI 25,164.32$ Credit Accumulated depr. ROI 25,164.32$ Debit Interest expense 12,582.16$ Credit Long-term lease obligation 12,582.16$ Debit Current portion lease obligation 30,000.00$ Debit Operating expenses $3,000.00 Credit Cash 33,000.00$ Debit Long-term lease obligation 30,600.00$ Credit Current portion lease obligation 30,600.00$ Initial recognition right of use and lease obligation within and over twelve months Straight line method depreciation over 10 years Accretion expense lease obligation Recording the lease payment in year 1, including CAM costs Amount due within twelve months Carry forward balances at the end of Year 3 Lease liability Beginning Balance Interest Expense Lease Payments Ending Balance 1 251,643.17$ 12,582.16$ 30,000.00$ 234,225.33$ 2 234,225.33$ 11,711.27$ 30,600.00$ 215,336.59$ 3 215,336.59$ 10,766.83$ 31,212.00$ 194,891.42$ Right of Use Beginning Balance Depreciation Ending Balance 1 251,643.17$ 25,164.32$ 226,478.85$ 2 226,478.85$ 25,164.32$ 201,314.54$ 3 201,314.54$ 25,164.32$ 176,150.22$ 9
  10. 10. Modifications There are three possible accounting treatments, each presented in the following slides:  Is the modification in substance a separate new lease (e.g. renting more space)? If yes, then account for as a separate new lease by adding the right of use of one or more underlying assets and measure the modification like any other new lease.  Does the modification decrease the scope of the lease (e.g. less floor space or a shorter lease term with commensurate change in payments)? If yes, then decrease the pre-modification right of use asset and the pre- modification lease liability and recognize any gain or loss in the income statement.  Does the modification decrease the scope of the lease (e.g. increase in lease term) without a commensurate change in payments? If yes, adjust the right of use and the lease liability with a measurement of the discounted liability using a revised interest rate. 10
  11. 11. Accounting for a modification (1) The lessor and the lessee agree to modify the lease for the retail space at the end of the 3rd year, increasing the floor space from 1,500 to 2,000 sq. feet at $21 per sq. ft., $2.1 per sq. ft. for CAM costs and all other terms and conditions unchanged. The additional space is in substance a new lease with a separate measurement and accounting. The lessee's incremental borrowing rate is 6% per annum. Initial measurement new lease Debit Right of use (ROI) asset 61,965.34$ Credit Current portion lease obligation 10,500.00$ Credit Long-term lease obligation 51,465.34$ Journal entries Year 4new lease Debit Depreciation ROI 6,196.53$ Credit Accumulated depr. ROI 6,196.53$ Debit Interest expense 3,717.92$ Credit Long-term lease obligation 3,717.92$ Debit Current portion lease obligation 10,500.00$ Debit Operating expenses $1,050.00 Credit Cash 11,550.00$ Debit Long-term lease obligation 10,710.00$ Credit Current portion lease obligation 10,710.00$ Initial recognition right of use and lease obligation within and over twelve months Straight line method depreciation over 7 years Accretion expense new lease obligation Recording the new lease payment in year 4, including CAM costs Amount due within twelve months Year Lease components Non-lease components Annual Payments 4 $10,500.00 $1,050.00 $11,550.00 5 $10,710.00 $1,071.00 $11,781.00 6 $10,924.20 $1,092.42 $12,016.62 7 $11,142.68 $1,114.27 $12,256.95 8 $11,365.54 $1,136.55 $12,502.09 9 $11,592.85 $1,159.28 $12,752.13 10 $11,824.71 $1,182.47 $13,007.18 Year Commitment Present Value 1 10,500.00$ 9,905.66$ 2 10,710.00$ 9,531.86$ 3 10,924.20$ 9,172.17$ 4 11,142.68$ 8,826.05$ 5 11,365.54$ 8,492.99$ 6 11,592.85$ 8,172.50$ 7 11,824.71$ 7,864.10$ Lease liability 61,965.34$ 11
  12. 12. Accounting for a modification (2) The lessor and the lessee agree to modify the lease for the retail space at the end of the 3rd year, reducing the floor space from 1,500 to 1,000 sq. feet and maintaining all other terms and conditions unchanged. Lessee determines the proportionate decrease in the carrying amount of the right-of-use asset and in the carrying amount of the lease liability on the basis of the remaining right-of-use asset. The difference between the decrease in the lease liability and the decrease in the right-of-use asset is a gain in profit or loss at the effective date of the modification. Subsequent measurement Debit Curr.port. lease obligation 10,612.08$ Debit Lease obligation 43,739.65$ Credit Right of use 46,222.60$ Credit Gain from lease termination 8,129.13$ Journal entries Year 4 Debit Depreciation ROI 18,561.09$ Credit Accumulated depr. ROI 18,561.09$ Debit Interest expense 6,496.38$ Credit Long-term lease obligation 6,496.38$ Debit Current portion lease obligation 21,224.16$ Debit Operating expenses $2,122.42 Credit Cash 23,346.58$ Debit Long-term lease obligation 21,648.64$ Credit Current portion lease obligation 21,648.64$ Reduction of lease obligation and right of use and recognition gain for the difference Straight line method depreciation over 7 years for revised right of use Accretion expense on revised lease obligation Recording the lease payment in year 4, including adjusted CAM costs Amount due within twelve months 12
  13. 13. Accounting for a modification (3) At the beginning of the 3rd year, the Lessee and the Lessor agree to amend the original lease by extending the contractual lease term by 5 years. The annual lease payments are unchanged and the Lessee’s incremental borrowing rate at the beginning of the 4th year is 6% per annum. The modification is accounted for with an adjustment to the right of use and to the lease liability with a discounted liability using the interest rate at modification date. Year Commitment Present Value 1 31,836.24$ 30,320.23$ 2 32,472.96$ 29,453.94$ 3 33,122.42$ 28,612.40$ 4 33,784.87$ 27,794.90$ 5 34,460.57$ 27,000.76$ 6 35,149.78$ 26,229.31$ 7 35,852.78$ 25,479.90$ 8 36,569.83$ 24,751.90$ 9 37,301.23$ 24,044.70$ 10 38,047.25$ 23,357.71$ 11 38,808.20$ 22,690.35$ 12 39,584.36$ 22,042.05$ Lease liability 311,778.15$ Subsequent measurement Debit Right of use (ROI) asset 116,886.73$ Credit Long-term lease obligation 116,886.73$ Journal entries Year 4 Debit Depreciation ROI 25,981.51$ Credit Accumulated depr. ROI 25,981.51$ Debit Interest expense 15,588.91$ Credit Long-term lease obligation 15,588.91$ Debit Current portion lease obligation $31,836.24 Debit Operating expenses $3,183.62 Credit Cash 35,019.86$ Debit Long-term lease obligation 32,472.96$ Credit Current portion lease obligation 32,472.96$ Recognition of the modified term of the lease with an increase in right of use and in lease obligation Straight line method depreciation over 12 years Accretion expense revised lease obligation Recording the lease payment in year 4, including CAM costs Amount due within twelve months 13
  14. 14. Transition to IFRS 16: Option 1 Retrospective  Restate comparatives as if IFRS 16 always applied.  The lease liability is calculated on the commencement date of the lease as the present value of the future rentals discounted using the interest rate implicit in the lease or otherwise the lessee's incremental borrowing rate applicable at the commencement date of the lease.  The restatement for the reporting entity in case study at the end of the 3rd year is as follows: Year 1 Year 2 Debit Right of use $251,643.17 Debit Depreciation right of use $25,164.32 Credit Curr.Port. Lease obligation $30,000.00 Credit Acc. Depr. Right of use $25,164.32 Credit Lease obligation $221,643.17 Debit Interest expenses $11,711.27 Debit Depreciation right of use $25,164.32 Credit Lease obligation $11,711.27 Credit Acc. Depr. Right of use $25,164.32 Credit Operating expenses (reversal) $33,660.00 Debit Interest expenses $12,582.16 Debit Operating expenses $3,060.00 Credit Lease obligation $12,582.16 Debit Curr. Port. Lease obligation $30,600.00 Credit Operating expenses (reversal) $33,000.00 Debit Operating expenses $3,000.00 Effect in net income before taxes -$6,275.58 Debit Curr.Port. Lease obligation $30,000.00 Year 3 Effect in net income before taxes -$7,746.48 Debit Depreciation right of use $25,164.32 Credit Acc. Depr. Right of use $25,164.32 Debit Interest expenses $10,766.83 Credit Lease obligation $10,766.83 Credit Operating expenses (reversal) $34,333.20 Debit Operating expenses $3,121.20 Debit Curr. Port. Lease obligation $31,212.00 Effect in net income before taxes -$4,719.15 14
  15. 15. Transition to IFRS 16: Option 2 Cumulative Catch-up  Comparatives remain as previously reported.  Any difference between asset and liability is recognized in the opening retained earnings at transition date.  Calculate the outstanding liability for existing operating leases using the incremental borrowing rate at the date of transition if interest rate implicit in the lease is not available.  Measure the asset as if IFRS 16 had been applied from lease commencement OR  Measure the asset at amount equal to liability (adjusted for accruals and prepayments).  The restatement for the reporting entity in case study at the end of the 3rd year, with a measurement at commencement date and using the interest rate at commencement date, and the carry forward of the asset measured as if IFRS 16 was applied from lease commencement is a follows: Year 4 Opening Balances Debit Right of use $176,150.22 Debit Retained earnings $18,741.21 Credit Curr.Port. Lease obligation $31,836.24 Credit Lease obligation $163,055.18 15
  16. 16. How to adopt IFRS 16 (1)  Understanding IFRS 16 a) reviewing IFRS 16-related information from IASB and other externally prepared websites b) discussing the implications with industry peers c) considering additional education and training for this topic;  Reviewing a) processes, systems, data collection and internal controls to develop a comprehensive project management process b) identifying the required but not available data and developing a plan to obtain such information c) creating a database of all lease contracts including a summary of key contractual provisions 16
  17. 17. How to adopt IFRS 16 (2)  Assessing the effect of IFRS 16 a) in systems, lease accounting policies, disclosures, internal controls, and discuss any potential issue and change with the auditors b) making a decision on the method to be applied on transition c) preparing pro-forma financial statements to illustrate the effect of adopting IFRS 16 d) determining (if any) the implications for contractual arrangements (e.g. compensation, acquisition, lending) e) modifying (if necessary) covenants and third party agreements f) determining whether additional training is required;  Implementing IFRS 16 a) reflecting the adoption in accounting policies, systems and internal controls b) updating budgets and forecast for the effects of IFRS 16; and  Communicating the effects of IFRS 16 a) with the board of directors and the audit committee b) developing a communication plan for all stakeholders (e.g. lenders and investors) including disclosure in the MD&A. 17
  18. 18. Educational materials  http://www.ifrs.org/Current-Projects/IASB- Projects/Leases/Documents/IFRS_16_project-summary.pdf IASB January 2016  http://www.ey.com/Publication/vwLUAssets/ey-leases-a-summary-of-ifrs-16-and- its-effects-may-2016/$FILE/ey-leases-a-summary-of-ifrs-16-and-its-effects-may- 2016.pdf E&Y May 2016  https://www.slideshare.net/kpmg/ifrs-16-leases-a-more-transparent-balance-sheet- 56984678 KPMG January 2016  http://www.ifrs.org/Current-Projects/IASB-Projects/leases- implementation/Documents/IFRS-16-Modifications-Webcast.pdf IASB March 2017  http://efrag.org/Assets/Download?assetUrl=%2Fsites%2Fwebpublishing%2FProjec t%20Documents%2F269%2FIFRS%2016%20Leases_Illustrative%20Examples.pd f IASB January 2016 18

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