IFRS 16, Leases - Lessee Perspective

Organizations considering a conversion to the International Financial Reporting Standards (IFRS) from U.S. Generally Accepted Accounting Principles (U.S. GAAP) should be aware of key lease accounting differences between both accounting standards.  IFRS 16, Leases (IFRS 16) establishes a single lessee accounting model and requires a lessee to recognize assets and liabilities for all leases that have a term greater than 12 months unless the lease assets are of a low value.

Lessees record a right-of-use asset that represents the right to use the leased asset and a lease liability that represents the obligation to make lease payments.  IFRS 16 was effective for all entities for periods beginning on or after January 1, 2019.  Subsequent to the IFRS 16 effective date, certain companies may find it necessary to report under IFRS 16 due to a change in reporting requirements or dual reporting requirements.   The lease accounting updates in International Financial Reporting Standard 16, Leases (IFRS 16), are challenging to implement regardless of the complexity or simplicity of a lessee’s portfolio of leases.  The calculations used to determine the right-of-use asset and lease liability are not terribly complex, as they follow well-established effective interest method and asset amortization models; however, all of the analyses leading up to the actual calculations present significant challenges.  This article is part of a series covering considerations for organizations contemplating conversion from U.S. GAAP to IFRS. This article will highlight some of the key aspects of IFRS 16 and compare those provisions to its U.S. GAAP counterpart (Topic 842) and highlight common adoption questions.

The single lease accounting model referred to in the IFRS 16 text means that there is not a distinction between operating leases and finance leases, whereas Topic 842 retains the distinction between operating and finance leases.  The classification analysis under Topic 842 is similar to the current capital-lease-versus-operating-lease test under Topic 840, but the Topic 842 classification tests do not contain bright-line thresholds.  Those with dual reporting requirements might be wondering what the difference is between operating leases and finance leases under Topic 842 since leases are reported on the balance sheet regardless of classification. The key distinction is in the expense recognition during the subsequent accounting.  Operating leases under Topic 842 will recognize a straight-line lease expense, whereas Topic 842 finance leases recognize amortization and interest expense.  This results in accelerated expense recognition in the earlier period of a finance lease compared to an operating lease.  The recognition and initial and subsequent measurement of a finance lease under Topic 842 are the same under IFRS 16.

IFRS 16 contains similar exemptions and practical expedients to Topic 842, including the package of three transitional practical expedients: the hindsight practical expedient, short-term lease exemption, practical expedient to not separate lease and non-lease components, and the portfolio approach practical expedient.  IFRS 16 includes a low-value lease exemption not contained in Topic 842.  The low-value threshold is not explicitly defined in the IFRS 16 standard.  Many organizations have elected to utilize their capitalization threshold to identify low-value leases, which we believe is an appropriate accounting policy.

The discount rate is used to calculate the present value of the lease liability in IFRS 16 and should ideally reflect how the contract is priced.  If it is readily determinable, the rate implicit in the lease contract should be used to discount the lease liability.  If the implicit interest rate cannot be readily determined, a lessee is permitted to use its incremental borrowing rate.  There are conceptual differences in the definition of the incremental borrowing rate within IFRS 16 compared to Topic 842.  Under IFRS 16, the incremental borrowing rate is the rate of interest that a lessee would have to pay in order 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.  For those with dual reporting requirements, the Topic 842 definition of incremental borrowing rate is less prescriptive than the IFRS 16 definition.  It is defined as the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment.  Topic 842 also includes an optional accounting policy election for nonpublic entities to use a risk-free discount rate in lieu of an incremental borrowing rate, whereas IFRS 16 is silent to any such accounting policy election for nonpublic entities.  Depending on the sophistication and resources of an entity’s treasury management function, it may be appropriate and necessary to select an incremental borrowing rate(s) from published sources, seek rate quotes from lenders, and perform sensitivity analyses over the rate(s).

The optional practical expedients generally make it easier for lessees to transition from legacy lease accounting guidance; however, it can be easy to unintentionally violate the practical expedients during adoption.  Common errors include misapplications of the hindsight practical expedient and the package of three transitional practical expedients.   For example, the new lease standard potentially allows entities the ability to reassess whether or not certain contracts are or do not lease.  However, if the package of three transitional practical expedients is elected, then lessees cannot reassess these contracts at transition unless the contract was incorrectly assessed as a lease under legacy lease accounting guidance.

Why would a lessee need to perform completeness procedures if the transitional practical expedients seemingly protect a lessee from have to reassess whether or not contracts are leases or to reassess the lease term?  On the surface, yes, the practical expedients allow lessees to carry forward their leases as determined under legacy lease accounting guidance.  However, the practical expedients do not shield lessees from errors in assessment under legacy lease accounting guidance.  For this reason, it is important to perform a completeness assessment at transition.

Two of the most frequently asked questions that we receive during IFRS 16 implementation projects are, “What should I do with my deferred rent liability under previous lease accounting?” and “Why do I have an adjustment to retained earnings as a result of adoption?”  The most common answer to these two questions is accrued rent (deferred rent liability).  Deferred rent liabilities resulted from the recognition of straight-line rent expense for operating leases with escalating rent payments.  When transitioning to IFRS 16 or Topic 842, an existing deferred rent liability is subsumed into the right-of-use asset balance, which results in a right-of-use asset balance that appropriately does not match the lease liability.  If the deferred rent liability was missed under legacy lease accounting, then the accounting debit would be to retained earnings as a transition adjustment to “catch up” expense that should have been recognized earlier in prior periods.   Other items that may impact the transition to the new lease standards include prepaid rent, lease incentives such as tenant improvement allowances, and initial direct costs.

An Excel-based solution would be appropriate for a noncomplex portfolio of 10 or fewer leases.  If the lease profile is more complex or greater than 10 individual leases, management is better served by a lease software solution, such as SimpLEASE. 

Schneider Downs provides assurance and advisory services for international entities and organizations following IFRS. For more information concerning international business matters and their impact on your organization, please visit the Schneider Downs Our Thoughts On blog or email us at [email protected].

Organizations need to find a suitable solution for calculating the FASB ASC Topic 842 right-of-use assets and lease liabilities at the transition date and the subsequent lease accounting.  Generally, an Excel-based solution would be appropriate for a noncomplex portfolio of 10 or fewer leases.  If the lease profile is more complex or greater than 10 individual leases, management is better served by a lease software solution, such as simpLEASE. In addition to offering our clients simpLEASE, Schneider Downs provides advisory services for the technical aspects of lease accounting. 

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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