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IFRS 16 Leases is the biggest change to accounting since the international accounting standards themselves were introduced. Lease costs which once sat above EBITDA now fall into depreciation expense while the asset sits on the balance sheet, in some cases drastically changing key financial ratios. This tutorial will discuss the best practice approach to modelling leases under the new Standard as presented in our webinar.
IFRS 16 Leases is effective from 1 January 2019, replacing the previous IAS 17 Standard. It applies to both operating and financing leases, however there are some exemptions for low value or short-term leases.
A lease is an agreement whereby the lessor (the legal owner of an asset) conveys to the lessee (the user of the asset) the right to use an asset for an agreed period in return for a payment or series of payments.
The following lease contracts are outside the scope of the Standard:
Contracts meeting the definition of a lease should be recorded on the balance sheet. In applying the definition of a lease, there are several criteria that must be met, including:
The lease term is the non-cancellable period during which the lessee has the right to use the asset, and comprises:
Assessment of whether it is reasonably certain that the entity will exercise any such options will need to be carried out by the lessee. This assessment may include:
Fixed payments from commencement date
+ Certain variable payments
+ Residual value guarantee
+ Exercise price of purchase options
+ Termination penalties
Lease liability
+ Initial direct costs
+ Costs of removal and restoring
+ Payments made at or prior to commencement
– Lease incentives received
The lease liability is initially measured at the present value of the lease payments that have not yet been paid. These payments include:
The discount rate used in calculating the present value of the lease payments is the rate implicit in the lease, which is defined as the rate of interest that causes the present value of:
If this cannot be determined, then the entity should use its incremental borrowing rate (the rate at which it could borrow funds to purchase a similar asset).
Regardless we would anticipate that the discount rate will simply be an input to a financial model.
In each subsequent period, the discounting is unwound. This increases the lease liability on the balance sheet, and creates an interest expense in the P&L. The lease liability is also reduced by cash payments made on the lease.
Initial cost of the right of use asset comprises:
The right of use asset should be depreciated from the commencement date to the earlier of the end of the useful life of the right of use asset or the end of the lease term.
Modelling leases using IFRS 16 does not directly impact cashflows. However, it may have two indirect impacts on the cashflows:
It must also be considered whether the additional complexity of IFRS 16 is worth modelling. What is the purpose of the model (e.g., transactional, or operational) and the materiality of the lease cost compared to the net profit?
It is important to consider which cashflows should be considered to generate the initial value of the lease liability and right of use asset.
Using the discount rate appropriate under the Standard, discount the cashflows of the lease to its commencement date.
It’s important to remember that the cashflows have been discounted to the start of the period, and therefore additions must be taken into consideration for calculating the interest expense. The finance cost is calculated by multiplying the Balance b/f plus any additions at the start of the period by the period’s interest rate implicit in the lease. The Lease Liability is then reduced by any lease payments made in that period.
The initial measurement of the Right of use Asset should be the same as that of the Lease Liability in most cases. Be sure to consider any circumstances where this may not be true. The total value of the discounted lease cashflows at the commencement date is then depreciated using the straight-line method throughout the life of the lease.
Take care as these items may need to be considered carefully for other calculations (e.g., tax depreciation).
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