Financial modelling for IFRS 16 leases

Financial modelling for IFRS 16 leases

By Joshua Grimm

Monday 10th October 2022

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.

Definitions and accounting background

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:

  • Leases of biological assets
  • Service concession arrangements
  • Licences of intellectual property granted by a lessor
  • Rights held by a lessee under licensing agreements
  • Leases to explore for or use non-regenerative resources

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:

  • Is there an identified asset that the customer has the right to use?
  • Does the customer have the right to control the use of the asset?
  • Does the customer receive substantially all the economic benefits from the use of the asset?
  • Does the customer have the right to direct the use of the asset?

The lease term is the non-cancellable period during which the lessee has the right to use the asset, and comprises:

  • The non-cancellable period
  • Periods covered by an option to extend the lease, if the lessee is reasonably certain to exercise the option
  • Periods covered by an option to terminate the lease, if the lessee is reasonably certain to exercise the option

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:

  • Comparison with market rates
  • Significant leasehold improvements made
  • Costs relating to the termination of the lease
  • The importance of the underlying asset to the lessee’s operations

Components of a lease on balance sheet

1.     Lease liability

Fixed payments from commencement date

+ Certain variable payments

+ Residual value guarantee

+ Exercise price of purchase options

+ Termination penalties

2.     Right of use (ROU) asset

Lease liability

+ Initial direct costs

+ Costs of removal and restoring

+ Payments made at or prior to commencement

            – Lease incentives received

Key differences between IAS 17 and IFRS 16

IAS 17 (old standard)

  • Classification was based on who bears the risks and rewards of the asset under the lease
  • For lessees, finance leases were recognised on the balance sheet while operating leases were expensed directly to the P&L

IFRS 16 (new standard)

  • Classification based on who has the right of use of the asset
  • For lessees, most leases recognised on the balance sheet and presented as Right of Use Asset and Lease Liability

Lease liability

Initial measurement

The lease liability is initially measured at the present value of the lease payments that have not yet been paid. These payments include:

  • Fixed payments
  • Variable payments that depend on an index or a rate, initially valued using the index or rate at the lease commencement date
  • Amounts expected to be payable under residual value guarantees
  • Options to purchase the asset that are reasonably certain to be exercised
  • Termination penalties if the lease term reflects the expectation that these will be incurred

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:

  • The lease payments, and
  • The unguaranteed residual value
  • To equal the sum of
  • The fair value of the underlying asset, and
  • Any initial direct costs of the lessor

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.

Subsequent measurement

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.

Right of use (ROU) asset

Initial measurement

Initial cost of the right of use asset comprises:

  • The amount of the initial measurement of the lease liability
  • Lease payments made at or before the commencement date
  • Initial direct costs
  • The estimated costs of removing or dismantling the underlying asset as per the conditions of the lease

Subsequent measurement

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.

Impact on financial statements

Modelling leases using IFRS 16 does not directly impact cashflows. However, it may have two indirect impacts on the cashflows:

  1. Distributions:
    1. The timing difference of the expense in the P&L may impact the build up of distributable reserves (i.e., retained earnings or legal reserves)
    1. This may impact the timing of dividend distributions if the local company law restricts dividends to these reserves
  2. Tax:
    1. There is an additional interest expense and depreciation charge when modelling IFRS 16
    1. Many jurisdictions have restrictions to the deductibility of financing costs (commonly modelled), so should the IFRS 16 interest be considered in these restrictions?
    1. Will vary by jurisdiction. Tax treatments of leases is a complex area and should be discussed with your tax advisor.

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?

Modelling a lease in Excel using IFRS 16

Step 1: build up the cashflows of the lease

It is important to consider which cashflows should be considered to generate the initial value of the lease liability and right of use asset.

Step 2: calculate the present value of the lease cashflows

Using the discount rate appropriate under the Standard, discount the cashflows of the lease to its commencement date.

Step 3: Create the Lease Liability account and calculate the lease finance cost

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.

Step 4: Create the Right of Use (ROU) Asset account and calculate the depreciation charge

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.

Step 5: Include these calculated items into your financial statements

  1. Lease cashflows à cashflow statement
  2. Finance cost of lease à profit and loss statement
  3. Depreciation of right of use asset à profit and loss statement
  4. Lease liability Balance c/f à balance sheet
  5. Right of use asset Balance c/f à balance sheet

Take care as these items may need to be considered carefully for other calculations (e.g., tax depreciation).