This blog summarizes the important ideas regarding IFRS 16 Leases, which became effective for periods beginning on or after 1 January 2019. The standard significantly changed lease accounting, primarily for lessees.

1. Definition of a Lease and Identifying a Lease:

Core Definition: A lease is defined as a contract that conveys the right to use an asset for a period of time in exchange for consideration.

Identifying a Lease: Determining whether a contract contains a lease involves assessing if the customer has the right to control the use of an identified asset for a period of time. This involves two key aspects:

• Identified Asset: The asset must be either explicitly specified in the contract or implicitly specified when it is made available for use.
• An asset is not identified if the supplier has a substantive right to substitute the asset throughout the period of use, meaning they have both the practical ability and would economically benefit from the substitution. Even if a supplier wouldn’t economically benefit from substituting a new battery for less than three years, each battery in a 10-year contract for 100 similar batteries is still an identified asset.

Control of the Asset: The customer controls the asset if they have the right to:

• Obtain substantially all of the economic benefits from use of the identified asset throughout the period of use. These benefits include primary output, by-products, and other economic benefits realizable from a commercial transaction with a third party. The assessment is limited to the defined scope of use within the contract.
• Direct the use of the identified asset. This involves having the right to make decisions about how and for what purpose the asset is used throughout the period of use. If relevant decisions are predetermined, a lease exists if the customer directs the operating decisions.

Separation of Lease and Non-Lease Components: Contracts may contain both lease and non-lease components. Entities need to separate these components, allocating the consideration based on their relative stand-alone prices. The right to use an underlying asset is a separate lease component if the lessee can benefit from its use on its own or with readily available resources, and the asset is not highly dependent on or interrelated with other assets in the contract.

2. Lessee Accounting:

Recognition: Generally, lessees recognize a right-of-use (ROU) asset and a corresponding lease liability at the commencement date for all leases.

Recognition Exemptions: Two exemptions exist for lessees:

• Short-term leases: Leases with a term of 12 months or less.
• Leases of low-value assets: The standard does not define a specific value, but examples include small IT equipment. For these exemptions, lease payments are generally recognized as an expense on a straight-line basis over the lease term. However, a head lease of a low-value asset does not qualify for the exemption if the lessee sub-leases the asset.

Initial Measurement:

• Lease Liability: Measured at the present value of the lease payments discounted using the interest rate implicit in the lease or, if that cannot be readily determined, the lessee’s incremental borrowing rate.
• Right-of-Use Asset: Measured at cost, comprising:
  • The initial amount of the lease liability.
  • Any lease payments made at or before the commencement date, less any lease incentives received.
  • Any initial direct costs incurred by the lessee.
  • An estimate of costs the lessee will incur in dismantling and removing the underlying asset or restoring the site on which it is located.

Subsequent Measurement:

• Lease Liability: Increased by interest expense and decreased by lease payments made. It is remeasured if there are changes in the lease term, lease payments, or the assessment of an option to purchase the underlying asset.
• Right-of-Use Asset: Generally depreciated over the shorter of the asset’s useful life and the lease term. It may also be subject to impairment testing. The carrying amount of the ROU asset is adjusted for the remeasurement of the lease liability. If the ROU asset’s carrying amount is zero, further reductions in the lease liability are recognized in profit or loss.

Lease Term: Determined as the non-cancellable period of the lease, including periods covered by an option to extend if the lessee is reasonably certain to exercise that option, and periods covered by an option to terminate if the lessee is reasonably certain not to exercise that option. Entities must consider all relevant facts and circumstances creating an economic incentive for the lessee to exercise an option. Lessees are required to reassess the lease term if significant events or changes in circumstances within their control occur. Lessors are not permitted to reassess the lease term.

A lease is no longer enforceable when both the lessee and lessor have the right to terminate without permission and with no more than an insignificant penalty. If only the lessee has a termination option, this is effectively a termination option for the lessee only.

Peppercorn Leases: Within the public sector, leases provided for nil or nominal consideration are generally treated as finance leases.

Intra-Government Agreements: The definition of a contract (and thus a lease) is expanded in the public sector to include intra-government agreements that are not legally enforceable but are akin to enforceable contracts.

3. Lessor Accounting:

Lessor accounting under IFRS 16 is substantially unchanged. Lessors classify leases as either operating leases or finance leases.

• A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the underlying asset. Otherwise, it is an operating lease.
• Intermediate Lessors (Sub-leases): An intermediate lessor accounts for the head lease and the sub-lease separately. The classification of the sub-lease is based on the right-of-use asset arising from the head lease, not the underlying asset itself. If the head lease is a short-term lease for which the exemption was applied, the sub-lease is classified as an operating lease.

4. Sale-and-Leaseback Transactions:

Involve the seller-lessee transferring an asset to a buyer-lessor and then leasing it back.

• If the transfer is a sale: The seller-lessee derecognizes the underlying asset, recognizes a ROU asset, and recognizes a gain or loss only on the rights transferred to the buyer-lessor.
• If the transfer is not a sale: The seller-lessee continues to recognize the asset, and the amounts received from the buyer-lessor are treated as a financial liability. The buyer-lessor recognizes a financial asset.
• Leaseback Transaction Not on Market Terms:
  • Below Market Terms: The shortfall in consideration received by the seller-lessee is treated as a prepayment of lease payments.
  • Above Market Terms: The additional consideration provided by the buyer-lessor is treated as additional financing.

5. Presentation and Disclosure:

IFRS 16 requires lessees to present interest expense on lease liabilities separately from the depreciation charge for ROU assets in the statement of profit or loss. Lessees may choose to present lease liabilities separately from other liabilities in the statement of financial position. Extensive disclosures are required for both lessees and lessors to provide information about the nature, amount, timing, and uncertainty of cash flows arising from leases.

6. Impact of IFRS 16:

IFRS 16 has led to a significant increase in recognized assets and liabilities on lessees’ balance sheets, as operating leases (previously off-balance sheet) are now recognized. This change has impacted financial ratios and performance indicators, with some industries experiencing notable changes in profit margins before interest and tax.

At Prabix Advisory, we simplify the challenges of implementing IFRS 16 on leases, ensuring businesses properly recognize lease liabilities and right-of-use assets in their financial statements. Our team assists with lease data collection, contract analysis, impact assessment, and disclosure requirements in compliance with international standards and UAE regulations. Whether you are transitioning to IFRS 16 or improving ongoing compliance, Prabix provides practical, tailored solutions that enhance transparency and reduce reporting risks.