Audit Partner at RSM Poland
For quite some time now we have been observing the increased activity of entities, asking questions about leases and requesting the analysis of contracts they have signed to use specific assets, be it lease or rental.
The new standard, which is supposed to enter into force in a month or so, will apply not only to entities that have signed lease contracts (either operational or finance), but also to entities that have obligations under other types of documents, such as tenancy contracts, rental contracts, etc. Each and every contract that conveys the right to use the asset (or a substantive part of the asset) for a predefined period of time in exchange for consideration must be considered individually. The contract name (title) cannot be the guiding principle here.
This year we wrote quite a lot in our blog about the new standard of IFRS 16, which significantly changes the concept behind analysing contracts in terms of the need to recognise transactions in the lessee’s balance sheet. In principle, most contracts transfer the right to the asset to the user in exchange for consideration, thus a majority of lessees/tenants shall be obliged to present this right-of-use in their balance sheet. And we are not talking here strictly about assets, but about the right-of-use asset that must be properly measured.
During our IFRS training sessions, accountants and our clients ask numerous questions: Will there be any exemptions from the IFRS 16 rules, as it was in the past? How should the asset (right-of-use asset) be measured according to the new rules? How should it be presented in the balance sheet? What if the asset value is not provided for in the rental contract or the contract has been signed for a short time period (1 year)?
I will try to answer most of these questions.
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1. IFRS 16 does not apply to me, because my contracts do not have the words ‘finance lease’ in the title.
This approach is wrong. IFRS 16 applies to all entities that have concluded contracts to use the assets regardless of the form of the contract.
2. We have signed an indefinite-term contract; hence we are not able to determine the value of the liabilities, and thus the right-of-use asset.
This approach is wrong. Every entity must assess, to the best of their knowledge and available information, what the most probable term of using these assets will be. To calculate this properly, you have to take a number of elements into account, including any possible periods covered by the extension option (if the lessee is certain to exercise the option of extension) and the termination option (it applies only to the option of contract termination by the lessee), if the lessee is reasonably certain not to exercise the termination option. What is most crucial is that this estimate must result from the earlier practice of the entity and must be aligned with the entity’s plans for the coming years. Thus, the entity should consider all the relevant information and circumstances that may weigh in favour of the fact that the contract will be in force for e.g. 10 years, even though it has been concluded for an indefinite term.
3. Until now, we had all our contracts correctly recognised as either finance or operational lease on the basis of IAS 17. Can I continue with this method of lease settlement?
As regards contracts that have been so far treated as finance lease under IAS 17, you may continue your approach from 1 January 2019 without any unnecessary adjustments. When it comes to operational lease contracts, the transition is going to involve establishing whether the entity wants to choose the value of lease liabilities as at 1 January 2019 for the right-of-use asset (1) or introduce the right-of-use asset in the value that would have been defined if IFRS 16 had been used earlier (2).
4. When should I enter the leased assets into the balance sheet?
From the point of view of finance and accountancy professionals, the commencement date seems to be of importance, i.e. the moment in which the lessor transfers the control of an identified asset to the lessee. This is the date the lessee shall recognise and measure the right-of-use assets, and recognise liabilities on the debit side of the balance sheet. Thus, it does not have to be the contract signing date.
5. At the commencement date, we entered the right-of-use assets to the books in the amount of expected payments that we will be paying throughout the lease term, discounted at a discount rate of 4%. Is it correct?
As a rule of thumb and with the assumption that all the fixed components of the payment have been recognised, we could answer ‘yes’. If the user is also obliged to pay the option exercise price (purchase option), it should be included, as well. In addition, you have to take any variable components that are based on an index or a rate into account.
When it comes to discounting at a given rate (4% in the above case), I leave it to your judgement. The determined value of payments is discounted at an interest rate from a given lease contract, and if this rate cannot be determined, it is discounted at a rate that would have been used if the lessee took out a loan/credit (for a term similar to the lease contract term) to purchase an asset similar to the right-of-use asset they acquire on the basis of the lease contract.
6. Where do we disclose the lease in the balance sheet according to the new rules? In what item?
In our opinion, the best solution would be to present the right-of-use asset in a separate balance sheet item, depending on the fixed asset this right pertains to; if you are using leased cars, you could present it under a heading ”means of transport PLN XXX thousand” and add the following line to this item: including the right-of-use asset PLN YYY thousand. The same goes for machines, land or buildings.
7. We have just signed a contract to use a premises. Do I need to know its market value to enter it into the books?
No. All you need is a payment schedule.
8. Can we apply exemptions in order not to convert the lease?
Yes. IFRS 16 does not apply to matters regulated by other standards (e.g. biological assets, IAS 41), and offers exemptions for short-term leases or leases of low-value assets.
9. If we have a 12-month contract, can we assume that we do not have a conversion obligation under IFRS 16?
The answer to this question is not clear. If the contract really is short-term and it is not expected to be extended, then yes, you can apply an exemption. However, if the intention, other factors or practice show that contract extension is very likely, you have to determine the contract duration. We will give you an example to illustrate how to approach this: if the lessee (entity A) concludes a lease contract for office space for a term of 2 years with the option of two extensions for the next 4 years and knowing that contract rollover is not going to result in any additional expenses for company A, and entity A has made substantive investments in the furnishings in rented premises, then maybe this 10-year period would be the most suitable in this case.
In part two, we are going to present more questions and answers concerning IFRS 16. At the same time we encourage you to submit your doubts concerning leases to the following e-mail address: firstname.lastname@example.org.
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