IFRS 16: The Leases Standard Is Changing - PwC

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www.pwc.comIFRS 16: The leasesstandard ischangingAre you ready?IFRS 16 – The new leasesstandardJanuary 2016

New standardThe IASB has published IFRS 16 – the new leases standard. It comesinto effect on 1 January 2019. Virtually every company uses rentalsor leasing as a means to obtain access to assets and will therefore beaffected by the new standard.Redefines commonly used financial metricsThe new requirements eliminate nearly all off balance sheetaccounting for lessees and redefine many commonly used financialmetrics such as the gearing ratio and EBITDA. This will increasecomparability, but may also affect covenants, credit ratings,borrowing costs and your stakeholders’ perception of you.Business modelThe new standard may affect lessors’ business models and offerings,as lease needs and behaviours of lessees change. It may alsoaccelerate existing market developments in leasing such as anincreased focus on services rather than physical assets.Business data and processesChanges to the lease accounting standard have a far-reaching impact onlessees’ business processes, systems and controls. Lessees will requiresignificantly more data around their leases than before given the onbalance sheet accounting for almost all leases. Companies will need totake a cross-functional approach to implementation, not just accounting.Prepare nowThe earlier you begin to understand what impact the new standardmay have on your organisation the better prepared you will be to ironout potential issues and reduce implementation costs and compliance risk.

ContentThe impact of the new leases standard2What is in scope?3How to separate lease and non-lease components4What is the new model?5Examples of practical implications7The impact on industries8Financial, operational and business impacts10Transition accounting and effective date13Contacts14

The impact of the new leasesstandardThe IASB published IFRS 16 Leases in January 2016 with an effective date of 1 January 2019. The new standardrequires lessees to recognise nearly all leases on the balance sheet which will reflect their right to use an asset for aperiod of time and the associated liability for payments.Leasing is an important and widelyused financing solution. It enablescompanies to access and use propertyand equipment without incurringlarge cash outflows at the start.It also provides flexibility andenables lessees to address the issueof obsolescence and residual valuerisk. In fact sometimes, leasing isthe only way to obtain the use of aphysical asset that is not availablefor purchase.Under existing rules, lessees accountfor lease transactions either as operatingor as finance leases, depending oncomplex rules and tests which, inpractice, use ‘bright-lines’ resulting in allor nothing being recognised on balancesheet for sometimes economically similarlease transactions.Therefore, lessees will be greatlyaffected by the new leases standard.The lessors’ accounting largely remainsunchanged. However they might see animpact to their business model andlease products due to changes in needsand behaviours.The impact on a lessee’s financialreporting, asset financing, IT, systems,processes and controls is expected to besubstantial. Many companies lease avast number of big-ticket items,including cars, offices, power plants,retail stores, cell towers and aircraft.Lesseest The new standard will affect virtually all commonly used financial ratios and performance metrics such as gearing, currentratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows.These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behaviouralchanges. These impacts may compel many organisations to reassess certain ‘lease versus buy’ decisions.t Balance sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will also be a change toboth the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern(acceleration of lease expense relative to the recognition pattern for operating leases today).t Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships, andtechnology – are expected to be greatly affected. The impact for entities with numerous small leases, such as tabletsand personal computers, small items of office furniture and telephones might be less as the IASB offers an exemptionfor low value assets (assets with a value of 5,000 or less when new). Low value assets meeting this exemption do nothave to be recognised on the balance sheet.t The cost to implement and continue to comply with the new leases standard could be significant for most lessees.Particularly if they do not already have an in-house lease information system.Lessorst Lessees and lessors may need to consider renegotiating or restructuring existing and future leases.t Business and legal structures supporting leases should also be reassessed to evaluate whether these continue to beeffective (for example, joint ventures and special purpose entities).t Lessor accounting remains largely unchanged from IAS 17 however, lessors are expected to be affected due to thechanged needs and behaviours from customers which impacts their business model and lease products.The pervasive impact of these rules requires companies to transform their business processes in many areas, includingfinance and accounting, IT, procurement, tax, treasury, legal, operations, corporate real estate and HR.2 IFRS 16: The leases standard is changing – are you ready? PwC

What is in scope?The scope of IFRS 16 is generallysimilar to IAS 17 and includes allcontracts that convey the right to usean asset for a period of time inexchange for consideration, except forlicences of intellectual propertygranted by a lessor, rights held by alessee under licensing agreements(such as motion picture films, videorecordings, plays, manuscripts, patentsand copyrights), leases of biologicalassets, service concession agreementsand leases to explore for or useminerals, oil, natural gas and similarnon-regenerative resources. There is anoptional scope exemption for lessees ofintangible assets other than thelicences mentioned above.However, the definition of a lease isdifferent from the current IFRIC 4guidance and might result in somecontracts being treated differently in thefuture. IFRS 16 includes detailedguidance to help companies assesswhether a contract contains a lease or aservice, or both. Under current guidanceand practice, there is not a lot of emphasison the distinction between a service or anoperating lease, as this often does notchange the accounting treatment.The analysis starts by determining if acontract meets the definition of a lease.This means that the customer has theright to control the use of an identifiableasset for a period of time in exchangefor consideration.Example: Lease vs. serviceCompany A enters into a fixed three-yearcontract with a stadium operator (Supplier) touse a space in a stadium to sell its goods. Thecontract states the amount of space and thatthe space may be located at any one of severalentrances of the stadium. The Supplier has theright to change the location of the spaceallocated to Company A at any time. There areminimal costs to the Supplier associated withchanging the space. Company A uses a kiosk(that Company A owns) to sell its goods thatcan be moved easily. There are many areas inthe stadium that are available and would meetthe specification for the space in the contract.The contract does not contain a lease becausethere is no identified asset. Company A controlsits own kiosk. The contract is for space in thestadium, and this space can be changed at thediscretion of the Supplier. The Supplier has thesubstantive right to substitute the spaceCompany A used because:a) The Supplier has the practical ability tochange the space used at any time withoutCompany A’s approval.b) The Supplier would benefit economicallyfrom substituting the space.PwC The leases standard is changing – are you ready? 3

How to separate lease andnon-lease componentsCurrently, many arrangements embedan operating lease into the contract oroperating lease contracts includenon-lease (e.g. service) components.However, many entities do not separatethe operating lease component in thecontracts because the accounting for anoperating lease and for a service/supplyarrangement generally have a similarimpact on the financialstatements today.Under the new leases standard, lesseeaccounting for the two elements of thecontract will change because leases willhave to be recognised on thebalance sheet*.Both lessees and lessors are required toseparate lease components fromnon-lease components in theircontracts if both of the followingcriteria are met:a. The lessee can benefit from use ofthe asset either on its own ortogether with other resources thatare readily available to the lessee.Readily available resources aregoods or services that are sold orleased separately (by the lessor orother suppliers) or resources thatthe lessee has already obtained(from the lessor or from othertransactions or events); andb. The underlying asset is neitherdependent on, nor highlyinterrelated with, the otherunderlying assets in the contract.After the identification of lease andnon-lease components, paymentsshould be allocated as follows:t Lessors should apply the guidance inIFRS 15 Revenue from Contracts withCustomers when allocating thetransaction price to separatecomponents. Allocation is based on therelative standalone selling prices (SSP).If no observable information isExample: Separating lease componentsCompany A enters into a 15-yearcontract for the right to use threespecified, physically distinct darkfibers within a larger cableconnecting Hong Kong to Tokyo andmaintenance services. The entitymakes all of the decisions about theuse of the fibers by connecting eachend of the fibers to its electronicsequipment (i.e. Company A ‘lights’the fibers). The entity concluded thatthe contract contains a lease.The agreement consist of the lease ofthree dark fibers and maintenanceservices. The observable standaloneprices can be determined based on theamounts for similar lease contractsand maintenance contracts enteredinto separately. If no observableinputs are available, Company A hasto estimate the standalone prices ofboth components.* Except for the exempted short term leases and low value asset leases, see page 74 IFRS 16: The leases standard is changing – are you ready? PwCavailable, entities are required toestimate the SSP. IFRS 15 distinguishesthree methods of estimation: adjustedmarket assessment approach, expectedcost plus margin approach and residualapproach. Entities may want tocombine the adoption of the new leasesstandard with the new revenuerecognition standard (effective 1January 2018), considering theinterdependencies between the twostandards. This may prove to be themost cost-efficient.t Lessees should separate leasecomponents from non-leasecomponents unless they apply theaccounting policy election describedbelow. Activities that do not transfer agood or service to the lessee are notcomponents in a contract. Allocationof payments should be similar tolessors as described above. Thestandard gives the policy election forlessees to not separate non-leasecomponents from a lease componentfor a class of an underlying asset. Insuch cases, the whole contract isaccounted for as a lease.The requirements of IFRS 16 forseparating lease and non-leasecomponents and allocating theconsideration to separatecomponents will requiremanagement judgement whenidentifying those components andapplying estimates to determinethe observable standalone prices.Lessees may not currently havethe data to separate lease andnon-lease components. i.e. Hence,lessors might need to provide theinformation to separate lease andnon-lease components to theircustomers. In the past they mightnot have priced these elementsseparately to customers.

What is the new model?The distinction between operating andfinance leases is eliminated for lessees,and a new lease asset (representing theright to use the leased item for the leaseterm) and lease liability (representing theobligation to pay rentals) are recognisedfor all leases*.Lessees should initially recognise aright-of-use asset and lease liabilitybased on the discounted paymentsrequired under the lease, taking intoaccount the lease term as determinedunder the new standard. Determiningthe lease term will require judgmentwhich was often not needed before foran operating lease as this did notchange the expense recognition. Initialdirect costs and restoration costs arealso included.Lessor accounting does not change andlessors continue to reflect the underlyingasset subject to the lease arrangementon the balance sheet for leases classifiedas operating. For financingarrangements or sales, the balance sheetreflects a lease receivable and thelessor’s residual interest, if any.The key elements of the new standardand the effect on financial statementsare as follows:t A ‘right-of-use’ model replaces the‘risks and rewards’ model. Lesseesare required to recognise an assetand liability at the inception ofa lease.t All lease liabilities are to bemeasured with reference to anestimate of the lease term, whichincludes optional lease periodswhen an entity is reasonably certainto exercise an option to extend (ornot to terminate) a lease.t Contingent rentals or variable leasepayments will need to be included inthe measurement of lease assets andliabilities when these depend on anindex or a rate or where in substancethey are fixed payments. A lesseeshould reassess variable leasepayments that depend on an index ora rate when the lessee remeasuresthe lease liability for other reasons(for example, because of areassessment of the lease term) andwhen there is a change in the cashflows resulti

as lease needs and behaviours of lessees change. It may also accelerate existing market developments in leasing such as an increased focus on services rather than physical assets. Business data and processes Changes to the lease accounting standard have a far-reaching impact on lessees’ business processes, systems and controls. Lessees will require