U NIVERSITY OF E CONOMICS IN P RAGUE Faculty of Finance and Accounting
Finance and Accounting
MASTER THESIS
The implementation of IFRS 16 by a Lessee
Author: Asel Raimjanova
Supervisor: doc. Ing. David Procházka, Ph.D.
Academic Year: 2021
Declaration of Authorship
The author hereby declares that he compiled this thesis independently, using only the listed resources and literature, and the thesis has not been used to obtain a different or the same degree.
The author grants to the University of Economics in Prague permission to reproduce and to distribute copies of this thesis document in whole or in part.
Prague __________ ____________________
Signature
ACKNOWLEDGMENT
I would like to express my sincere gratitude and appreciation for my supervisor, Professor David Procházka, for his valuable guidance and patient support through each stage of this study.
ABSTRACT
The thesis examines theoretical and practical aspects of implementation of the new standard IFRS 16 “Leases”. The theoretical part of the thesis reviews the background of the topic. In particular, the chapter contains main features, determination of the lease, development of lease standards and detailed overview of IFRS 16.
The practical part focuses on the implementation of IFRS 16 using a case study of a multinational pharmaceutical company. In this chapter, I examine the administrative aspects of IFRS 16 implementation, as well as, new accounting policy, related to the adoption of the new standard.
JEL Classification M40, M41, H83.
Keywords: Finance lease, Operating lease, IFRS 16, Lessee, Lessor, IASB, Lease accounting software.
CONTENT
LIST OF FIGURES ...vi
LIST OF TABLES ... vii
ABBREVIATIONS ... viii
1 INTRODUCTION ... 1
1.1 Main features of a Lease ... 2
1.2 Historical background of lease accounting ... 6
1.2.1 Development of lease accounting standards ... 7
1.3 Operating leases and off-balance sheet financing ... 8
2 LEASE ACCOUNTING OUTLOOK ... 12
2.1 IFRS 16 historical timeline ... 12
2.2 IFRS 16 overview ... 13
2.2.1 Scope and Identifying a Lease... 13
2.2.2 The lease term ... 17
2.2.3 Recognition and Measurement ... 18
2.2.4 Depreciation of the right-of-use asset ... 23
2.2.5 Disclosure requirements for lessee ... 24
2.3 IAS 17 and IFRS 16 comparison ... 26
2.4 Impact of IFRS 16 implementation ... 27
2.5 IFRS 16 and covid-19 ... 30
3 EMPIRICAL APPLICATION ... 35
3.1 Administrative aspects of IFRS 16 implementation ... 35
3.2 Lease accounting policy ... 38
3.3 Novartis incremental borrowing rate ... 39
3.4 Lease contracts reconciliation ... 41
3.5 Case study 1. Finance lease initial evaluation ... 44
3.6 Case Study 2. Off - balance sheet lease evaluation ... 53
4 CONCLUSION ... 58
5 BIBLIOGRAPHY ... 60
Appendix 1 Case study 1 ... 62
Appendix 2 Case study 2 ... 67
vi LIST OF FIGURES
Figure 1.1 Timeline of leasing standards ... 7
Figure 2.1 IFRS 16 evolution timelines ... 13
Figure 2.2 Lease asset identification flow ... 15
Figure 2.3 ROU asset assessment ... 16
Figure 2.4 ROU asset measurement ... 18
Figure 2.5 Lease liability measurement ... 19
Figure 2.6 Subsequent measurement of the ROU asset and lease liability ... 21
Figure 2.7 Lease liability measurement (Cost model) ... 21
Figure 2.8 IFRS 16 application methods ... 24
Figure 2.9 Quantitative Disclosure Requirements ... 25
Figure 2.10 IFRS 16 impacts for lessees ... 29
Figure 3.1 IFRS 16 implementation process of Novartis ... 37
Figure 3.2 Novartis lease identification flow chart ... 45
vii LIST OF TABLES
Table 2.1 IAS 17 and IFRS 16 comparison ... 26
Table 2.2 Impact of IFRS 16 on income statement ... 27
Table 3.1 Lease commitments ... 42
Table 3.2 ROU assets ... 43
Table 3.3 ROU assets and Lease liabilities ... 43
Table 3.4 Assumptions for calculation of lease liability and ROU asset ... 46
Table 3.5 Lease payment schedule ... 48
Table 3.6 Summary of fixed lease payments ... 49
Table 3.7 ROU asset depreciation ... 50
Table 3.8 Lease liability ... 51
Table 3.9 ROU asset and lease liability illustration in the balance sheet ... 52
Table 3.10 Property lease contract overview ... 54
Table 3.11 Summary of fixed lease payments ... 54
Table 3.12 ROU asset over the lease term ... 55
Table 3.13 Lease liability over the lease term ... 56
Table 3.14 ROU asset and lease liability illustration in the balance sheet ... 56
viii ABBREVIATIONS
D/E = Debt to Equity
EBITDA = Earnings before Interest, Tax, Depreciation and Amortization FASB = Financial Accounting Standards Board
FRA = Full Retrospective Approach G4+1 = the Group of Four Plus One
IASB = International Accounting Standards Board IASC = International Accounting Standards Committee IFRS = International Financial Reporting Standards MRA = Modified Retrospective Approach.
ROU = Right-of-use ROA = Return on Assets ROE = Return on Equity
SEC = United States Securities and Exchange Commission
1 1 INTRODUCTION
The main purpose of the international standards of the International Accounting Standards Board’s (IASB) is to improve and develop reliability, transparency and comparability of financial reporting. The IASB has been making a remarkable contribution to the transparency, reliability and comparability of companies’ financial statements. However, for many years there was a disunity in different accounting treatment of finance and operating leases. Many companies used different approaches in determining the category of the lease. Due to these factors, in January 2016, the IASB issued a new standard for the lease accounting: IFRS 16 Leases. The standard will lead to the capitalization of the majority of current operating leases by lessees.
The purpose for implementation of the new lease standard came from the desire to make a most accurate and transparent presentation of the rented asset by the lessee regarding the registration on both sides of balance sheet: the right of use of the rented asset and the obligations arising from rental payments. In addition, the standard introduces a clear separation between leases and contracts for the provision of services - leases will need to be recognized in the balance sheet, while contracts for the provision of services will continue to be reflected off - balance sheet.
The new standard comes into force in January 2019. Until then, companies were collecting significant additional information about their leases, as well as generating new estimates and performing new calculations.
The purpose of this thesis is to investigate theoretical aspects of lease accounting standards and empirically examine IFRS 16 implementation on the example of a company. The structure of the thesis consists of theoretical background of the leases and practical implementation of IFRS 16 on the example of multinational pharmaceutical company.
Concretely, my research interest is to investigate the development of the lease accounting standards and to examine the administrative challenges of practical implementation of the newly adopted standard. The thesis is also dedicated to analyzing the current amendments to IFRS 16, proposed by IASB, regarding Covid-19 related rent concessions. Given the urgency of the matter, the IASB significantly shortened the consultation periods and accelerated the process. Thus, the IASB issued amendments to the lease standard in 2020 and 2021.
2 1.1 Main features of a Lease
Corporations exert themselves to fight economic uncertainty. Financial managers continuously are taking care of the profitability, cash flow, and viability of the company. Leasing affords a great option for borrowing and provides the opportunity for the company to appreciate their business without making a hard investment (Salem Press, 2016).
Leasing has been recognized as an important source of funding for many years. It is a financial strategy of acquiring resources (in the form of machinery and equipment) for the economic transformation of enterprises. Leasing is recognized around the world as an effective financing method that can be used to facilitate capital accumulation as more and more global equipment needs are met through this unique form of financing (Nwanyanwu, A., 2015).
Leasing is not only an additional source of finance, but it also offers the company predictable payments and credit facilities. Importantly, it allows, if appropriately designed, the lessee to align costs with the return from an investment. While the form that leasing takes is constantly evolving in response to market demand, changes imposed by legislation, and regulation of one form or another, its advantages remain much the same as they were when leasing was first developed in the 50s and 60s (Limited IAA-Advisory, 2016).
Leasing is a contract, where the lessor allows the lessee the right to use an asset for a specified term in exchange for the payment of consideration. Leasing began to emerge in the 1950s as a viable alternative to purchasing equipment. There is no doubt that the leasing industry plays an important role in the financial community. A lessee can rent almost any asset on various terms.
Nevertheless, leasing had its own disadvantages: legal requirements and financial considerations are sometimes extremely complex, and rental documents are often difficult for business people to understand. However, due to intense competition among leasing companies, some progress has been made in favor of equipment renters - for example, many leasing companies now provide lease documents written in plain English, so they are more understandable (Contino, R., 2019).
Gordon E. (2008) defines a lease as an agreement between two parties, a leasing company or lessor and a user or lessee. In the lease agreement the lessor negotiates the purchase of an asset for subsequent use within an agreed period of time in exchange for the rental payment. The rent is determined in advance and is paid at regular intervals depending on the mutual convenience of both parties. However, the lessor remains the owner of the equipment during the primary period.
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By applying for a lease, the lessee can use the economic value of the leased asset, using it as if it owned its own, without having to pay capital costs. The rent can be easily paid during the lease term from the profits generated from the use of the leased asset.
What do companies lease? The following list is an example of assets that are typically leased:
● aircrafts
● computers
● vehicles
● office equipment and furniture
● manufacturing and medical equipment (Salem Press, 2016).
Advantages and disadvantages of a lease.
Gordon E. (2008) summarized the following main advantages of a Lease:
▪ Allow alternative uses of funds: The lease provides the firm with the ability to use and control assets without incurring huge capital costs. The firm is obliged to make only recurring rental payments. This allows significant savings on alternative uses that would otherwise be associated with fixed assets.
▪ Faster and cheaper loan: a lease costs are less than other methods of assets acquisition.
This allows firms to purchase assets without going through a rigorous formal verification process. Consequently, acquiring assets under a lease is cheaper and faster than any other source of funding.
▪ Flexibility: lease agreements are easier to adapt to the needs of the lessee than conventional financing. The rental payments can be structured according to the cash flow of the lessee. It can be skipped in months when cash flows are expected to be lower.
▪ Facilitates obtaining additional borrowings: Leasing can increase long-term ability to raise funds. The lessee can use more funds for working capital needs. Moreover, the acquisition of assets under a lease does not affect the debt capital ratio. Consequently, if necessary, the lessee can apply for additional loans.
▪ Protection against obsolescence. A firm can avoid the risk of obsolescence by entering into an operating lease.
▪ 100% lease financing: lease allows the firm to use the asset without making an initial down payment. Therefore, the lessee is guaranteed 100% of financing.
▪ Small Firm Benefit: firms that are either small or have an uncertain income statement can obtain use of the asset through lease financing.
According to Gordon E. (2008) a lease could have several disadvantages as well:
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▪ Tax benefits such as subsidies may not be available for a leased asset.
▪ The market value of the leased asset, such as land and properties, may increase over the lease term. In this case, the lessee loses the benefit of the potential capital gain.
▪ The cost of financing is usually higher than the cost of debt financing.
▪ If a lessee is willing to terminate a certain line of the business, he will not be able to terminate the lease contract except by paying heavy fines. If it was a purchased asset, the company could sell the asset at his will.
▪ In lease contract the asset is owned by the lessor, not the lessee. Consequently, the lessee alone is not entitled to a defense in the event of a supplier's breach of warranties in respect of the leased assets.
▪ If the lessee is unable to pay the rent regularly, the lessor will suffer losses, especially if the asset is complex and less liquid.
▪ In the absence of exclusive laws governing the lease transaction, several problems arise between the lessor and the lessee, leading to unnecessary complications and conflicts that can be avoided.
There are three steps for lease transactions:
1. The lessee has to make a decision about the asset required and select the lessor company.
The lessee has to select specifications of the design, warranties, the price, delivery and service conditions.
2. The lessee, then concludes a lease agreement with the lessor. The lease agreement shall contain the following terms and conditions:
a. The lease period which is noncancelable.
b. The frequency of the rental payments during the lease term.
c. Information further option to renew the lease agreement or to purchase the asset at the end of the lease term.
d. Information about service costs, maintenance, taxes, asset insurance and other expenses.
3. The asset must be delivered to the lessee after the contract is signed by all parties (Gordon E., 2008).
Generally, lease agreements can be classified as Finance and Operating leases.
Finance leases are also known as capital leases, long-term leases, net leases, and closed leases.
In a financial lease, the lessee selects the asset, determines the size and terms of sale, and negotiates with the leasing company to purchase it. A lessee enters into an irretrievable and
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non-cancellable contractual agreement with the leasing company. The lessee uses the equipment exclusively, maintains it, insures it and uses after-sales service and warranty service.
As the lessee committed to pay the rent for the entire lease period, he also carries the risk of asset obsolescence. A finance lease can also have an acquisition option, where at the end of a predetermined period the lessee has the option to purchase the equipment at a predetermined ultimate price. A finance lease may also contain a non-cancellable clause, which means that the lessor transfers asset ownership to the lessee at the end of the lease term (Gordon E., 2008).
In a finance lease, the lease rate will be fixed based on the type of lease, the lease term, the frequency of rent payments, and the depreciation rate and other tax incentives available. The leasing company also charges a nominal service fee to cover legal and other expenses. The leasing company can also insist on a pledge or bank guarantee in some cases. In many cases, finance leases are used as a financial planning and tax planning tool. Finance leases are very popular in USA, UK, Japan and India (Gordon E., 2008).
Operating leases are also known as serviced leases, short-term leases, or true leases. In this type of agreement, the lease term between the lessor and the lessee is less than the full expected economic life of the leased asset. This means that the lease contract is for a limited period, which can be a month, six months, a year, or several years. The rental agreement is terminated by giving the agreed notice in accordance with the lease agreement. Typically, the rent for the lease will be higher compared to other leases due to the short period of the primary lease. The risk of obsolescence is borne by the lessor, who also bears the maintenance and other related costs. The lessor also provides services such as handling warranty claims, paying taxes, planning and performing asset maintenance, and keeping complete records. Operating lease is suitable for:
▪ Computers, police cars and other office equipment, vehicles, handling equipment, etc., which are susceptible to obsolescence and;
▪ When the tenant is interested in resolving a temporary problem (Gordon E., 2008).
Lease decision making process.
Successful financial management is required to make well-timed business decisions. One such decision is to decide whether to purchase or rent the underlying asset. These two alternatives should be carefully examined before making any final decision. The financial viability of both alternatives should be assessed by adopting conventional capital budgeting methodology.
Usually the NPV (Net Present Value) method is used for this purpose (Gordon E., 2008).
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This analysis compares the cost of each alternative by considering the timing of the payments, tax benefits, the interest rate on a loan, the lease rate, and other financial arrangements. In fact, the ultimate cost is dependent on the validity of assumptions about future values and changes in the future value of money. To perform the analysis, certain assumptions need to be made about the economic life of the asset, residual value, and depreciation. For lease evaluation, it is necessary to determine the net cash cost of each year. These amounts are derived by deducting tax savings from the lease payment. This calculation yields the net cash cost for each year over the lease term. Each year’s net cash cost is discounted to assess the present value of payment.
The sum of the discounted cash flows is called the net present value of the cost of leasing. This figure is compared with the final sum of the discounted cash flows for the loan and purchase alternatives. Finally, the option with the lower present value of the cash outflows should be selected (Slee R.T., 2011).
1.2 Historical background of lease accounting
Historically, the leasing industry has developed products designed to meet economic needs.
The main economic reasons for the existence of leasing are as follows:
• to finance the acquisition of fixed assets;
• to reduce the risk of property ownership;
• to allow property users to maintain working capital;
• to reduce credit risk between sub-prime loans and traditional lending institutions;
• mediating income tax benefits for lessor and lessees;
• to outsource significant activities related to the maintenance and management of fixed assets to specialists.
Beyond the economic reasons for leasing, many companies choose to lease over acquisition in order to get an off-balance sheet accounting view that they deem desirable (Monson D., 2001).
Over the past few decades, the leasing business has experienced significant growth, and a tremendous portion of this volume is reflected in the statements of financial position. The huge popularity of leasing is understandable because it offers great flexibility, often combined with a number of economic advantages over ownership. Thereby, in leasing, the lessee, acting as a borrower, can usually receive 100% financing, whereas in a traditional credit purchase agreement, the buyer usually has to make a contribution to the initial capital. Lease legally may offer tax advantages over the option to purchase, depending on tax rules applicable in a given jurisdiction. The lessee is protected against the risk of obsolescence and wear, although the
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terms of the lease vary depending on the extent to which the lessor bears this risk. There will be a steady stream of lease payments to the lessor which includes interest, which will often be at higher rates than commercial loan rates, and usually some residual value at the end of the lease term (Alibhai S., 2020)
1.2.1 Development of lease accounting standards
According to Contino R. (2019), FASB and IASB have devoted an impressive amount of time and effort to learn how to account for leasing, from both the lessor and the lessee’s point of view since 1977. That is why leasing is a very relevant topic.
Figure 1.1 Timeline of leasing standards
Source: own elaboration
The figure 1.1 illustrates historical timeline of lease standards. International Accounting Standards Committee (IASC) did not participate until 1982. Previously, standards were set by US institutions such as the Accounting Principles Board, the predecessor of the FASB, and the Securities and Exchange Commission (SEC). The predecessor of IASB, IASC issued the Exposure Draft 19, Accounting for Leases (E19) in October 1980. E19 provided the following four criteria for a lease to be classified as a finance lease:
• Under a lease, ownership of the asset is to be transferred to the lessee at the end of the lease term;
• The lessee has an option to purchase the asset at a price that is expected to be significantly below the fair value at the date the option can be exercised;
• The lease term is the majority (usually 75 percent or more) of the economic life of the asset. Ownership may or may not ultimately be transferred.
• The present value at the commencement of the lease term of the minimum lease payments is greater than or equal to substantially all (usually 90 percent or more)
FASB FAS 13 Accounting
for Leases 1976
IASC ED (E19) Accounting
for Leases 1980
IASC IAS 17 Accounting for Leases 1982
IASB (revised )IAS 17 Leases
2003 IASB -
IFRS 16
2019
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of the fair value of the leased asset net of grants and tax credits to the lessor at the commencement of the lease term (IASB 2007).
In 1982 IASC published the official standard IAS 17: Accounting for Leases. The Committee made revisions of IAS 17 in 1996 and 2003. In June 1996, the IASC Board revised IAS 17 to reconsider some of the significant issues reported by the International Organization of Securities Commissions. The reported issues included the classification of finance and operating leases. The Board was advised to consider new approaches to capitalizing leases (for example, capitalizing all leases for more than one year, including leases that are currently classified as operating leases. However, the Board decided that new approaches of capitalizing leases should be considered at a later stage (IASB 2007).
In 2003, the IASB revised IAS 17 again to clarify the classification of land and buildings leases and to remove alternative accounting options for initial direct costs in the financial statements of lessors. Once again, the Board of Directors did not revise the fundamental approach to accounting for leases contained in IAS 17 (IASB 2007).
However, it took decades to form a comprehensive new set of standards, such as IFRS 16, that seeks to address the issue of lease accounting. IFRS 16 was published in January 2016. The new lease standard is the result of a long-term project carried out in collaboration with the FASB to eliminate all existed disagreements. This has a significant impact on many lessees as it removes the classification of capital and operating leases in lessee’s accounting. The standard addresses many of the gray areas associated with leases and is likely to change the behavior of many companies. Therefore, various corrections and interpretations have been issued to clarify or resolve many complex management issues.
1.3 Operating leases and off-balance sheet financing
Prior IFRS 16 introduction, accounting standards applicable to leases, clearly distinguished accounting treatment of finance and operating lease by lessee. A finance lease is a capital lease that is recognized by the lessee as an asset and liability. The capitalized asset was measured as the present value of the future lease payments during the specified period of time. The lessee recognized depreciation and interest expense during the contract term. The operating lease is treated by the lessee as rental arrangements and was reflected on a systematic basis (usually straight-line) as expenses only in the income statement. Lessees had to disclose for operating and finance leases information about the lease payments in 1 year, from 1 to 5 years and over
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5 years. Therefore, financial analysts could evaluate operating lease commitments according to those disclosures (Bratten B., 2013).
Operating lease accounting has been one of the oldest and most visible discussions in the accounting field. The authorities argue that managers deliberately use long-term operating lease obligations to avoid capitalizing the company’s assets on the balance sheet. Lease accounting standards described the operating lease as a short-term lease. However, many industries report extremely high amounts of non-cancellable operating lease liabilities for several years in advance, which means that the operating lease is indeed for long-term use. In fact, firms report higher operating leases than capital leases. Operating lease commitments are not formally recognized. However, users of financial statements can capitalize these liabilities using the mandatory footnote disclosures of future lease payments and approximate the balance sheet and income statement as if all leases were capital leases. The capitalization of operating leases on the balance sheet has a very noticeable effect on many of the key figures measured in the balance sheet and income statement (Imhoff A., 1997).
Operating lease is one of the most popular off-balance sheet financing instruments. Logically, the higher the share of total assets of a company under operating lease agreements, the greater the impact of capitalization. Particularly in rental-intensive industries such as retail and aircraft manufacturing, off-balance sheet activities should be scrutinized when analyzing a company's financial performance (Imhoff A., 1991).
Wang &Yang (2016) compared the finance lease with a mortgage. A finance lease is an arrangement in which the lessor, owner of the leased item and suppliers, rent out to the lessee.
The lessee pays the rent to the lessor in installments. During the term of the lease agreement, the lessor owns the leased items, and the lessee has the right to use them. The lessor transfers ownership to the lessee at the end of the lease contract. Therefore, financial leasing is similar to the financial service provided by a mortgage of commercial banks.
The operating lease, which did not appear in the balance before 2019, holds the lessor responsible for the maintenance and upkeep. The terms of this lease are typically 75% or less of the asset’s useful life, and the present value of the lease payments should not exceed 90% of the fair market value of the asset (Salem Press, 2016).
The FASB and IASB provided certain criteria, based on which, accounting treatments of operating and finance lease were distinguished. However, there were many arguments that economically similar lease commitments could be easily modified in order to obtain the desired accounting treatment (Bratten B., 2013).
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As operating lease did not appear in the balance sheet, the company with such an arrangement would be considered less leveraged and more profitable (if measured by ROA) during the analysis. Due to this reason, treating a lease as an operating lease was a favorable arrangement for many public corporations (Salem Press, 2016). It has been common practice in many industries to register most leases as leases, even though they are de facto capital leases. Despite the actions of the accounting standards makers, firms seem to be finding a way to treat most leases as operating leases. Bypassing capitalization rules gives managers flexibility as they can exclude certain financial liabilities from the balance sheet. Balance sheet optimization can be linked to managers' incentives to improve productivity and leverage ratios. Some of their compensation can be tied to indicators such as ROA or ROCE, which can be improved through the use of off-balance sheet assets. Thus, financial indicators calculated directly from the financial statements may be inaccurate with heavy use of operating leases (Imhoff A., 1991).
According to Monson D. (2001) market participants fully trust on amounts reported in the financial statements to analyze performance and creditworthiness of the company (interest coverage, solvency ratios). Equity investor are interested in return on assets and assets turnover to compare the company with other one within the same industry. However, these analyses could lead to incorrect results about the performance of companies due to the fact that companies had selected different accounting conventions (Monson D., 2001).
Many economists were stating inconsistencies in lease accounting treatments. Thus, Imhoff A.
(1991) opened questions about operating lease capitalization necessity. According to the research, the constructive capitalization of material long-term lease contracts is necessary for comparison and accurate evaluation of financial results. The author was concerned that certain industries were having operating leases as an important source of financing. However, the recognition of lease agreements was different among those industries. For these reasons, capitalization of operating leases is an important process in industry comparison.
Bohusova H. (2015) examined how the operating lease capitalization would increase financial statement comparability. According to the study, many companies preferred operating lease since they could hide the potential liability and decrease the financial leverage indicators. By hiding operating lease liabilities, companies could increase operating profit to external users in the post-Enron era. As a result, approximately 1.5 trillion dollars of the operating lease were not reflected in the balance sheet. Bohusova H. commented that financial statements were not comparable from the leasing activities perspective. Because of it, the financial analysts were forced to make their own assessments of the assets and liabilities arising from the lease agreements.
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Bratten B. (2013) analyzed how market participants had assessed recognized and disclosed items in the financial statements. The authors were mainly focused to analyze lease disclosures in financial statements. According to the research, disclosed and recognized lease commitments were not processed differently by market participants when the amounts are reliable and easily identifiable. Their results stated that well determined and reliable disclosures were effective for the market participants for making investments decisions and resource allocations.
Wilkins T. (1983) conducted interesting research to investigate comparability of the financial statements of companies using different methods of lease accounting treatments. The aim of the paper was to determine whether the assessment of loan officers of company’s solvency and amount they are willing to borrow is independent from which accounting methods they use for leases. The author conducted an experiment where Singapore bank associates were presented with financial statements of two companies in order to assess their ability to repay two separate four-year term loan. The term loans had similar interest rate and loan repayments schedule. The financial reports of the companies were constructed with alternative methods of lease accounting. The result stated that banks had evaluated differently based on financial leverage but not by different methods of fixes asset financing. However, the companies could be treated similarly if bank officers would have been more demanded to get details of lease obligations (Wilkins T., 1983).
To eliminate all discrepancies in accounting treatment of the leasing, IASB and FASB issued a discussion in 2009 and initiated a joint project. The new lease standards were issued in January 2016 which would be applied for the fiscal year 2019 (IFRS 16). The main purpose of the standard is to introduce a single accounting model for the lessee, increasing the transparency and comparability of the financial statement (Alibhai S., 2020).
The new standard brought fundamental changes to lease accounting that replace previous accounting and no longer distinguishes between an operating and finance lease. FASB issued a similar standard - ASC 842 (Nešleha J., 2019).
12 2 LEASE ACCOUNTING OUTLOOK 2.1 IFRS 16 historical timeline
After decades of debate over leasing accounting policies, a significant step towards new leasing standards began when the Group of Four Plus One (G4 + 1), composed of accounting standards developers from Australia, Canada, New Zealand, the United Kingdom and the United States and the International Accounting Standards Committee published their special report in 1996.
The new lease accounting approach assumed capitalization of all leases. The G4 + 1 refined their proposed model by publishing a document on the implementation of the New Approach in 2000. Their report concluded that lessees should recognize the present value of all lease assets and liabilities using the constructive capitalization method. The report argues that the distinction between capital and operating leases is artificial and unsatisfactory in assessing firms' performance and debt. It was suggested that the proposed lease accounting reform would enhance the usefulness of financial reporting by increasing comparability through a unified lease regime (Imhoff A., 1991).
The IASB published a paper to discuss the new rules in 2009. Based on the comments received, they published the first preliminary draft in 2010, which proposed a right-of-use model for recognizing lease assets and liabilities. The artificial classification of finance and operating leases will be replaced by the right to use the asset. Therefore, all leases will be recognized from the outset as a right to use the underlying asset, with some exceptions, such as leases of minor financial significance or leases with a maturity of 12 months or less. Therefore, lessees will apply a single accounting model to all of their leases, regardless of the nature of the asset (IASB 2013).
13 Figure 2.1 IFRS 16 evolution timelines
Source: own elaboration
Figure 2.1 above shows a timeline for the evolution of modern lease accounting. This process took about two decades. Understanding the significant accounting changes, the IASB took a very careful approach and proceeded with caution during the project. The board of directors actively questioned feedback after each step. It is interesting to note that the IASB actually changed the proposal from the first ED to the second based on the feedback received. Therefore, IFRS 16 is the result of advising accounting firms, various industries, investors, analysts, regulators, and many other users of financial statements (IASB 2013).
2.2 IFRS 16 overview
2.2.1 Scope and Identifying a Lease
IFRS 16 replaces the following existing accounting standards and lease interpretations:
• IAS 17 Leases;
• IFRIC 4 Determining whether an Arrangement contains a Lease;
• SIC-15 Operating Leases – Incentives;
• SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.
1996 • G4+1 special report
1999 • G4+1 Leases: Implementation of a New Approach 2009 • Discussion Paper
2013 • IASB-FASB Exposure Draft Feedback 2016 • Publication of IFRS 16
2019 • IFRS 16 implementation
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IFRS 16 establishes the principles for the recognition, measurement, presentation, and disclosure of leases. The main goal of the standard is to ensure that lessee and lessors provide relevant information in a way that faithfully represents these transactions. This information supports financial statements with a basis for evaluating the impact of a lease on the financial position, financial performance, and cash flow of the company. It should be noted that the guidance on lessor accounting is largely unchanged from IAS 17 and therefore the focus of this thesis is on the requirements for lessees.
The scope of IFRS 16 is generally identical to IAS 17 in that it refers to nature of a leased asset except for:
• Lease for the exploration or use of minerals, oil, natural gas and similar non- renewable resources;
• Leases of biological assets, subject to IAS 41 Agriculture, owned by a lessee;
• Service concession arrangements within the scope of IFRIC 12 Service Concession Arrangements;
• Licenses of intellectual property granted by a lessor within the scope of IFRS 15 Revenue from Contracts with Customers;
• Rights held by a lessee under licensing agreements within the scope of IAS 38 Intangible Assets for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights (IFRS 16, 3).
Additionally, to the above-mentioned contracts, a lessee can choose not to apply IFRS 16 for the following leased assets:
• Short-term leases which have a lease term of 12 months or less;
• Low value leased assets;
• Intangible assets (IFRS 16, 4-5).
IFRS 16 offers examples of low-value assets which include tablet and personal computers, small items of office furniture, and telephones (B8). Moreover, the Basis of Conclusions to IFRS 16 (BC100) gives a threshold amount of 5000 USD. This option can be applied on an individual basis.
In order to apply IFRS 16 there are curtain requirements that must be fulfilled as shown above:
15 Figure 2.2. Lease asset identification flow
Source: IFRS16, B31
✓ The first criterion to be assessed in determining whether a lease agreement includes the right of use of an identified asset for a period. This is in line with the requirement that the customer must control the leased asset. Typically, the asset will be clearly identified in the lease contract. Alternatively, the contract can include the right of use of an identified asset if the asset is implicitly identified when it becomes available for use by the customer.
✓ The second criterion to be assessed is determining whether a customer can control the use of an identified asset. This criterion is fully fulfilled if the customer has the essential right to obtain all the economic benefit from the use of the leased asset during the period of use.
The economic benefits from the use of an asset include its main products and by-products (including potential cash flows from these items), as well as other economic benefits from the use of the asset that can be realized because of a commercial transaction with a third party (IFRS 16, B21).
To assess whether a customer has the substantial right to all economic benefits from the use of a leased asset, the assessment should be based within the determined scope of the contract:
• if the contract restricts the use of the vehicle to only one specific territory during the period of use, the company should consider the economic benefits only from the use of the vehicle in this territory, and not elsewhere.
Lease asset is identified that the
customer has right to use
The lessee obtain substantially all
the economic benefits
Lessee have the right to direct use
of the asset
The contract contains a lease
The contract does not contain a lease
16
• if the contract specifies that the customer can use the vehicle only until a certain mileage is reached during the period of use, the organization should consider the economic benefits only from using the vehicle until the permitted mileage is reached, but not more than it (IFRS 16, B22).
The third criterion to be assessed in determining whether a customer has the right to direct use of a leased asset. This criterion evaluates who directs how and for what purpose the asset is used during the period given by the contract:
Figure 2.3 ROU asset assessment
Source: BDO IFR Advisory Limited, 2017
The customer has the right to direct the use of the identified asset during the period of use only if one of the following conditions is met:
• the customer has the right to direct how and for what purpose the asset cab be used during the lease contract; or
• significant decisions about how and for what purpose the asset is used are predetermined and:
• the customer has the right to operate the asset during the period of use, without the supplier having the right to change the operating instructions; or
• the customer has designed the asset (or certain aspects of the asset) in a way that predetermines how and for what purpose the asset will be used during the period of use
In general, a contract contains a lease component only if the component is associated with an identified asset. It can be specified in the contract or taken out of context. In this case, the
Who directs how and for what purpose
the asset is used throughout the period of use?
Supplier Contract does not
contain a lease
Pre-determineddue to nature of asset
See Section 4.4.1. for further analysis
Customer Contract contains a
lease
17
accountant must understand whether the lessee has full control over the asset. In other words, if the lessor has a real opportunity during the lease to replace this asset with another having similar properties and characteristics, then the lessee does not have 100% control over the identified asset. It follows that there will be no lease component in this agreement (Kadochnikova A., 2020)
2.2.2 The lease term
When estimating the lease term and considering the duration of the non-terminating lease period, an entity should apply the definition of a contract and determine the period over which the contract is protected. A lease is no longer protected if both the lessee and the lessor have the right to terminate the lease without the permission of the other party, paying no more than a minor fine. An entity shall define the lease term as a non-terminating lease period, together with:
• periods for which an option to renew the lease is provided, if it is certain that the lessee will exercise that option; and
• periods for which an option is provided to terminate the lease if it is reasonably certain that the lessee will not exercise the option (IFRS 16, B34).
The lease term begins on the commencement date of the lease and includes rental-free periods provided to the lessee by the lessor (IFRS 16, B36).
A lessee shall reassess whether it is sufficiently confident to exercise an extension option or not to exercise an option to terminate a lease when either a significant event or meaningful change in circumstances occurs that:
• controlled by the lessee; and
• affects the assessment of whether the lessee will exercise an option that was not previously considered in determining the lease term, or that the lessee will not exercise an option that was previously considered in determining the lease term (IFRS 16, B41).
18 2.2.3 Recognition and Measurement
According to the standard, a lessee shall recognize a right-of-use (ROU) asset and a lease liability at the commencement date (IFRS 16.22). A lessee shall measure the ROU asset at the present value of the future lease payments. The lease payments shall be discounted by the interest rate implicit in the lease or by the lessee’s incremental borrowing rate (IFRS 16.26).
The cost of the ROU asset is initially related to the estimated cost of the lease liability, with several additional adjustments. The cost of the ROU asset shall include any lease payments made at or before the commencement date. The asset shall also comprise any initial direct and estimated costs incurred by the lessee for disassembling and maintaining the asset. The lessee may incur those obligations at the starting date or because of using the leasing asset during the given period (IFRS 16.24).
Figure 2.4 ROU asset measurement
Source: own elaboration
At the commencement date of the lease, the lease payments that are included in the measurement of the lease liability consist of the following payments for the right to use the underlying asset during the lease term that have not yet been paid at the commencement date (IFRS 16.27).
ROU asset
Initial measurement of lease liability
initial direct costs
lease payments on or before the commencement date
estimated costs for leased assted maintencance
19 Figure 2.5 Lease liability measurement
Source: own elaboration
Variable lease payments that depend on an index or rate described include payments linked to a consumer price index, payments linked to a base interest rate (for example, LIBOR), or payments that are vary depending on changes in market rental rates (IFRS 16.28).
Variable lease payments can take many forms. They can be indexed at a rate such as inflation, LIBOR, or CPI, or tied to the asset itself (for example, the percentage of sales for a retail store in a mall).
Accounting for variable lease payments is summarized as follows:
1. Variable payments depend on an index or a rate:
a. Include in the initial measurement of the lease using the index or rate as at the commencement date.
b. Remeasure lease in the period the rate or index changes 2. In-substance fixed payments
a. Include in the initial measurement of the lease.
b. Remeasure the lease in the period in-substance fixed payments are changed or are resolved
3. Other variable payments
a. Do not include in the initial measurement of the lease.
b. Recognize in profit or loss when incurred Lease liability
fixed payments
qualifying variable lease payments
expected amounts to be payable under residual value guarantees the exercise price of a purchase
option
penalty payments for early lease termination
20
All components of the lease liability must be discounted to reflect the present value of future payments during the lease term. The discount rate is the rate implicit in the lease unless it cannot be readily determined. In other cases, the lessee's incremental borrowing rate is used instead.
The incremental borrowing rate of the lessee is the rate that reflects the amount that the lessee would have to pay in order to obtain a loan for a similar term and with similar security, the funds necessary to obtain an asset with a similar value to the ROU asset in a similar economic environment. This is because the rate should be the amount that would be charged to acquire an asset of similar value in the same period.
In practice, judgment may be required to estimate the incremental borrowing rate in the context of a ROU asset, especially when the value of the underlying asset differs significantly from the value of the ROU asset. A weighted average cost of capital (WACC) of the company is generally not suitable to be used as a proxy for the incremental borrowing rate because it is usually not representative of the rate, that the company will pay on loans. The WACC includes the cost of equity-based capital, that is unsecured and inferior to other creditors (BDO IFR Advisory Limited, 2017).
According to Kadochnikova A. (2020) if a lease contract does not contain information about the discount rate, the lessee should use the rate at which he will be able to attract borrowed funds while maintaining all the necessary conditions. Therefore, it is considered the attraction of the same amount of borrowed funds for the purchase of a similar asset, for the same period, with similar security and in similar economic conditions.
Thus, the incremental borrowing rate will depend on many factors, such as:
▪ the economic characteristics of the lessee;
▪ the period for which the borrowed funds will be attracted;
▪ the amount of borrowed funds;
▪ the nature of the security, i.e. the quality of the underlying asset;
▪ the economic situation, legislation and the currency in which the lease payments will be made.
Thereby, when concluding a lease agreement, the parties must decide what the discount rate will be: the rate for raising additional borrowed funds or a self-calculated rate that takes into account all the characteristics of the lessee and the lessor (Kadochnikova A., 2020).
21
Figure 2.6 Subsequent measurement of the ROU asset and lease liability
Source: BDO IFR Advisory Limited, 2017
To apply the cost model, the lessee must measure the ROU asset at cost:
• minus accumulated depreciation and accumulated impairment losses; and
• adjusted for the revaluation of the lease liability (IFRS 16, 30).
If ROU asset relates the class of property, plant and equipment, the lessee may apply the revaluation model in IAS 16 (IFRS 16, 35).
To apply the fair value model, the lessee shall also apply that fair value model for ROU assets that meet the definition of investment property in IAS 40 (IFRS 16, 34).
Figure 2.7. Lease liability measurement (Cost model)
Source: IFRS 16, 36
ROU asset measurement Models
Cost Model
Revaluation Model
Fair Value Model Investment Property
(IAS 40)
Initial measure
ment
Interest on lease liability
Lease Payments
Revaluat ion
Lease Liability
22
As it shown in Figure 2.7, the lessee shall measure the lease liability as follows to apply the cost model:
• increasing the carrying amount to reflect interest on the lease liability;
• reducing the carrying amount to reflect the lease payments made; and
• reevaluating the carrying amount to reflect a lease liability modification.
Reassessment and modification of the lease liability
A lessee shall remeasure the lease liability by discounting the revised lease payments using the revised discount rate in any of the following cases:
• There is a change in the lease term;
• There is a change in the valuation of a call option for the underlying asset (IFRS 16, 40);
• There is a change in the amounts expected to be paid under the residual value guarantee;
• There is a change in future lease payments as a result of changes in the index or rate used to determine those payments (IFRS 16, 42).
Lease modifications arise from changes in the lease agreement between the lessee and the lessor after the commencement of the lease. Accounting for the modification depends on whether the amended terms increase or decrease the lease volume.
The lessee must account for the lease modification as a separate lease if the following two conditions are met:
• the modification increases the scope of the lease by adding a right to use one or more underlying assets; and
• The rental reimbursement is increased by an amount commensurate with the individual price for the increase in scope (IFRS 16, 44).
If both criteria are met, a lessee would follow the guidance of the initial recognition and measurement of lease liabilities and ROU assets.
For the lease modifications, that are not accounted for as separate leases, the lessee must:
• allocate the consideration in the modified lease;
• determine the lease term in the modified lease;
• re-measure the lease liability by discounting the revised lease payments using the revised discount rate. The revised discount rate is defined as the rate implicit in the
23
lease over the remaining lease term, if that rate can be readily determined, or as the rate at which the lessee will raise additional borrowings at the date of the revaluation if the rate implicit in the lease cannot be easily identified.
• decrease the carrying amount of the ROU asset to reflect the cancellation of the lease in part or in whole in the case of lease modifications that reduce the scope of the lease. The lessee shall recognize profit or loss arising from the cancellation of the lease;
• adjust the ROU asset accordingly for all other lease modifications.
2.2.4 Depreciation of the right-of-use asset
After the commencement date, ROU asset shall be measured at a cost:
● less accumulated depreciation or accumulated impairment losses;
● adjusted for any remeasurement of the lease liability. (IFRS 16.30)
If a lessor will transfer ownership of the leased asset to a Lessee at the end of the lease term, then a lessee shall depreciate lease commitment from the commencement date to the end of the useful life of the asset. lease assets shall be depreciated from the starting date to the earlier of the end of the useful life of the ROU asset or the end of the lease contract (IFRS 16.32).
After commencement date, lease liability shall be measured by:
● any increase if the carrying amount to reflect an interest and the lease liability;
● decrease of the carrying amount by lease payments made;
● adjustments for any remeasurement of the lease liability (IFRS 16.36).
Lessee shall clearly identify ROU assets and lease liability in the financial statement as a separate item or as a note (IFRS 16.47).
Interest expenses on the lease liability shall be reflected in the income statement separately from the depreciation charge for the ROU asset. These expenses are included to finance costs (IFRS 16.48).
The modified retrospective approach does not require a restatement of comparative periods.
Instead, the cumulative effect of applying IFRS 16 is accounted for as an equity adjustment at the beginning of the current reporting period in which it was first applied, known as the “date
24
of initial application”. The modified retrospective approach is summarized as follows (IFRS 16.C5):
Figure 2.8 IFRS 16 application methods
Source: BDO IFR Advisory Limited, 2017
2.2.5 Disclosure requirements for lessee
The lessee must disclose information about lease impact in the financial statement. The lessee is required to disclose the following quantitative information for the reporting period:
Modified Retrospective
Approach
Operating Leases
Lease liability - equal to remaining lease payments using incremental borowing
rate at the
ROU asset - equal to the lease liability adjusted for prepaid
ROU asset - accrued lease payments immediately before the date of initial application; or as if IFRS 16 had always
been applied but using the incremental borrowing rate at the date of initial
applicaiton
Finance
Leases Lease liability - Use previous carrying value of finance lease liability
ROU asset - Use previous carrying value of finance lease asset
25 Figure 2.9 Quantitative Disclosure Requirements
Source: IFRS 16.51-58
Qualitative Disclosure Requirements:
• A summary of the nature of leasing activities of the reporting entity;
• Potential cash outflows that the entity is exposed to that are not included in the lease liability, including:
o variable lease payments;
o Renewal options and completion options;
o Residual value guarantees; as well as
o Lease agreements that have not started yet, but the lessee is committed.
• Restrictions or conditions imposed by lease agreements; as well as
• Information on sale and leaseback transactions (IFRS 16, 59).
Balance Sheet
• Additions to ROU assets.
• Carrying value of ROU assets at the end of the reporting period by class.
• Maturity analysis of lease liabilities separately from other liabilities based on IFRS 7 requirements.
Income statement
• Depreciation for assets by class.
• Interest expense on lease
• liabilities.
• Short-term leases expensed
• Low-value leases expensed
• Variable lease payments expensed
• Income from subleasing
• Gains or losses arising from sale and
leaseback transactions.
Cash Flow
• Total cash outflow for leases
26 2.3 IAS 17 and IFRS 16 comparison
IAS 17 Leases focuses on determining when a lease is economically equivalent to purchasing a leased asset. When it had been determined that the lease is economically similar to the purchase of the underlying asset, it was classified as a finance lease and recorded on the balance sheet of the company. All other leases were classified as operating leases and were not reflected in the balance sheet of the company. Off-balance sheet leases were accounted for similarly to service contracts, with the company recognizing the lease expense in the income statement (IASB, 2016).
Table 2.1 IAS 17 and IFRS 16 comparison
Differences IAS 17 IFRS 16
Lease classification IAS 17 requires lessees to account for leases as finance or operating depending on classification criteria.
IFRS 16 requires lessees to recognize lease asset and lease liability on their balance sheet.
Definition Risks-and –reward model is
used to determine whether a contract contains a lease.
Right – of – use model is used to determine whether a contract contains a lease.
Operating lease expenses Operating lease payments are recognized on a straight- line basis over a lease term.
Expenses are recognized as depreciation of ROU assets and finance charge on lease liability.
Recognition of the lease asset
Finance lease asset and liability are measured at fair value or the present value of minimum lease payments, whichever is lower.
ROU asset is measured at the present value of lease payments.
Reassessment of lease liability
No requirement for reassessment
Lease liability has to be reassessed after the
commencement date if there is a lease modification, or if there is a change in
estimates relating to lease term.
Source: Effects Analysis, International Financial Reporting Standard, 2016
27 2.4 Impact of IFRS 16 implementation
For companies with significant off-balance sheet leases, IFRS 16 changes the nature of the expense associated with those leases. IFRS 16 replaces the straight-line operating lease expense with the depreciation charge for the leased asset and interest expense on the lease liability These changes are consistent with the accounting treatment for all lease expenses. The difference in the expense profile between IFRS 16 and IAS 17 is expected to be insignificant for many companies with a portfolio of leases that begin and end in different reporting periods.
For companies with significant off-balance sheet leases, the application of IFRS 16 is expected to result in an increase in lease assets and financial liabilities. The carrying amount of lease assets generally decreases faster than the carrying amount of the lease liability. This will result in a decrease in reported equity compared to IAS 17 for companies with significant off-balance sheet leases. This impact is similar to the effect of asset purchase financing on reported equity that arises from financing the purchase of an asset, either through a former on balance sheet lease or a loan (IASB, 2016).
The volume of off-balance sheet lease financing is significant. Listed companies using IFRS or US GAAP disclose nearly $ 3 trillion of off-balance sheet lease liabilities. For nearly half of listed companies using IFRS or US GAAP, the amounts recognized are expected to be affected by changes in lease accounting. Some industries will be more affected than others.
Table 2.2 Impact of IFRS 16 on income statement
Income statement
IAS 17 IFRS 16
Finance lease Operating lease All leases
Revenue x x x
Operating costs (excluding depreciation and amortization)
Single expense EBITDA
Depreciation and amortization Depreciation Depreciation Operating profit
Finance costs Interest Interest
Profit before tax
28
Source: Effects Analysis, International Financial Reporting Standard, 2016
For entities with significant off-balance sheet leases, IFRS 16 is expected to increase EBITDA before than it was reported using IAS 17.
This is because, applying IFRS 16, the company presents an implicit interest in the lease payments under the former off-balance sheet lease as part of the finance cost. In contrast, when IAS 17 was applied, all off-balance sheet lease expenses were included in operating expenses.
The level of the increase in operating profit and finance costs depends on the significance of the lease assets of the company, the lease contract’s term and the discount rates applied.
Profit before tax or operating profit will also increase with the application of IFRS 16. This is because the measures applied to IFRS 16 exclude interest on lease liabilities, whereas with the application of IAS 17 they included all expenses related to off-balance sheet leases.
According to IASB, investors, and analysts often use Profit before tax in their analyses, when assessing a company's operating performance or determining enterprise value. This is because they often want to measure a company's performance, regardless of its funding or ownership structure. The IASB noted that for some sectors of the industry, such as healthcare, the increase in profits is not incredibly significant. However, for industrial sectors that use significant amounts of off-balance sheet leases, such as airlines, retailers, travel, and leisure, profit increases are expected to be significant.
Companies shall begin preparing for IFRS 16 by reviewing their leases and recalculating their lease liabilities and the individual non-lease components included in their leases. With a carefully planned implementation plan, firms can smoothly transition to the new rules. Some of the consequences of applying IFRS 16 are easy to predict, such as increases in assets and liabilities, as is shown in the table 2.
However, after implementation in 2019, there may be some unexpected consequences.
According to KPMG (2016), analysts will closely monitor three priority areas after implementation: impact on the bottom line, implementation costs, and behavioral changes following the entry into force of the new standards. The transition period gave companies time to prepare.
29 Figure 2.10 IFRS 16 impacts for lessees
Source: EY, 2016
Organizations will have to redesign many activities or renew them as a result of the new Lease Standard adoption. Many departments within the organization will be involved and their joint efforts will be required to overcome the negative impacts of applying IFRS 16. Among them - the need to consider the impact on the financial statements and performance indicators of the company when entering into agreements that are or may contain leases (EY, 2016).
Another challenging question of IFRS 16 implementation is its impact on industries. PwC (2016) PwC conducted a global lease capitalization study to assess the impact of the new lease standard on reported debt, leverage, solvency, and EBITDA for a sample of more than 3,000 listed companies reporting under IFRS in a variety of industries and countries. The study determines the minimum impact of capitalization of existing off-balance sheet operating leases based on disclosures of liabilities in companies' published financial statements in 2014. There are significant differences in the impact of lease capitalization across industries, as well as between individual companies within the same industry. Based on their study, the average growth in corporate debt would be about 22 percent and the average increase in EBITDA is 13
Impact for lessees
Data collection and
ongoing data management
Tax consideratio ns Financial
statements and metrics
Lease procurement
and negotiation Accounting
policies and manuals IT systems,
proceses and controls
Financial statements and metrics
30
percent. The aviation industry, which is the focus of the study, will face an increase in debt of about 47 percent and an increase in EBITDA of 33 percent.
2.5 IFRS 16 and covid-19
The COVID-19 pandemic has caused devastation around the world and tragic loss of life. To adapt to this difficult and uncertain time companies had to quickly take actions to address immediate risks such as shifting to a remote workforce, shifting priorities to stay solvent, and meeting urgent business continuity needs.
Changes in the economy signal that the “new normal” could significantly alter the strategy of business leasing and, therefore, lease accounting.
These changes may include “holiday” rents provided by the lessor to private lessees. IFRS 16 Leases considers that changes in lease payments may occur over the lease term. For significant lease changes, companies should determine whether those changes were part of the original lease terms. Changes could have been appeared from lease contract amendments or from government actions to Covid 19 pandemic. Companies must treat identically changes appeared from the contract itself or from government regulations. (George A., 2020).
Potential Impacts: impairment of assets
The current economic landscape is driving companies to make significant decisions regarding their costs and leases. For some companies, the reduction of overall leases stems from workplace transitioning to more remote work; for others, decreasing real estate leases comes as a result of the shutdown of physical storefronts and lack of customers due to social distancing guidelines. For material leases, lessees must compare the net present value of lease payments to the property’s fair value in order to comply with lease standard if the carrying value of an asset is less than its fair value, the sum of the estimated undiscounted cash flows attributable to the long-lived asset should be compared to the carrying amount of the long-lived asset (or asset group). If the asset fails this test, it is compared with fair value to determine if impairment exists. Nonetheless, in these cases, lessees should determine all the implications of lease modifications and terminations when they discuss lease contracts with lessors. (George A., 2020)
According to IFRS standards, IAS 36 Impairment of Assets is applied in determining whether there is an impairment of right-of-use assets (for lessees) and items of property, plant and equipment under operating leases (for lessors). Circumstances that lead to lease concessions as
