IFRS 16 working paper

IFRS 16 for a Lessee
Measuring and accounting for a lease agreement
1
Antonello Dessanti
dessanti@live.com

IFRS 16 in brief
 IFRS 16 is a new standard that replaces IAS 17, IFRIC 4, SIC-15 and SIC-27
 IFRS 16 is effective for annual reporting periods beginning on or after 1 January 2019.
Earlier application is permitted for entities that apply IFRS 15 Revenue from Contracts with
Customers at or before the date of initial application of this Standard.
 Significant changes are applicable for a lessee, namely the measurement and recognition of
the right of use (asset) and the lease obligations (liability).
 Recognition exemptions are available for short-term leases and leases for which the
underlying asset is of low value (paragraphs 5 – 8).
 A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature
of the asset is such that, when new, the asset is typically not of low value. For example,
leases of cars would not qualify as leases of low-value assets because a new car would
typically not be of low value (paragraph B.6).
 The exemptions have to be adopted by the reporting entity, individually or for by class of
underlying asset to which the right of use relates.
2

IAS 17 vs. IFRS 16
IAS 17
 IAS 17 required an assessment to
determine whether the lease is an
operating or a finance lease.
 No recognition in the balance sheet for
the operating leases.
 Future commitments of operating
leases(undiscounted) are disclosed in the
financial statements for future
commitments.
 Lease installments are recognized in the
income statement within the operating
expenses and classified in the statement
of cash flows as cash used for operating
activities.
IFRS 16
 The right of use and of the lease
obligation are recognized at the
commencement date of the lease
agreement.
 Depreciation charge of the right of use
and interest expenses of the lease
obligation are recognized in the income
statement.
 Lease installments reduce the lease
obligations and are classified in the
statement of cash flows as cash used for
financing activities (lease components)
and as cash used for operating activities
(non-lease components).
3

Effect analysis IFRS 16
 On January 2016, IASB estimated that the present value of lease
payments for 1,145 worldwide IFRS reporting entities will increase the total
assets by US$1.83 Trillion.
 On February 2016, a PWC study based on 3,199 worldwide IFRS reporting
entities (excluding United States) estimated an increase in debt by 25%.
 Industries likely to experience most significant impact on financial ratios
are Retail, Airlines, Professional Services, Health Care, Textile & Apparels,
and Wholesale.
 Median increase in debt: 22%
 Median increase in EBITDA: 13%
 Median increase in leverage ratio (debt / EBITDA): 2.03 – 2.14
4

Impact on financial statements5
Balance Sheet Example
Total assets Increase 3-years lease with a present value of $60,000
Net assets Decrease
Working capital Decrease Balance Sheet
Asset turnover ratio Decrease IAS 17 IFRS 16
Gearing ratio Increase Current assets $45,000 $45,000
Income Statement Fixed assets $15,000 $75,000
EBITDA Increase Total assets $60,000 $120,000
EBIT Increase Current liabilities $30,000 $50,000
Interest coverage ratio Decrease Long-term liabilities $10,000 $50,000
EPS (*) Decrease Total liabilities $40,000 $100,000
Net income (*) Decrease Net assets $20,000 $20,000
Statement of cash flows
Cash used for operating activities Decrease Working capital $15,000 -$5,000
Cash used for financing activities Increase Working capital ratio 1.5 0.9
Debt $10,000 $50,000
(*) Higher costs during the early years of the Debt to Equity 0.5 2.5
lease

Definition of a lease
 The guidance for determining whether an agreement contains a lease is based
on who does control the use of the asset
 At inception of a contract, an entity shall assess whether the contract is, or
contains, a lease. A contract is, or contains, a lease if the contract conveys the
right to control the use of an identified asset for a period of time in exchange for
consideration (paragraph 9).
 The asset must be identified (paragraphs B13.B20).
 Controls occurs directing the use and obtaining the benefits from the use:
Customer controls the use of the asset = Lease agreement
Supplier controls the use of the asset = Service agreement
 Refer to IASB “IFRS 16 Illustrative examples” issued in January 2016 for more
guidance on determining whether an agreement contains a lease.
6

Key judgements, exemptions and policy choices
Judgements IFRS 16 ref.
Identifying a lease based on the definition of a lease Para 9.12
B9-B33
Determining whether it is reasonably certain that an extension or a termination option will
be exercised
Para 18
B34-41
Identifying the appropriate rate to discount the lease payments Para 26
Exemptions
Short-term leases (by class of asset) or low value asset leases (lease by lease basis) Para 5.8
B3-B8
Policy choices
Applying IFRS 16 to a portfolio of similar leases B1
Separation of non-lease components from lease components by class of assets Para 15
Applying IFRS to leases of intangible assets Para 4
Transition choice (full retrospective or cumulative catch-up) C5-C13
7

Case study: renting a retail space
 This case study is for renting a retail space with three different types of
modifications.
 The lease agreement is for 1,500 sq. feet with a term of 10 years and no
option to renew.
 The annual lease is $20 per sq. foot (net rent) and $2.0 per sq. foot for
common area maintenance (CAM) costs. The lease installments will increase
annually by 2% (consumer price index).
 The reporting entity determined that net rent is a lease component and CAM
costs are non-lease components. The increase for inflation adjustment is
included in the measurement of the lease liability.
 The gross annual rental cost in the 1st year is $33,000, of which $30,000 are
for lease components and $3,000 for non-lease components.
 There is no interest rate implicit in the lease and the lessee's incremental
borrowing rate is 5% per annum at commencement date.
8

Initial measurement and accounting
Year
Lease
components
Non-lease
components
Annual
Payments
1 $30,000.00 $3,000.00 $33,000.00
2 $30,600.00 $3,060.00 $33,660.00
3 $31,212.00 $3,121.20 $34,333.20
4 $31,836.24 $3,183.62 $35,019.86
5 $32,472.96 $3,247.30 $35,720.26
6 $33,122.42 $3,312.24 $36,434.67
7 $33,784.87 $3,378.49 $37,163.36
8 $34,460.57 $3,446.06 $37,906.63
9 $35,149.78 $3,514.98 $38,664.76
10 $35,852.78 $3,585.28 $39,438.05
Year Commitment Present Value
1 30,000.00$ 28,571.43$
2 30,600.00$ 27,755.10$
3 31,212.00$ 26,962.10$
4 31,836.24$ 26,191.75$
5 32,472.96$ 25,443.42$
6 33,122.42$ 24,716.46$
7 33,784.87$ 24,010.28$
8 34,460.57$ 23,324.27$
9 35,149.78$ 22,657.86$
10 35,852.78$ 22,010.50$
Lease liability 251,643.17$
Initial measurement
Debit Right of use (ROI) asset 251,643.17$
Credit Current portion lease obligation 30,000.00$
Credit Long-term lease obligation 221,643.17$
Journal entries Year 1
Debit Depreciation ROI 25,164.32$
Credit Accumulated depr. ROI 25,164.32$
Debit Interest expense 12,582.16$
Debit Current portion lease obligation 30,000.00$
Debit Operating expenses $3,000.00
Credit Cash 33,000.00$
Debit Long-term lease obligation 30,600.00$
Initial recognition right of use and lease
obligation within and over twelve
months
Straight line method depreciation over
10 years
Accretion expense lease obligation
Recording the lease payment in year 1,
including CAM costs
Amount due within twelve months
Carry forward balances at the end of Year 3
Lease liability
Beginning
Balance
Interest
Expense
Lease
Payments
Ending
Balance
1 251,643.17$ 12,582.16$ 30,000.00$ 234,225.33$
2 234,225.33$ 11,711.27$ 30,600.00$ 215,336.59$
3 215,336.59$ 10,766.83$ 31,212.00$ 194,891.42$
Right of Use
Beginning
Balance
Depreciation
Ending
Balance
1 251,643.17$ 25,164.32$ 226,478.85$
2 226,478.85$ 25,164.32$ 201,314.54$
3 201,314.54$ 25,164.32$ 176,150.22$
9

Modifications
There are three possible accounting treatments, each presented in the
following slides:
 Is the modification in substance a separate new lease (e.g. renting more
space)? If yes, then account for as a separate new lease by adding the
right of use of one or more underlying assets and measure the
modification like any other new lease.
 Does the modification decrease the scope of the lease (e.g. less floor
space or a shorter lease term with commensurate change in payments)?
If yes, then decrease the pre-modification right of use asset and the pre-
modification lease liability and recognize any gain or loss in the income
statement.
 Does the modification decrease the scope of the lease (e.g. increase in
lease term) without a commensurate change in payments? If yes, adjust
the right of use and the lease liability with a measurement of the
discounted liability using a revised interest rate.
10

Accounting for a modification (1)
The lessor and the lessee agree to modify the lease for the retail space at the end of the 3rd year, increasing
the floor space from 1,500 to 2,000 sq. feet at $21 per sq. ft., $2.1 per sq. ft. for CAM costs and all other
terms and conditions unchanged. The additional space is in substance a new lease with a separate
measurement and accounting.
The lessee's incremental borrowing rate is 6% per annum.
Initial measurement new lease
Journal entries Year 4new lease
Initial recognition right of use and lease
obligation within and over twelve
months
Straight line method depreciation over 7
years
Accretion expense new lease obligation
Recording the new lease payment in year
4, including CAM costs
Year
Lease
components
Non-lease
components
Annual
Payments
4 $10,500.00 $1,050.00 $11,550.00
5 $10,710.00 $1,071.00 $11,781.00
6 $10,924.20 $1,092.42 $12,016.62
7 $11,142.68 $1,114.27 $12,256.95
8 $11,365.54 $1,136.55 $12,502.09
9 $11,592.85 $1,159.28 $12,752.13
10 $11,824.71 $1,182.47 $13,007.18
1 10,500.00$ 9,905.66$
2 10,710.00$ 9,531.86$
3 10,924.20$ 9,172.17$
4 11,142.68$ 8,826.05$
5 11,365.54$ 8,492.99$
6 11,592.85$ 8,172.50$
7 11,824.71$ 7,864.10$
11

The lessor and the lessee agree to modify the lease for the retail space at the end of the 3rd year, reducing
the floor space from 1,500 to 1,000 sq. feet and maintaining all other terms and conditions unchanged.
Lessee determines the proportionate decrease in the carrying amount of the right-of-use asset and in the
carrying amount of the lease liability on the basis of the remaining right-of-use asset.
The difference between the decrease in the lease liability and the decrease in the right-of-use asset is a
gain in profit or loss at the effective date of the modification.
Subsequent measurement
Debit Curr.port. lease obligation 10,612.08$
Debit Lease obligation 43,739.65$
Credit Right of use 46,222.60$
Credit Gain from lease termination 8,129.13$
Reduction of lease obligation and right
of use and recognition gain for the
difference
Straight line method depreciation over 7
years for revised right of use
Accretion expense on revised lease
obligation
including adjusted CAM costs
12

At the beginning of the 3rd year, the Lessee and the Lessor agree to amend the original lease by extending
the contractual lease term by 5 years.
The annual lease payments are unchanged and the Lessee’s incremental borrowing rate at the beginning
of the 4th year is 6% per annum.
The modification is accounted for with an adjustment to the right of use and to the lease liability with a
discounted liability using the interest rate at modification date.
1 31,836.24$ 30,320.23$
2 32,472.96$ 29,453.94$
3 33,122.42$ 28,612.40$
4 33,784.87$ 27,794.90$
5 34,460.57$ 27,000.76$
6 35,149.78$ 26,229.31$
7 35,852.78$ 25,479.90$
8 36,569.83$ 24,751.90$
9 37,301.23$ 24,044.70$
10 38,047.25$ 23,357.71$
11 38,808.20$ 22,690.35$
12 39,584.36$ 22,042.05$
Subsequent measurement
Debit Current portion lease obligation $31,836.24
Recognition of the modified term of the
lease with an increase in right of use and
in lease obligation
Straight line method depreciation over
12 years
Accretion expense revised lease
obligation
including CAM costs
13

Transition to IFRS 16: Option 1 Retrospective
 Restate comparatives as if IFRS 16 always applied.
 The lease liability is calculated on the commencement date of the lease as the present value of the
future rentals discounted using the interest rate implicit in the lease or otherwise the lessee's
incremental borrowing rate applicable at the commencement date of the lease.
 The restatement for the reporting entity in case study at the end of the 3rd year is as follows:
Year 1 Year 2
Debit Right of use $251,643.17 Debit Depreciation right of use $25,164.32
Credit Curr.Port. Lease obligation $30,000.00 Credit Acc. Depr. Right of use $25,164.32
Credit Lease obligation $221,643.17 Debit Interest expenses $11,711.27
Debit Depreciation right of use $25,164.32 Credit Lease obligation $11,711.27
Credit Acc. Depr. Right of use $25,164.32 Credit Operating expenses (reversal) $33,660.00
Debit Interest expenses $12,582.16 Debit Operating expenses $3,060.00
Credit Lease obligation $12,582.16 Debit Curr. Port. Lease obligation $30,600.00
Credit Operating expenses (reversal) $33,000.00
Debit Operating expenses $3,000.00 Effect in net income before taxes -$6,275.58
Debit Curr.Port. Lease obligation $30,000.00
Year 3
Effect in net income before taxes -$7,746.48 Debit Depreciation right of use $25,164.32
Credit Acc. Depr. Right of use $25,164.32
Debit Interest expenses $10,766.83
Credit Lease obligation $10,766.83
Credit Operating expenses (reversal) $34,333.20
Debit Curr. Port. Lease obligation $31,212.00
Effect in net income before taxes -$4,719.15
14

Transition to IFRS 16: Option 2 Cumulative Catch-up
 Comparatives remain as previously reported.
 Any difference between asset and liability is recognized in the opening retained earnings at
transition date.
 Calculate the outstanding liability for existing operating leases using the incremental borrowing
rate at the date of transition if interest rate implicit in the lease is not available.
 Measure the asset as if IFRS 16 had been applied from lease commencement OR
 Measure the asset at amount equal to liability (adjusted for accruals and prepayments).
 The restatement for the reporting entity in case study at the end of the 3rd year, with a
measurement at commencement date and using the interest rate at commencement date, and
the carry forward of the asset measured as if IFRS 16 was applied from lease commencement is
a follows:
Year 4 Opening Balances
Debit Right of use $176,150.22
Debit Retained earnings $18,741.21
Credit Curr.Port. Lease obligation $31,836.24
Credit Lease obligation $163,055.18
15

How to adopt IFRS 16 (1)
 Understanding IFRS 16
a) reviewing IFRS 16-related information from IASB and other externally prepared
websites
b) discussing the implications with industry peers
c) considering additional education and training for this topic;
 Reviewing
a) processes, systems, data collection and internal controls to develop a
comprehensive project management process
b) identifying the required but not available data and developing a plan to obtain
such information
c) creating a database of all lease contracts including a summary of key
contractual provisions
16

How to adopt IFRS 16 (2)
 Assessing the effect of IFRS 16
a) in systems, lease accounting policies, disclosures, internal controls, and discuss any potential
issue and change with the auditors
b) making a decision on the method to be applied on transition
c) preparing pro-forma financial statements to illustrate the effect of adopting IFRS 16
d) determining (if any) the implications for contractual arrangements (e.g. compensation,
acquisition, lending)
e) modifying (if necessary) covenants and third party agreements
f) determining whether additional training is required;
 Implementing IFRS 16
a) reflecting the adoption in accounting policies, systems and internal controls
b) updating budgets and forecast for the effects of IFRS 16; and
 Communicating the effects of IFRS 16
a) with the board of directors and the audit committee
b) developing a communication plan for all stakeholders (e.g. lenders and investors) including
disclosure in the MD&A.
17

Educational materials
 http://www.ifrs.org/Current-Projects/IASB-
Projects/Leases/Documents/IFRS_16_project-summary.pdf IASB January 2016
 http://www.ey.com/Publication/vwLUAssets/ey-leases-a-summary-of-ifrs-16-and-
its-effects-may-2016/$FILE/ey-leases-a-summary-of-ifrs-16-and-its-effects-may-
2016.pdf E&Y May 2016
 https://www.slideshare.net/kpmg/ifrs-16-leases-a-more-transparent-balance-sheet-
56984678 KPMG January 2016
 http://www.ifrs.org/Current-Projects/IASB-Projects/leases-
implementation/Documents/IFRS-16-Modifications-Webcast.pdf IASB March 2017
 http://efrag.org/Assets/Download?assetUrl=%2Fsites%2Fwebpublishing%2FProjec
t%20Documents%2F269%2FIFRS%2016%20Leases_Illustrative%20Examples.pd
f IASB January 2016
18

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