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Basis For Conclusions on IFRS 16 Measurement

Basis For Conclusions on IFRS 16 Measurement

Basis For Conclusions on IFRS 16 Measurement

IFRS 16 is an International Financial Reporting Standard (IFRS) promulgated by the International Accounting Standards Board (IASB) providing guidance on accounting for leases. IFRS 16 was issued in January 2016 and will be effective for most companies that report under IFRS in 2019. Upon becoming effective, it will replace the earlier leasing standard, IAS 17.[1] Users are permitted to transition to the new standard either by full retrospective application (i.e., restating all leases as if they had always been accounted for under IFRS 16, with the difference between asset and liability at the transition date charged to retained earnings) or by a cumulative catch-up methodology, in which finance leases continue unchanged while IAS 17 operating leases are converted to finance leases with the initial liability and asset equal to the present value of the remaining rent (using the lessee’s incremental borrowing rate as the discount rate for the present value).

A primary principle of IFRS 16 is that all lessee leases should be reported on the balance sheet, although there are exceptions for small items (e.g., under $5000) and for leases with a term of 12 months or less. Under IFRS 16, a lessee is required to recognize an asset for the right to use the leased item and a liability for the present value of its future lease payments.

IFRS 16 requires lessors to classify leases as either an “operating lease” or a “financing lease.” The lessor recognizes revenue under a financing lease as essentially interest payments on the amount financed. The lessor recognizes income under an operating lease on a systematic consistent with the benefits derived from the leased assets, which may be a straight-line basis.

IFRS 16 was developed in collaboration with the Financial Accounting Standards Board (FASB) in the United States, but while the new FASB leasing standard will share many common features with IFRS 16, such as reporting all large leases on the balance sheet, there will be some significant differences between the two standards.

Basis For Conclusions on IFRS 16 Measurement

Measurement bases of the right-of-use asset and the
lease liability
The IASB decided to require a cost measurement basis for the right-of-use asset and lease liability, with cost measured by reference to the present value of the lease payments. The IASB concluded that this approach will provide useful information to users of financial statements. This is because it is consistent with the approach used to measure other similar assets and liabilities and thus is expected to result in more comparable information than other approaches. The IASB also concluded that using a cost measurement basis will be less costly for preparers than other approaches.

The IASB considered whether to refer to other Standards rather than specify in IFRS 16 the initial and subsequent measurement of the right-of-use asset and lease liability. The IASB did not adopt an approach that would refer to other Standards because:

(a) the approach would have been inconsistent with the IASB’s decision not to apply a components approach to lease accounting (see paragraph BC153). For example, if a lessee were to account for all of the features of a lease applying other Standards, the requirements on financial instruments may have routinely required options in a lease to be accounted for separately.
(b) the approach could have been complex to apply, particularly when a lease contains relatively common features such as extension options, variable lease payments and residual value guarantees.

Basis For Conclusions on IFRS 16 Measurement

Initial measurement of the right-of-use asset
The IASB decided that a lessee should measure the right-of-use asset at cost,
defined as:
(a) the present value of the lease payments;
(b) any initial direct costs incurred by the lessee
(c) an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories.

The IASB considered whether a lessee should initially measure the right-of-use asset at fair value, which may provide more relevant information about the economic benefits to be derived from use of the underlying asset. However, initial measurement of a right-of-use asset at cost is consistent with the measurement of many other non-financial assets, such as assets within the scope of IAS 16 and IAS 38. Measuring right-of-use assets on a basis similar to that used to measure the underlying asset maintains the comparability of amounts reported for leased and owned assets, which contributes to the usefulness of the information provided to users of financial statements. Furthermore, measuring the right-of-use asset at cost is less complex and less costly for entities than measuring that asset at fair value, because there often is not an active market for right-of-use assets. The IASB thinks that, for many leases, a cost measurement basis will also provide a reasonable approximation of the fair value of the right-of-use asset at the commencement date.

Initial direct costs

IFRS 16 requires a lessee to include initial direct costs in the initial measurement of the right-of-use asset and depreciate those costs over the lease term. Including initial direct costs in the measurement of the right-of-use asset is consistent with the treatment of costs associated with acquiring other non-financial assets (for example, property, plant and equipment and intangible assets).

The IASB decided that lessees and lessors should apply the same definition of  initial direct costs. This decision was made primarily to reduce complexity in applying IFRS 16. As described in paragraph

the IASB also decided that the definition of initial direct costs for lessors should be consistent with the definition of ‘incremental costs’ in IFRS 15. Consequently, IFRS 16 defines initial direct costs as incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained.

The IASB considered whether initial direct costs incurred by lessees should be allocated between the right-of-use asset and the lease liability at the commencement date. However, the IASB concluded that such an approach could be costly for entities to apply, with little incremental benefit for users of financial statements.

Basis For Conclusions on IFRS 16 Measurement

Initial measurement of the lease liability
Lease term: options to extend or terminate a lease
Leases often grant the lessee a right to extend a lease beyond the non-cancellable
period, or to terminate a lease before the end of the lease period. Depending on
the terms and conditions of the option, a three-year lease with an option to
extend for two years could be economically similar to a three-year
non-cancellable lease or a five-year non-cancellable lease. However, a lease with
options would never be exactly the same as a lease without any options.

There are a number of different ways that an entity could reflect duration-related options that exist in leases:

(a) a components approach, in which options in a lease are recognised and measured as separate components of the lease. The IASB did not adopt a components approach because it would have created a complex lease
accounting model, would have been difficult to apply because options may be difficult to measure, and would have ignored the inter relationship between the term of a lease and the exercise of options

(b) a disclosure approach, in which an entity recognises a lease liability or a lease receivable for the non-cancellable period and discloses the existence of any options to extend the term. Although simple to apply, the IASB did not adopt this approach because the measurement of lease assets and lease liabilities would ignore the existence of options, including those that are virtually certain to be exercised. Consequently, this approach would potentially misrepresent the assets and liabilities arising from a lease.

(c) a measurement approach, in which options in a lease are included in the measurement of lease assets and lease liabilities using a particular method. That method could be, for example:

(i) a probability-weighted measurement method (in which the measurement of lease assets and lease liabilities reflects the probability of each possible lease term);

(ii) a probability threshold method (in which an entity includes optional periods in the lease term if the exercise of the options meets a specified threshold, for example reasonably certain, virtually certain or more likely than not); or

(iii) an economic incentive method (in which an entity includes optional periods in the lease term if an entity has an economic incentive to exercise the option).

Basis For Conclusions on IFRS 16 Measurement

Discount rate 
The IASB’s objective in specifying the discount rate to apply to a lease is to specify a rate that reflects how the contract is priced. With this in mind, the IASB decided that, if readily determinable by the lessee, a lessee should use the interest rate implicit in the lease.

The interest rate implicit in the lease is likely to be similar to the lessee’s incremental borrowing rate in many cases. This is because both rates, as they have been defined in IFRS 16, take into account the credit standing of the lessee, the length of the lease, the nature and quality of the collateral provided and the economic environment in which the transaction occurs. However, the interest rate implicit in the lease is generally also affected by a lessor’s estimate of the residual value of the underlying asset at the end of the lease, and may be affected by taxes and other factors known only to the lessor, such as any initial direct costs of the lessor. Consequently, the IASB noted that it is likely to be difficult for lessees to determine the interest rate implicit in the lease for many leases, particularly those for which the underlying asset has a significant residual value at the end of the lease.

Basis For Conclusions on IFRS 16 Measurement

Lease payments
Variable lease payments

Some or all of the lease payments for the right to use an asset during the lease term can be variable. That variability arises if lease payments are linked to:

(a) price changes due to changes in a market rate or the value of an index. For example, lease payments might be adjusted for changes in a benchmark interest rate or a consumer price index.

(b) the lessee’s performance derived from the underlying asset. For example, a lease of retail property may specify that lease payments are based on a specified percentage of sales made from that property.

(c) the use of the underlying asset. For example, a vehicle lease may require the lessee to make additional lease payments if the lessee exceeds a specified mileage.

Variable lease payments that are in-substance fixed lease payments

In-substance fixed lease payments are payments that may, in form, contain variability but that in substance are unavoidable. IFRS 16 requires a lessee to include in-substance fixed lease payments in the measurement of lease liabilities because those payments are unavoidable and, thus, are economically indistinguishable from fixed lease payments. The IASB understands that this approach is similar to the way in which entities applied IAS 17, even though IAS 17 did not include explicit requirements in this respect. In response to requests from stakeholders, IFRS 16 also includes examples in the application guidance of the types of payments that are considered to be in-substance fixed payments to help in applying the requirement.

Basis For Conclusions on IFRS 16 Measurement

Subsequent measurement of the right-of-use asset

The IASB decided that, after the commencement date, a lessee should measure the right-of-use asset at cost less accumulated depreciation and accumulated impairment losses, adjusted for remeasurements of the lease liability.

The IASB did not adopt an alternative approach whereby a lessee would be required to measure the right-of-use asset at fair value after initial measurement, because this approach would be:
(a) inconsistent with the subsequent measurement of many other non-financial assets; and
(b) more complex and costly for entities to apply than a cost-based approach, because it requires the use of both current expected cash flows and current interest rates.

Basis For Conclusions on IFRS 16 Measurement

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