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The Rules: IFRS 16 shifts pressure point to distinguishing between a service and a lease

THE new leases standard, IFRS 16, will trigger great change. The idea of an operating lease evaporates for lessees, and now all leases will be on balance sheet. This will increase assets and debt. The biggest impact will be for the retail and services sectors with property leases, but it will also hit contracts for other long-lived assets in the airline, transportation, extractive and construction industries.

Under the old standard the pressure point was distinguishing between a finance lease and an operating lease. With the new standard, the pressure point shifts to distinguishing between a service and a lease.

Those are the headlines in a nutshell.

There is a new definition of a lease which focuses on control, rather than the risks and rewards of ownership. A lease gives the customer control over the right to use a specific asset, for the period of the lease. The term ‘right-of-use’ was created to acknowledge that for many leases the asset is only being used for the term of the lease, after which it will be returned to the lessor.

All leases create a right-of-use asset, with a corresponding liability for the lease debt. How this affects a particular business will depend on the composition of its portfolio of leases, and in particular the financing rate and the length of the non-cancellable period.

For example, for an operating lease with five years to run and a financing rate of 8% the leased assets and lease liability are likely to be about 3.4 times the annual operating lease expense. The lower the financing rate and the longer the lease period the higher the multiple. For a 15 year lease with quarterly payments and a finance rate of 8% the multiple would be about 8.7 meaning that, for example, the initial lease asset and lease liability for an annual property rental of £750,000 would be £6,648,020.

These right-of-use assets will be classified in the same category as the underlying assets being leased. For example, leases of property, plant and equipment are part of property, plant and equipment. If the right-of-use asset meets the definition of an investment property it must be presented as an investment property, and so on.

There is a practical expedient which allows businesses to continue to account for the qualifying leases like an operating lease, with the related assets and debt remaining off-balance sheet. Two types of lease qualify for this simplified accounting-short-term leases and leases of low-value assets.

A lease is short-term if it is for 12 months or less, provided that it does not include a purchase option. A series of one-year leases with options to renew or to cancel will not generally qualify. This is because the standard requires that the substance of options should be assessed, focusing on the economic incentives to extend or cancel the lease.

Low-value assets are items like laptops, office furniture, telephones and other similar items. The IASB has provided an indicative threshold of $5,000.

The balance sheet is not the only financial statement affected. The timing and geography of expense recognition will change. Total expenses over the life of a lease from applying the new standard will be the same as under the old one, but they will be recognised earlier. Operating leases used to give an even recognition of expenses over the lease period. Now, because finance costs are front-end loaded, there will be more expense recognised in the early period of the lease and less later on.

Expense classification will also change. The IAS 17 operating lease expense was included in operating expenses. The new accounting shifts the expense into depreciation, which is below EBITDA, and interest (financing), which is below EBIT. Those metrics are important to many analysts and are referenced in accounting-based contracts. Both will increase because the old operating lease expense is excluded from them, shifting further down the income statement.

The new pressure point will be distinguishing between a service and a lease. This is where judgement will be required.

A lease must involve a specific asset. Renting space in a retail complex where the location is at the owner’s discretion is a service. Renting a specific location would be a lease. But even this can be complicated for multi-occupancy properties, where part of the payment is for access to common areas. Shared space cannot be controlled by a lessee so would not be a leased asset.

Some contracts involving assets will include service components. In the aviation sector a “wet” lease includes the provision of crew. Only the payments for the right to use the aircraft are included in the right-of-use asset and lease liability. The payments that relate to the crew are a service. Technically the Standard allows you to take a simple route and treat the whole contract as a lease. But the financial reporting consequences of that could be significant.

We expect many businesses will, in practice, want to separate these service components from the lease. So it is likely that the way new contracts are written could also change, and existing contracts amended, in the light of the IFRS 16 requirements.

The world of the lessee has changed. It is estimated that trillions of dollars of contracts will come on-balance sheet. There is much to think about, plan for, and explain to investors.

Veronica Poole is global IFRS leader and UK head of accounting at Deloitte

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