Watch out! Transition to IFRS 16 ahead
By Syed Md Enamul Kabir
Entities relying heavily on leases need to be cautious and calculated when choose a transition approach from the approaches permitted in IFRS 16 Leases, because different transition approaches have different implications in respect of transition costs and post-transition profit or loss. Since lessor accounting has remained almost the same in IFRS 16 as was in IAS 17, we here have covered transition issues and approaches from the perspective of lessees only.
Lease definition on transition
The definition of lease has changed in IFRS 16 and, hence, the first question naturally is whether a lessee needs to reassess all the existing lease-type contracts in the light of the new definition of lease. IFRS 16 permits two options:
- Reassess all the existing lease-type contracts in the light of the new definition of lease; or
- As a practical expedient, continue the assessment made applying IAS 17 and related interpretation (IFRIC 4) and apply the new definition of lease only to contracts entered into on or after the date of initial application of IFRS 16.
Lessees opting for the above practical expedient shall apply IFRS 16 to contracts identified as leases applying IAS 17 and IFRIC 4 and shall not apply IFRS 16 to contracts not identified as leases applying IAS 17 and IFRIC 4 (IFRS 16.C3).
While it may be tempting to continue the assessment previously made applying IAS 17 and IFRIC 4, lessees should consider the seriousness with which previous assessments were made, because some lessees might not be serious about identification of lease elements in contracts because of almost the same accounting implications of service contracts and operating leases. If lessees think that they were not serious enough in the past in identification of lease contracts, reassessing the existing contracts in the light of the new definition will help the lessees take informed decisions in respect of implementation of IFRS 16.
Transition approaches for lessees
Lessees have the option to apply IFRS 16 to all existing lease contracts either retrospectively to each prior period presented applying IAS 8 (known as full retrospective approach) or by adjusting the opening balance of retained earnings at the date of initial application by the cumulative effect of initial application of IFRS 16 without any restatement of the comparative information presented (known as modified retrospective approach or cumulative catch-up approach) (IFRS 16. C5-C7). According to our understanding, applying full retrospective approach should be costlier and more time consuming than applying cumulative catch-up approach.
If a lessee chooses to apply cumulative catch-up approach to all existing lease contracts, lease liabilities for all lease contracts previously classified as operating leases shall be measured using the remaining lease payments and the lessee’s incremental borrowing rate at the date of initial application (IFRS 16.C8a). Under the cumulative catch-up approach, right-of-use (ROU) assets for lease contracts previously classified operating leases shall be measured either assuming that IFRS 16 had always been applicable but using the lessee’s incremental borrowing rate at the date of initial application or at an amount equal to the lease liabilities (+/- a few adjustments) (IFRS 16.C8b).
Lessees applying cumulative catch-up approach are not required to make any transition adjustments for leases of low value items (IFRS 16.9a). Lessees applying cumulative catch-up approach can choose not to make any transition adjustments for previously classified operating leases having remaining lease terms of less than one year on the date of initial application (IFRS 16.C10c). Such relief is not available when full retrospective approach is applied for transition.
Lessees applying cumulative catch-up approach shall carry forward the carrying amounts at the date of initial application of lease assets and lease liabilities recognized in respect of leases originally classified and recognized as finance leases on the basis of IAS 17 (IFRS 16.C11).
A lessee’s incremental borrowing rate at the date of initial application of IFRS 16 is expected to vary among lease contracts according to the lease term and nature of security held. However, lessees applying cumulative catch-up approach can apply a single discount rate to a portfolio of leases previously classified as operating leases and having reasonably similar characteristics (such as leases with a similar remaining lease term for a similar class of underlying asset in a similar economic environment) (IFRS 16.C10a).
Most lessees will find that a range of accounting outcomes on transition is possible because of several policy choices permitted in IFRS 16. Full retrospective approach will be costly and time consuming, but will result in better comparability. On the other hand, cumulative catch-up approach will be less costly and less effortful, but will make the comparison with prior periods difficult. We suggest that lessees having lease contracts with significant financial impact evaluate all the possible consequences of different transition approaches and then decide what approach best suits them.
IFRS 16 Leases issued by IASB in January 2016. Available from IFRS Foundation website: https://www.ifrs.org/issued-standards/list-of-standards/ifrs-16-leases/
About the author
Syed Md Enamul Kabir FCA, MBA is the Managing Partner of ESS & Partners.
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