IFRS 16

IFRS 16

A team of professionals at one of Malta’s leading Accounting firms, GCS Malta, have prepared the following article that outlines leases under IFRS 16.

Firstly, a lease under IFRS 16 is defined as a ‘contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period in exchange for consideration’. The focus shall be on contracts that are not in the legal form of a lease but involves the use of a specific asset and hence might contain a lease (example; outsourcing, contract manufacturing, transportation and power supply agreements).

The underlying asset needs to be defined as ‘identified’ for a contract to be considered a lease. With the right to control the use of an identified asset means having the right to direct and obtain economic benefits. In simpler terms, should the customer control the use of an identified asset for a length of time, then the contract contains a lease. This will only be the case if the customer (the lessee) can make important decisions about the use of the asset. In such cases, the lessee needs to recognise these rights on the balance sheet as a ‘right-of-use’ asset. However, in a service contract, the supplier controls the use of any assets used to deliver the service and so there is no right-of-use asset to recognise.

Three key evaluations need to be met in order to conclude that a contract is or contains a lease.

1.    Is there an identified asset?

–    No – Contract is not (does not contain a lease).

–    Yes – Move on to point 2.

An identified asset is an asset that is either explicitly identified in the contract or is implicitly specified by being identified at the time that the asset is made available for use by the customer.

If an asset is explicitly specified, a customer does not have the right to use an identified asset if the supplier has a substantive substitution right throughout the period of use.

2.    Does the customer have the right to obtain substantially all the economic benefits from the use of the identified asset throughout the period of use?

–    No – Contract is not (does not contain a lease).

–    Yes – Move on to point 3.

When making such an evaluation, a customer should consider its rights within the defined scope of the contract. There are various ways that a customer can obtain economic benefits such as by using, holding or sub-leasing the asset.

IFRS16 eliminates the possibility that companies might include variable lease payments solely to avoid arrangement being classified as a lease and therefore lease accounting.

3.    Does the customer have the right to direct the use of the identified asset throughout the period of use?

In this evaluation, the customer must have the right to direct ‘how and for what purpose’ the asset is used throughout the period of use. The customer considers the decisions that directly impact the economic benefits to be derived from the use of the asset in this evaluation. These include:

•    Rights to decide the type of output to be produced by the asset(s)

•    Rights to decide when the output is produced

•    Rights to decide where the output is produced

•    Rights to decide whether the output is produced and the quantity thereof.

Contracts include terms and conditions that protect the supplier’s interest in the asset, protect its personnel and/or ensure the supplier complies with laws and regulations. These rights are protective and do not, in isolation, prevent the customer from having the right to direct the use of the asset within the scope of the contract.

Transition considerations

When transitioning to IFRS16, both lessees and lessors can choose whether to apply the new lease definition to all their contracts or apply for transitional relief from reassessing whether contracts in place at the date of initial application are or contain a lease. If an entity chooses to apply for this relief, then the new lease definition will be applied to contracts entered or modified on or after the date of initial application.

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