Transitioning to IFRS 16 Transition to IFRS 16: Are you ready?

Implementation projects are costly and data requirements extensive. But a careful use of transition options and practical expedients optimize the trade-offs between cost, timing and comparability ­– and your company’s profit in the post-transition years.

In January 2016, the IASB issued IFRS 16 Leases – a major step towards realizing its long-standing goal of bringing most leases on-balance sheet for lessees. IFRS 16 Leases includes a single lease accounting model for lessees and does not distinguish finance and operating leases anymore. All companies that lease major assets for use in their business will see an increase in reported assets and liabilities. The larger your lease portfolio, the more changes you may have to make to your systems and processes – starting with the creation of an inventory of all leases that are on transition to the new standard. To limit costs and ease the complexity of transition, the IFRS 16 includes several approaches, individual options and practical expedients that can be used independently, and in some cases, on a lease-by-lease basis.

The key decisions for a company relate to the effective date, and which options and practical expedients to elect. Many different combinations and permutations are possible.

Entities can choose to apply the new lease definition to all contracts or to grandfather existing contracts. Grandfathering allows the application of IFRS 16 only to those contracts in which a lease was previously identified in accordance with IAS 17 and IFRIC 4. In all sectors, grandfathering may be the favourable option to reduce the assessment cost of existing lease contracts on the new lease definition as no further documentation or data retrieval is required. However, if existing leases were (erroneously) not treated as leases under IAS 17, the error is not grandfathered and shall be treated according to IAS 8. The required disclosures in the annual financial statements will uncover such errors by explaining any difference between the operating lease commitments disclosed applying IAS 17, just before initial application of IFRS 16, and the lease liabilities recognized in the balance sheet at the date of initial application.

Entities may either adopt the standard retrospectively or following the modified retrospective approach. If a lessee elects to apply IFRS 16 using the modified retrospective approach, then it does not need to restate comparative figures.

Only the modified restrospective approach allows the following options and practical expedients on transition.

• The short-term leases exemption is applied – on transition and subsequently – according to the class of underlying assets. As additional relief, during the transition an entity may also apply the short-term exemption to all leases with a remaining maturity of less than 12 months on a lease-by-lease basis.
• The leases of low-value items exemption is applied on a lease-by-lease basis without additional relief on transition. The IASB had an amount of USD 5,000 or less in mind (e.g. some laptops, tablets, individual printers, mobile phones), but the final standard does not provide a fixed amount. The exemption applies without regard to materiality (individually or in aggregate) of the leases to the reporting entity.

Both short-term leases and leases of low-value items do not lead to recognition of a lease liability and ROU asset.

The lease liability is measured at its present value of the remaining lease payments on the transition date. Entities may apply a single discount rate on a portfolio of leases with reasonably similar characteristics (practical expedient) instead of applying the incremental borrowing rate at the date of transition for each lease separately. Discussions may arise on the decision to use local or group discount rates. The use of the local rates meets the standard’s intention, but arguments such as missing data, volatility on local rates or leaks in local know how can lead to a group preferring the use of a group discount rate.

For leases previously classified as operating leases, a lessee is permitted to choose, on a lease-by-lease basis, how to measure the ROU asset using one of two methods:

• Option 1: as if IFRS 16 had always been applied (but using the incremental borrowing rate at the date of initial application of IFRS 16); or
• Option 2: at an amount equal to the lease liability (adjusted for any prepaid or accrued lease payments).

Typically Option 2 leads to larger ROU assets on transition being amortized during the lease term. Annual and total amortization of Option 2 is therefore higher than for Option 1. The difference in applying Option 1 is recognized directly in equity at transition and is never recognized as expense. Both options result in a different equity amount during the life of a lease, but there’s no further impact on total equity after lease’s termination.

Option 1 is the more complex approach and requires substantially more data, however it provides higher comparability. Option 2 is more cost effective, but impacts comparability until end of the lease.

If an entity decides to apply the onerous leases transition relief, no impairment test must be performed on the ROU asset at the date of transition. Instead, the ROU asset is adjusted by any previous onerous lease provisions in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The practical expedient only applies to measurement on transition. Subsequently, the company accounts for the ROU asset in accordance with IAS 16.

An entity may use hindsight, such as determining the lease term if the contract contains options to extend or terminate the lease. As in the modified retrospective approach, an entity can use information as at the date of initial application, but there’s a limited benefit from the option. But when using Option 1 to measure the ROU asset, applying the use of hindsight doesn’t require consideration of the initial assessment of the lease term and subsequent changes to it.

The following table summarizes the potential impact on the costs and comparability of options an entity in the financial services sector may choose during the transition to IFRS 16:

*compared to the application of the option after initial application

The choice of transition option will have a significant impact on the extent of data gathering and the timing of system and process changes and should be considered as soon as possible. For many companies, the choice of transition method and practical expedients will have a major impact on implementation costs, comparability of financial statements and profit trends in the years after transition. Are you ready?