IFRS 16, Leases came into effect for companies with accounting periods beginning on or after 1 January 2019. The impact on the balance sheets of lessees has been well documented, both in this column and elsewhere. As a reminder, the major difference is that all lease agreements over 12 months will be held as assets and liabilities in the accounts of the lessee.
Lessor accounting will not be changed under IFRS 16, but an area that this column has not discussed much is the new treatment regarding sale and leaseback. With the removal of the distinction between operating and finance leases, the accounting treatment for sale and leaseback arrangements also changed.
A sale or not?
Instead of determining whether the leaseback represents an operating or finance lease, the question has changed to whether the agreement constitutes a sale per IFRS 15, Revenue from contracts with customers.
If it is concluded that the asset transfer is not a sale, the accounting is quite simple. The seller-lessee continues to recognise the asset on its balance sheet, as there is no sale. The seller-lessee accounts for the proceeds as a financial liability per IFRS 9, Financial instruments. In substance, this shows that the arrangement is a financing transaction, similar to securing a loan against the asset.
The accounting for the transaction as a sale is a bit more complex. The seller-lessee will recognise a right-of-use (ROU) asset, replacing the previously held asset. Per paragraph 100(a) of IFRS 16, this is measured at the proportion of the previous carrying amount that is retained for use by the seller-lessee.
See the explanatory example in the panel below.
With variable payments
As the implementation of IFRS 16 gathers pace, questions are now being raised with the IFRS Interpretations Committee (IFRIC) about some of the finer points of its application.
It was asked what would happen in a case where the sale and leaseback has variable payments. This could arise in a situation where the payments are calculated as a percentage of the seller-lessee’s revenue generated using the asset during the 10-year term, instead of being fixed payments as described by IFRS 16.
In this situation, IFRS 16 states that the cost of the ROU asset consists of the amount of the initial measurement of the lease liability, among other costs. With the inclusion of variable payments, it is this point that becomes the most difficult to resolve. Paragraph 26 states that the lessee should initially measure the liability at the present value of the lease payments. Paragraph 27 specifies that these payments should be fixed payments or variable payments that depend on an index or rate.
This seems to suggest that a company applying paragraphs 26 and 27 of IFRS 16 to the example in the panel would record a lease liability of zero, as there are no fixed payments and the variable payments are not based on an index or rate. Based on the figures in the illustration above, if the lease liability is zero, then the ROU asset would be zero. This would mean that the full gain of US$800,000 would be recognised rather than the US$650,000 outlined above.
As IFRS 16 implementation gathers pace, questions are being raised about some finer points of its application
Sale and leaseback
A seller-lessee holds an asset with a carrying amount of US$1m and enters into a sale and leaseback arrangement, leasing it back for 10 years. The agreement constitutes a sale per IFRS 15. The amount paid by the buyer-lessor (equal to the fair value of the asset) is US$1.8m and the present value of the lease payments is US$450,000.
The proportion of the previous carrying amount that is retained for use by the seller-lessee is calculated by looking at the proportion of the asset retained for use, then applying it to the carrying amount.
Here, the present value of the payments is US$450,000 compared to the US$1.8m fair value of the asset. US$450,000/US$1.8m = 25%. This means effectively that 25% of the asset has been retained for use, and 75% of the asset has been disposed.
Applying this to the carrying amount of the asset would give a right-of-use (ROU) asset of US$250,000 (25% x US$1m = US$250,000).
Therefore the entries would be as follows:
|Dr ROU asset||250,000|
|Cr Lease liability||450,000|
|Cr Gain on disposal||600,000
This produces a smaller gain on disposal than the previous sale and leaseback treatment under an operating lease. In this case the gain would have simply been the difference between the proceeds of US$1.8m and the carrying amount of US$1m, giving a gain of US$800,000.
Economic principle is key
The IFRIC response is that the principle of the sale and leaseback accounting must be that the economics of the transaction must be reflected. Even if the payments do not seem to qualify for inclusion in the lease liability per paragraphs 26 and 27, the principle is that the seller-lessee has not transferred all the rights embedded in legal ownership of the asset.
IFRIC believes that the ROU asset could not be measured at zero, as this is not an accurate reflection of the proportion of the previous carrying amount retained. Measuring the ROU asset at zero would imply that the right to use the asset for 10 years has no value, which is untrue. While the payments may not be fixed or linked to an index, they are charged at a market rate, being a percentage of future sales.
IFRIC accepts that when calculating the proportion of the rights retained, IFRS 16 does not prescribe a particular method for the calculation, meaning that entities will need to assess what is an appropriate and reasonable method to use. In this case, it would be a sensible approach to determine the right of use retained by using the present value of the expected leaseback payments at market rates.
IFRIC acknowledged that this would mean that an entity in this scenario would not apply paragraphs 26 and 27 of IFRS 16. This would also be true of paragraphs 36 to 38 of IFRS 16, which talk of the subsequent treatment of the lease liability. In each of these paragraphs, IFIRC has stated that these sections of IFRS 16 were drafted without contemplating a situation where the measurement of the lease liability might include payments that do not meet the definition of lease payments.
IFRIC said it is currently unaware of any sale and leaseback transactions with payments that do not meet the definition of lease payments. Respondents did comment that such transactions do exist and may become more common in the retail industry, where some or all of the payments could be based on the seller-lessee’s revenue. Respondents also mentioned energy production facilities, where some or all of the leaseback payments might be based on the electricity produced.
Currently there are no projects on the IASB’s work plan or research pipeline that relate to sale and leaseback transactions. There will be a post-implementation review of the standard, although no date is set. Therefore, based on this issue, IFRIC proposes to publish a tentative agenda decision. This would outline the recommended treatment rather than amending the standard.
Gap in the standard
While IFRIC proposes the publication of an agenda decision that clarifies that the transaction will lead to a lease liability, even if the payments are variable, there is a further issue. This relates to the subsequent measurement of the liability.
IFRS 16 does not currently permit an entity to reassess the lease liability for changes in variable lease payments that do not depend on an index or rate. IFRIC and respondents recognised that there is a hole in the standard relating to this area, and work will be required.
In relation to the subsequent treatment of the lease liability, IFRIC is suggesting an amendment to the standard. This would provide further clarification on accounting for the subsequent measurement of the liability under such variable payments.
IFRIC voted on a proposal to undertake narrow scope standard setting on this, rather than leave it as part of the annual cycle of improvements. As there is a gap in the standard, it was decided that the IASB staff should go away and research into a specific recommended treatment on this specific issue.
This may not have an impact on many entities, but demonstrates the technical difficulties in implementing such a significant standard. This process shows us that some issues can be resolved with specific decisions recommending best practice, but other deeper issues will lead to actual amendments to the standard.