3.1.1 Joint arrangements

Entities often enter into joint arrangements (JOAs) with other entities for certain activities. For example, the exploration of oil and gas fields, or the development of pharmaceutical products.

A contract for the use of an asset by a joint arrangement might be entered into in a number of different ways, including:

• directly by the joint arrangement, if the joint arrangement has its own legal identity;
• by each of the parties to the joint arrangement (i.e. the lead operator and the other parties, commonly referred to as the non-operators) individually signing the same arrangement;
• by one or more of the parties to the joint arrangement on behalf of the joint arrangement. Generally, this would be evidenced in the contract and the parties to the joint arrangement would have similar rights and obligations as they would if they individually signed the arrangement. In these situations, the facts and circumstances, as well as the legal position of each entity, need to be evaluated carefully; and
• by the lead operator of the joint arrangement in its own name, i.e. as principal. This may occur when the lead operator leases equipment which it then uses in fulfilling its obligations as the lead operator of the joint arrangement and/or across a range of unrelated activities, including other joint arrangements with unrelated activities, such as with other joint operating parties.

A contract to receive goods or services may be entered into by a joint arrangement or on behalf of a joint arrangement, as defined by IFRS 11 – Joint Arrangements. In this case, the joint arrangement is considered to be the customer in the contract. [IFRS 16.B11]. Accordingly, in determining whether such a contract contains a lease, an assessment needs to be made as to which party (e.g. the joint arrangement or the lead operator) has the right to control the use of an identified asset throughout the period of use.

If the parties to the joint arrangement collectively have the right to control the use of an identified asset throughout the period of use as a result of their collective control of the operation, the joint arrangement is the customer to the contract that may contain a lease. It would be inappropriate to conclude that the contract does not contain a lease on the grounds that each of the parties to the joint arrangement either has rights to a non-physically distinct portion of an underlying asset and, therefore, does not have the right to substantially all of the economic benefits from the use of that underlying asset or does not unilaterally direct its use. Determining if the parties to the joint arrangement collectively have the right to control the use of an identified asset throughout the period of use would require a careful analysis of the rights and obligations of each party.

In the first three scenarios above, if it has been determined that a contract is, or contains, a lease, each of the parties to the joint arrangement (i.e. the joint operators comprising the lead operator and the non-operators) will account for their respective interests in the joint arrangement (including any leases) under paragraphs 20‑23 of IFRS 11. Therefore, they will account for their individual share of any right-of-use assets and lease liabilities, and associated depreciation and interest.

In the fourth scenario (i.e. where the lead operator enters the arrangement in its own name), the lead operator will need to assess whether the arrangement is, or contains, a lease. If the lead operator controls the use of the identified asset, it would recognise the entire right-of-use asset and lease liability on its balance sheet. This would be the case even if it is entitled to bill the non-operator parties their proportionate share of the costs under the joint operating agreement.

If the lead operator determines it is the lessee, it would also evaluate whether it has entered into a sublease with the joint arrangement (as the customer to the sublease). For example, the lead operator may enter into a five-year equipment lease with a supplier, but may then enter into a two-year arrangement with one of its joint arrangements, thereby yielding control of the right to use the equipment to the joint arrangement during the two-year period. In many cases, the lead operator will not meet the requirements to recognise a sublease because the arrangement does not create legally enforceable rights and obligations that convey the right to control the use of the asset to the joint arrangement. However, the conclusion as to whether the joint arrangement is a customer, i.e. the lessee in a contract with a lead operator, by virtue of the joint operating agreement, would be impacted by the individual facts and circumstances.

If there is a sublease with the operator, IFRS 11 would require the non-operators to recognise their respective share of the joint arrangement's right-of-use asset and lease liability and the lead operator would have to account for its sublease to the joint arrangement separately. However, if no sublease existed, the non-operators would recognise joint interest payables when incurred for their share of the costs incurred by the operator in respect of the leased asset.

In limited cases, the lead operator and non-operators will enter into a contract directly with the supplier in which the lead operator and non-operators are proportionately liable for their share of the arrangement. In this case, the parties with interests in the joint operation would recognise their proportionate share of the leased asset, liability and lease expense in accordance with IFRS 11.

There has been considerable debate as to how the term ‘on behalf of the joint arrangement’ should be interpreted and applied in practice. The IFRS Interpretations Committee discussed a question (in September 2018) relating to lease arrangements in a joint operation (JO) under IFRS 16. The question asked was how a lead operator (the party responsible for undertaking the operations on behalf of the other joint operators) of a JO which is not structured through a separate vehicle, recognises a lease liability. The question specifically focused on situations where the lead operator, as the sole signatory, enters into a lease contract with a third-party supplier (lessor) for an item of property, plant and equipment that will be operated jointly as part of the JO's activities. The lead operator has the right to recover a share of the lease costs from the other joint operators in accordance with the contractual and other arrangements governing the JO.

The Committee concluded, in the agenda decision published in March 2019,¹ that in accordance with IFRS 11, a joint operator identifies and recognises both:

1. liabilities it incurs in relation to its interest in the JO; and
2. its share of any liabilities incurred jointly with other parties to the joint arrangement.

The Committee observed that identifying the liabilities that a joint operator incurs and those incurred jointly, requires an assessment of the terms and conditions in all contractual arrangements that relate to the JO, including consideration of the laws pertaining to those agreements. The Committee further observed, in accordance with IFRS 11, the liabilities a joint operator recognises include those for which it has primary responsibility. Therefore, as sole signatory and where a lead operator has primary responsibility for a lease, the lead operator recognises 100% of the lease liability.

The Committee also highlighted the importance of disclosing information about joint operations that is sufficient for a user of financial statements to understand the activities of the joint operation and a joint operator's interest in that operation. Therefore the Committee concluded that the principles and requirements in IFRS standards provide an adequate basis for the lead operator to identify and recognise its liabilities in relation to its interest in a JO and, did not to add this matter to its standard-setting agenda.

Joint arrangements are particularly common in extractive industries and the implications of this agenda decision are discussed further in Chapter 43 at 18.

3.1.2 Identified asset

An arrangement only contains a lease if there is an identified asset. This concept is generally consistent with the ‘specified asset’ concept in IFRIC 4 – Determining whether an Arrangement contains a Lease.

An asset is typically identified by being explicitly specified in a contract. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer. [IFRS 16.B13].

A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fibre optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset. [IFRS 16.B20].

Some contracts involve a dedicated cable that is part of the larger network infrastructure (e.g. unbundled network element arrangements for the ‘last mile’ to a customer location, ‘special access’ arrangements for a dedicated connection between two locations). IFRS 16 does not specify or provide examples that clarify whether these arrangements are identified assets. However, the FASB's standard, ASC 842, includes an additional example that is similar to a dedicated cable (i.e. a segment of a pipeline that connects a single customer to a larger pipeline). That example clarifies that such segments of a larger pipeline are identified assets. As the IASB has stated that it and the FASB have reached the same conclusions on the definition of a lease, we believe that, under IFRS 16, the last mile of a network that connects a single customer to a larger network may be an identified asset. However, such arrangements may or may not meet the definition of a lease. Entities will need to be sensitive to this matter in both these and similar arrangements.

Land easements or rights of way are rights to use, access or cross another entity's land for a specified purpose. For example, a land easement might be obtained for the right to construct and operate a pipeline or other assets (e.g. railway line, utility pipes or telecommunication lines) over, under or through an existing area of land or body of water while allowing the landowner continued use of the land for other purposes (e.g. farming), as long as the landowner does not interfere with the rights conveyed in the land easement. A land easement may be perpetual or for a specified term. It may provide for exclusive or non-exclusive use of the land, and may be prepaid or paid over a defined term.

Perpetual easements are outside the scope of IFRS 16, as the definition of a lease requires the contract to be for a period of time. Therefore, entities must carefully evaluate easement contracts to determine whether the contract is perpetual or for a period of time. Examples of contracts that may appear perpetual but are term based include:

• very long-term contracts (e.g. the FASB indicated in the Basis for Conclusions (BC113) that very long-term leases of land (e.g. 999 years) are in the scope of ASC 842);
• contracts with a stated, non-cancellable lease term that ‘automatically renews’ if the lessee pays a periodic renewal fee. This is an in-substance fixed term contract with optional renewal periods; and
• contracts that define the period of use as the period over which the assets are used (e.g. as long as natural gas flows through a gathering system) is a fixed term contract (i.e. terminated when production ceases) rather than a perpetual contract because the gas reserves will ultimately be depleted.

When determining whether a contract for a land easement or right of way is a lease, entities will need to assess whether there is an identified asset and whether the customer obtains substantially all of the economic benefits of the identified asset and has the right to direct the use of that asset throughout the period of use.

In June 2019, the IFRS Interpretations Committee discussed a contract for subsurface rights.² In the contract described, a pipeline operator obtains the right to place an oil pipeline in underground space for 20 years in exchange for consideration. The contract specifies the exact location and dimensions (path, width and depth) of the underground space within which the pipeline will be placed. The landowner retains the right to use the surface of the land above the pipeline, but it has no right to access or otherwise change the use of the specified underground space throughout the 20-year period of use. The customer has the right to perform inspection, repairs and maintenance work (including replacing damaged sections of the pipeline when necessary).

During the discussion, the Committee noted the following:

• Paragraph 3 of IFRS 16 requires an entity to apply IFRS 16 to all leases, with limited exceptions. In the contract described in the request, none of the exceptions in paragraphs 3 and 4 of IFRS 16 apply. In particular, the Committee noted that the underground space is tangible. Accordingly, if the contract contains a lease, IFRS 16 applies to that lease. If the contract does not contain a lease, the entity would then consider which other IFRS Standard applies.
• Applying paragraph B9 of IFRS 16, to meet the definition of a lease the customer must have both:
  1. the right to obtain substantially all the economic benefits from use of an identified asset throughout the period of use; and
  2. the right to direct the use of the identified asset throughout the period of use.
• The specified underground space is physically distinct from the remainder of the land. The contract's specifications include the path, width and depth of the pipeline, thereby defining a physically distinct underground space. The space being underground does not in itself affect whether it is an identified asset – the specified underground space is physically distinct in the same way that a specified area of space on the land's surface would be physically distinct. As the landowner does not have the right to substitute the underground space throughout the period of use, the Committee concluded that the specified underground space is an identified asset as described in paragraphs B13–B20 of IFRS 16.
• The customer has the right to obtain substantially all the economic benefits from use of the specified underground space throughout the 20-year period of use. The customer has exclusive use of the specified underground space throughout that period of use.
• The customer has the right to direct the use of the specified underground space throughout the 20-year period of use because the customer has the right to operate the asset throughout the period of use without the supplier having the right to change those operating instructions. How and for what purpose the specified underground space will be used (i.e. to locate the pipeline with specified dimensions through which oil will be transported) is predetermined in the contract. The customer has the right to operate the specified underground space by having the right to perform inspection, repairs and maintenance work. The customer makes all the decisions about the use of the specified underground space that can be made during the 20-year period of use.

Consequently, the Committee concluded that the contract described in the request contains a lease as defined in IFRS 16. The customer would therefore apply IFRS 16 in accounting for that lease.

3.1.3 Substantive substitution rights

Even if an asset is specified, a customer does not have the right to use an identified asset if, at inception of the contract, a supplier has the substantive right to substitute the asset throughout the period of use (i.e. the total period of time that an asset is used to fulfil a contract with a customer, including the sum of any non-consecutive periods of time). [IFRS 16 Appendix A]. A supplier's right to substitute an asset is substantive when both of the following conditions are met:

• the supplier has the practical ability to substitute alternative assets throughout the period of use (e.g. the customer cannot prevent the supplier from substituting an asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
• the supplier would benefit economically from the exercise of its right to substitute the asset (i.e. the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset). [IFRS 16.B14].

The IASB indicated in the Basis for Conclusions to IFRS 16 that the conditions above are intended to differentiate between substitution rights that result in a supplier controlling the use of an asset, rather than the customer, and rights that do not change the substance or character of the contract. [IFRS 16.BC113].

If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier's substitution right is not substantive because the supplier does not have the practical ability to substitute alternative assets throughout the period of use. [IFRS 16.B15].

An entity's evaluation of whether a supplier's substitution right is substantive is based on facts and circumstances at inception of the contract. At inception of the contract, an entity should not consider future events that are not likely to occur. IFRS 16 provides the following examples of circumstances that, at inception of the contract, are not likely to occur and, thus, are excluded from the evaluation of whether a supplier's substitution right is substantive throughout the period of use:

• an agreement by a future customer to pay an above market rate for use of the asset;
• the introduction of new technology that is not substantially developed at inception of the contract;
• a substantial difference between the customer's use of the asset, or the performance of the asset, and the use or performance considered likely at inception of the contract; and
• a substantial difference between the market price of the asset during the period of use, and the market price considered likely at inception of the contract. [IFRS 16.B16].

The requirement that a substitution right must benefit the supplier economically in order to be substantive is a new concept. In many cases, it will be clear that the supplier will not benefit from the exercise of a substitution right because of the costs associated with substituting an asset. [IFRS 16.BC113]. If an asset is located at the customer's premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier's premises, and therefore, are more likely to exceed the benefits associated with substituting the asset. [IFRS 16.B17]. However, simply because a supplier concludes that the cost of substitution is not significant does not automatically mean that it would economically benefit from the right of substitution.

IFRS 16 further clarifies that a customer should presume that a supplier's substitution right is not substantive when the customer cannot readily determine whether the supplier has a substantive substitution right. [IFRS 16.B19]. This requirement is intended to clarify that a customer is not expected to exert undue effort to provide evidence that a substitution right is not substantive. We believe that the Board did not include a similar provision for suppliers, because they should have sufficient information to make a determination of whether a substitution right is substantive.

Contract terms that allow or require a supplier to substitute alternative assets only when the underlying asset is not operating properly (e.g. a normal warranty provision) or when a technical upgrade becomes available do not create a substantive substitution right. [IFRS 16.B18].

3.1.4 Right to obtain substantially all of the economic benefits from use of the identified asset

To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (for example, by having exclusive use of the asset throughout that period). A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding or sub-leasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items), and other economic benefits from using the asset that could be realised from a commercial transaction with a third party. [IFRS 16.B21].

Economic benefits arising from construction or ownership of the identified asset (e.g. tax benefits related to excess tax depreciation and investment tax credits as discussed in paragraph BC118 of the Basis of Conclusions to IFRS 16) are not considered economic benefits derived from the use of the asset. Therefore, they are not considered when assessing whether a customer has the right to obtain substantially all of the economic benefits.

When assessing the right to obtain substantially all of the economic benefits from use of an asset, an entity considers the economic benefits that result from use of the asset within the defined scope of a customer's right to use the asset. For example:

1. if a contract limits the use of a motor vehicle to only one particular territory during the period of use, an entity considers only the economic benefits from use of the motor vehicle within that territory, and not beyond; or
2. if a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity considers only the economic benefits from use of the motor vehicle for the permitted mileage, and not beyond. [IFRS 16.B22].

If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from use of an asset as consideration, those cash flows paid as consideration are considered to be part of the economic benefits that the customer obtains from use of the asset. For example, if the customer is required to pay the supplier a percentage of sales from use of retail space as consideration for that use, that requirement does not prevent the customer from having the right to obtain substantially all of the economic benefits from use of the retail space. This is because the cash flows arising from those sales are considered to be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to the supplier as consideration for the right to use that space. [IFRS 16.B23].

3.1.5 Right to direct the use of the identified asset

A customer has the right to direct the use of an identified asset throughout the period of use when either:

• the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or
• the relevant decisions about how and for what purpose an asset is used are predetermined; and
  • the customer either has the right to operate the asset, or to direct others to operate the asset in a manner that it determines, throughout the period of use, without the supplier having the right to change those operating instructions; or
  • the customer designed the asset, or specific aspects of the asset, in a way that predetermines how and for what purpose the asset will be used throughout the period of use. [IFRS 16.B24].

Requiring a customer to have the right to direct the use of an identified asset is a change from IFRIC 4. A contract may have met IFRIC 4's control criterion if, for example, the customer obtained substantially all of the output of an underlying asset and met certain price-per-unit-of-output criteria even though the customer did not have the right to direct the use of the identified asset as contemplated by IFRS 16. Under IFRS 16, such arrangements are no longer considered leases.

3.1.6 Flowchart of the decision making process

IFRS 16 contains a flowchart that depicts the decision making process for determining whether an arrangement contains a lease [IFRS 16.B31] and provides a summary of the discussion at 3.1.2 through 3.1.5.D above. This has been reproduced below.

We believe that the assessment of whether a contract is or contains a lease will be straightforward in most arrangements. However, judgement may be required in applying the definition of a lease to certain arrangements.

3.1.7 Reassessment of the contract

An entity reassesses whether a contract is, or contains, a lease only if the terms and conditions of the contract are changed. [IFRS 16.11]. A change in the terms and conditions of a contract does not include the exercise of an option (e.g. a renewal option) or failure to exercise an option that is included in the contract.

3.2.1 Identifying and separating lease components of a contract

An entity accounts for each lease component within a contract as a lease separately from non-lease components of the contract, unless the entity (lessees only) applies the practical expedient in paragraph 15 of IFRS 16. [IFRS 16.12]. See 3.2.2.B below.

The right to use an underlying asset is a separate lease component if both:

1. the lessee can benefit from use of the underlying asset either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee has already obtained (from the lessor or from other transactions or events); and
2. the underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract. For example, the fact that a lessee could decide not to lease the underlying asset without significantly affecting its rights to use other underlying assets in the contract might indicate that the underlying asset is not highly dependent on, or highly interrelated with, those other underlying assets. [IFRS 16.B32].

If one or both of these criteria are not met, the right to use multiple assets is considered a single lease component.

A contract may include an amount payable by the lessee for activities and costs that do not transfer a good or service to the lessee. For example, a lessor may include in the total amount payable a charge for administrative tasks, or other costs it incurs associated with the lease, that do not transfer a good or service to the lessee. Such amounts payable do not give rise to a separate component of the contract, but are considered to be part of the total consideration that is allocated to the separately identified components of the contract. [IFRS 16.B33].

For contracts that involve the right to use land and land improvements (e.g. buildings), IFRS 16 requires a lessor to classify (see 6.1 below) and account for the right to use land as a separate lease component, unless the accounting effect of doing so is immaterial to the lease. [IFRS 16.B57]. For example, separation of the land may not be necessary when the amount that would be recognised for the land lease component is immaterial to the lease. If the lease payments cannot be allocated reliably between the land and the buildings, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases (i.e. the entire lease is classified as an operating lease). [IFRS 16.B56]. An entity that leases an entire building (i.e. 100% of the building) is inherently leasing the land underneath the building and would potentially account for the land and building as separate lease components. However, this would not necessarily be the case when an entity only leases part of the building.

3.2.2 Identifying and separating lease from non-lease components of a contract

Many contracts contain a lease coupled with an agreement to purchase or sell other goods or services (non-lease components). The non-lease components are identified and accounted for separately from the lease component in accordance with other standards, unless the lessee applies the practical expedient as discussed at 3.2.2.B below. [IFRS 16.16]. For example, the non-lease components may be accounted for as executory arrangements by lessees (customers) or as contracts subject to IFRS 15 by lessors (suppliers).

Some contracts contain items that do not relate to the transfer of goods or services by the lessor to the lessee (e.g. fees or other administrative costs a lessor charges a lessee). These items are not considered separate lease or non-lease components, and lessees and lessors do not allocate consideration in the contract to these items. [IFRS 16.B33]. See 3.2.3.B below. However, if the lessor provides goods or services, such as maintenance, supply of utilities, including operating the underlying asset for the customer (e.g. vessel charter, aircraft wet lease), the contract would generally contain non-lease components.

Identifying non-lease components of contracts may change practice for some lessees. Under IAS 17, entities may not focus on identifying lease and non-lease components because the accounting treatment (e.g. accounting for an operating lease and a service contract) is often the same.

3.2.3 Determining and allocating the consideration in the contract – lessees

3.2.4 Determining and allocating the consideration in the contract – lessors

4.4.1 Cancellable leases

In determining the lease term and assessing the length of the non-cancellable period of a lease, an entity applies the definition of a contract and determines the period for which the contract is enforceable. A lease is no longer enforceable when the lessee and the lessor each has the right to terminate the lease without permission from the other party with no more than an insignificant penalty. [IFRS 16.B34].

Any non-cancellable periods (by the lessee and lessor) in contracts that meet the definition of a lease are considered part of the lease term. IFRS 16 further provides that, if only a lessee has the right to terminate a lease, that right is considered to be an option to terminate the lease available to the lessee that an entity considers when determining the lease term. If only a lessor has the right to terminate a lease, the non-cancellable period of the lease includes the period covered by the option to terminate the lease. [IFRS 16.B35].

The question arises as to whether penalty should be interpreted to include only the contractual amount payable by one party to the other if the termination option is exercised (i.e. the narrow interpretation) or whether significant economic disincentives should also be considered a penalty (i.e. the wide interpretation). With respect to the determination of the lease term, IFRS 16 requires an entity to consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, the option (see 4.4 above) and thus suggests that all aspects of termination penalties, whether contractual or financial in nature or not, should be considered. Although the guidance may not directly apply in this situation as the lessee is unable to exercise the option to renew the lease without the approval of the lessor, we believe, by analogy, it is appropriate to evaluate the existence of any significant economic disincentives taking into account all facts and circumstances.

This issue was discussed by the IFRS Interpretations Committee in June 2019. The Committee was asked how to determine the lease term of a cancellable lease or a renewable lease. Specifically, when applying paragraph B34 of IFRS 16 and assessing ‘no more than an insignificant penalty’ whether an entity considers the broader economics of the contract and not only contractual termination payments. Such considerations might include the cost of abandoning or dismantling leasehold improvements.

The Committee noted that in applying paragraph B34 and determining the enforceable period of the lease, an entity considers³:

• the broader economics of the contract and not only the contractual termination payments. For example, if either party has an economic incentive not to terminate the lease such that it would incur a penalty on termination that is more than insignificant, the contract is enforceable beyond the date on which the contract can be terminated; and
• whether each of the parties has the right to terminate the lease without permission from the other party with no more than an insignificant penalty. Applying paragraph B34, a lease is no longer enforceable only when both parties have such a right. Consequently, if only one party has the right to terminate the lease without permission for the other party with no more than an insignificant penalty, the contract is enforceable beyond the date on which the contract can be terminated by that party.

If an entity concludes that the contract is enforceable beyond the notice period of a cancellable lease, it then applies paragraphs 19 and B37-B40 of IFRS 16 to assess whether the lessee is reasonably certain not to exercise the option to terminate the lease.

The Committee noted that in assessing whether a lessee is reasonably certain to extend (or not to terminate) a lease, paragraph B37 of IFRS 16 requires an entity to consider all relevant facts and circumstances that create an economic incentive for the lessee. This includes significant leasehold improvements undertaken (or expected to be undertaken) over the term of the contract that are expected to have significant economic benefit for the lessee when an option to extend or terminate the lease becomes exercisable (paragraph B37(b) of IFRS 16). In addition, an entity considers the broader economics of the contract when determining the enforceable period of a lease. This includes, for example, the costs of abandoning or dismantling non-removable leasehold improvements. If an entity expects to use non-removable leasehold improvements beyond the date on which the contract can be terminated, the existence of those leasehold improvements indicates that the entity might incur a more than insignificant penalty if it terminates the lease. Consequently, applying paragraph B34 of IFRS 16, an entity considers whether the contract is enforceable for at least the period of expected utility of the leasehold improvements.

The Committee tentatively concluded that the principles and requirements in IFRS 16 provide an adequate basis for an entity to determine the lease term of cancellable and renewable leases.

Following publication of this tentative agenda decision, the Committee received a number of comment letters from constituents. At the time of writing, this issue is subject to further discussion by the Committee before it is finalised.

In many jurisdictions, property leases are subject to local property laws in addition to the contractual terms of the lease arrangement. That is, local laws and regulations may give the lessee legal renewal options not stated in the lease contract. Examples of where the local law may provide lessee's such rights include airport terminal and retail shopping space. When assessing the lease term, entities need to consider whether local laws and regulations create enforceable rights and obligations that need to be included in the evaluation of the lease term.

IFRS 16 also applies to contracts that are referred to as ‘cancellable,’ ‘month-to-month,’ ‘at-will,’ ‘evergreen,’ ‘perpetual’ or ‘rolling’ if they create enforceable rights and obligations. These types of leases generally allow for the contract to continue beyond a non-cancellable period until one party gives notice to terminate the contract (e.g. the contract will roll monthly until the lessee or the lessor elect to terminate the contract). If both the lessee and the lessor can terminate the contract without more than an insignificant penalty at any time at or after the end of the non-cancellable term, then there are no enforceable rights and obligations beyond the non-cancellable term (i.e. the lease term is limited to the non-cancellable term). However, if the lessee holds a renewal option, there may be other factors to consider to determine whether the lessee is reasonably certain to extend the lease, including economic disincentives discussed above.

4.4.2 Reassessment of lease term and purchase options – lessees

After lease commencement, IFRS 16 requires lessees to monitor leases for significant changes that could trigger a change in the lease term. A lessee reassesses whether it is reasonably certain to exercise an extension option, or not to exercise a termination option, upon the occurrence of either a significant event or a significant change in circumstances that:

1. is within the control of the lessee; and
2. affects whether the lessee is reasonably certain to exercise an option not previously included in its determination of the lease term, or not to exercise an option previously included in its determination of the lease term. [IFRS 16.20].

Examples of significant events or changes in circumstances that would trigger a reassessment include:

1. significant leasehold improvements not anticipated at the commencement date that are expected to have significant economic benefit for the lessee when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable;
2. a significant modification to, or customisation of, the underlying asset that was not anticipated at the commencement date;
3. the inception of a sublease of the underlying asset for a period beyond the end of the previously determined lease term; and
4. a business decision of the lessee that is directly relevant to exercising, or not exercising, an option (for example, a decision to extend the lease of a complementary asset, to dispose of an alternative asset or to dispose of a business unit within which the right-of-use asset is employed). [IFRS 16.B41].

An entity revises the lease term if there is a change in the non-cancellable period of a lease. For example, the non-cancellable period of a lease will change if:

1. the lessee exercises an option not previously included in the entity's determination of the lease term;
2. the lessee does not exercise an option previously included in the entity's determination of the lease term;
3. an event occurs that contractually obliges the lessee to exercise an option not previously included in the entity's determination of the lease term; or
4. an event occurs that contractually prohibits the lessee from exercising an option previously included in the entity's determination of the lease term. [IFRS 16.21].

As a lessee is required to reassess the lease term upon the occurrence of either a significant event or a significant change in circumstances that is within the control of the lessee, the revision of the lease term often happens before the actual exercise of the option in these circumstances. Additionally, if the reassessment of lease term or the exercise of a purchase option results in a change, lessees would remeasure the lease liability, using revised inputs (e.g. discount rate) at the reassessment date, and would adjust the right-of-use asset. However, if the right-of-use asset is reduced to zero, a lessee would recognise any remaining amount in profit or loss. See 4.5.11 below.

4.4.3 Reassessment of lease term and purchase options – lessors

IFRS 16 requires a lessor to revise the lease term to account for a lessee's exercise of an option to extend or terminate the lease or purchase the underlying asset, when exercise of such options was not already included in the lease term.

4.5.1 In-substance fixed lease payments

Lease payments include any in-substance fixed lease payments. In-substance fixed lease payments are payments that may, in form, contain variability but that, in substance, are unavoidable. In-substance fixed lease payments exist, for example, if:

1. payments are structured as variable lease payments, but there is no genuine variability in those payments. Those payments contain variable clauses that do not have real economic substance. Examples of those types of payments include:
   1. payments that must be made only if an asset is proven to be capable of operating during the lease, or only if an event occurs that has no genuine possibility of not occurring; or
   2. payments that are initially structured as variable lease payments linked to the use of the underlying asset but for which the variability will be resolved at some point after the commencement date so that the payments become fixed for the remainder of the lease term. Those payments become in-substance fixed payments when the variability is resolved;
2. there is more than one set of payments that a lessee could make, but only one of those sets of payments is realistic. In this case, an entity considers the realistic set of payments to be lease payments; or
3. there is more than one realistic set of payments that a lessee could make, but it must make at least one of those sets of payments. In this case, an entity considers the set of payments that aggregates to the lowest amount (on a discounted basis) to be lease payments. [IFRS 16.B42].

4.5.2 Lease incentives

Lease incentives are defined as ‘payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of costs of a lessee’. [IFRS 16 Appendix A].

A lease agreement with a lessor might include incentives for the lessee to sign the lease, such as an up-front cash payment to the lessee, payment of costs for the lessee (such as moving expenses) or the assumption by the lessor of the lessee's pre-existing lease with a third party.

For lessees, lease incentives that are received by the lessee at or before the lease commencement date reduce the initial measurement of a lessee's right-of-use asset. [IFRS 16.24(b)]. Lease incentives that are receivable by the lessee at lease commencement date, reduce a lessee's lease liability (and therefore the right-of-use asset as well). [IFRS 16.27(a)].

For lessors, lease incentives that are paid or payable to the lessee are also deducted from lease payments and affect the lease classification test. For finance leases, lease incentives that are payable to the lessee reduce the expected lease receivables at the commencement date and thereby the initial measurement of the lessor's net investment in the lease. [IFRS 16.70(a)]. For operating leases, lessors should defer the cost of any lease incentives paid or payable to the lessee and recognise that cost as a reduction to lease income over the lease term.

Example 13 of the Illustrative Examples to IFRS 16 indicates that the reimbursement of leasehold improvements from the lessor is accounted for by applying other standards and is not a lease incentive. The IASB received feedback that this may cause confusion as to why the reimbursement is not treated as a lease incentive, and how the definition within IFRS 16 of lease incentives should be applied. In May 2019 the IASB issued an exposure draft Annual Improvements to IFRS Standards 2018 – 2020. The ED proposes to amend Illustrative Example 13 to remove the illustration of the reimbursement of leasehold improvements by the lessor. The amendments are expected to be finalised in 2020.

4.5.3 Variable lease payments that depend on an index or rate

Variable lease payments that depend on an index or a rate include, for example, payments linked to a consumer price index, payments linked to a benchmark interest rate (such as LIBOR) or payments that vary to reflect changes in market rental rates. [IFRS 16.28]. The payments are included in the lease payments and are measured using the prevailing index or rate at the measurement date (e.g. lease commencement date for initial measurement). The IASB indicated in the Basis for Conclusions that, despite the measurement uncertainty associated with changes to index- or rate-based payments, the payments meet the definition of an asset (lessor) and a liability (lessee) because they are unavoidable and do not depend on any future activity of the lessee. [IFRS 16.BC165]. Lessees subsequently remeasure the lease liability if there is a change in the cash flows (i.e. when the adjustment to the lease payments takes effect) for future payments resulting from a change in index or rate used to determine lease payments. [IFRS 16.42(b)].

Lease contracts, particularly those relating to property, may include market rent reviews at future dates. The following example shows how these clauses may be treated.

• Year 1 – CU1,000
• Year 2 – CU1,000 × 4% fixed escalation = CU1,040
• Year 3 – CU1,040 × 4% fixed escalation = CU1,082

The market rent review applicable to years 4 and 5 is a variable lease payment that depends on an index or a rate (as described in IFRS 16 par 28). Entity A assesses the market rent at commencement date for the lease of the property for a period of two years, which is the length of the remaining lease term. This is determined to be CU1,060 per annum for years 4 and 5.

4.5.4 The exercise price of a purchase option

If the lessee is reasonably certain to exercise a purchase option, the exercise price is included as a lease payment. That is, entities consider the exercise price of asset purchase options included in lease contracts consistently with the evaluation of lease renewal and termination options. See 4.4 above.

4.5.5 Payments for penalties for terminating a lease

If it is reasonably certain that the lessee will not terminate a lease, the lease term is determined assuming that the termination option would not be exercised, and any termination penalty is excluded from the lease payments. Otherwise, the lease termination penalty is included as a lease payment. The determination of whether to include lease termination penalties as lease payments is similar to the evaluation of lease renewal options.

4.5.6 Amounts expected to be payable under residual value guarantees – lessees only

IFRS 16 requires lessees to include amounts expected to be payable to the lessor under residual value guarantees as lease payments.

A lessee may provide a guarantee to the lessor that the value of the underlying asset it returns to the lessor at the end of the lease will be at least a specified amount. Such guarantees are unconditional obligations that the lessee has assumed by entering into the lease. Uncertainty related to a lessee's guarantee of a lessor's residual value affects the measurement of the obligation rather than the existence of an obligation. [IFRS 16.BC170].

A lessee is required to remeasure the lease liability if there is a change in the amounts expected to be payable under a residual value guarantee. [IFRS 16.42(a)].

IFRS 16 does not state how frequently reassessment should occur for expected changes under residual value guarantees. However, we would expect entities to apply judgement to determine the frequency of reassessment based on the relevant facts and circumstances.

4.5.7 Amounts payable under residual value guarantees – lessors only

IFRS 16 requires lessors to include in the lease payments, any residual value guarantees provided to the lessor by the lessee, a party related to the lessee, or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee. [IFRS 16.70(c)]. This amount included in lease payments is different to that for a lessee which only includes the amount expected to be payable. See 4.5.6 above.

4.5.8 Variable lease payments which do not depend on an index or rate

Variable lease payments that do not depend on an index or rate and are not in-substance fixed (see 4.5.1 above), such as those based on performance (e.g. a percentage of sales) or usage of the underlying asset (e.g. the number of hours flown, the number of units produced), are not included as lease payments. Instead they are recognised in profit or loss (unless they are included in the carrying amount of another asset in accordance with other IFRS) in the period in which the event that triggers the payment occurs. [IFRS 16.38(b)].

In some cases, the variability may be resolved during the lease term, so that payments become fixed for the remainder of the lease term. The new fixed payments are then used to remeasure the lease liability (with an offset to the right-of-use asset). In some cases, the contract requires that when the contingency is resolved, the lessee is required to make an immediate catch up payment. The catch up payment relates specifically to the lessee's prior use of the asset. In this case, we believe, when the contingency is resolved, the catch up obligation is recognised as part of the lease liability and is expensed immediately (rather than adjusting the right-of-use asset).

Lease payments do not include payments allocated to the non-lease components of a contract. However, lease payments include amounts that would otherwise be allocable to the non-lease components of a contract when the lessee makes an accounting policy election to account for the lease and non-lease components as a single lease component. See 3.2.2.B above.

4.5.9 Security deposits

At the commencement of a lease, a lessee may be required to pay a security deposit to the lessor. As long as the deposit is a true deposit and not a prepaid lease payment, the deposit gives the lessee a right to receive the money back in cash from the lessor and is therefore a financial asset for the lessee and a financial liability for the lessor and is within the scope of IFRS 9. The deposit must initially be accounted for at fair value. The excess of the principal amount of the deposit over its fair value is a part of the lease payments within the scope of IFRS 16. It is therefore considered by the lessor in determining whether the lease is an operating or finance lease. The fair value of the deposit is determined based on the prevailing market rate of interest for a similar loan to the lessor, considering the lessor's credit-worthiness and, depending on facts and circumstances, any additional security available to the lessee.

When the deposit earns interest below the market rate, the excess of the principal amount of the deposit over its fair value is accounted for by both the lessee and lessor as a prepaid lease payment. The lessee includes this amount in the cost of its right-of-use asset at the lease commencement date. For the lessor, if the lease is classified as an operating lease, the prepaid lease payment is included in the total lease payments that are recognised as income on either a straight-line basis or another systematic basis if that basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished. If the lease is classified as a finance lease, the lessor includes the prepaid lease payment in the consideration for the lease (i.e. lease payments) and, therefore, in the determination of the gain or loss on derecognition of the underlying asset, if any.

Interest on the deposit is accounted for using the effective interest method by both the lessee and the lessor.

4.5.10 Value added tax and property taxes

When a lessee enters into a lease contract the lessor may be required to charge the lessee VAT in accordance with the local tax regulations. In many jurisdictions, the lessor charges VAT on behalf of the tax authority and payment is remitted to the tax authority. In circumstances when the VAT is the obligation of the lessee (i.e. not the lessor's obligation) the VAT charged is not a lease payment from the perspective of the lessor. From a lessee's perspective, typically the lessee only incurs a liability for the VAT when the lessor invoices the lease payment. In some cases VAT is not fully recoverable by the lessee, usually because either the activities of the lessee prohibit the recovery of VAT or recovery is prohibited due to the nature of the leased asset. Generally, we expect that lessees will not include VAT in lease payments in these situations. Non-recoverable VAT payments are in the scope of IFRIC 21 – Levies. See Chapter 26 at 6.8.

In some circumstances, a lessee may enter into a contract to lease property and the lessor is required to pay property taxes levied by a local government authority. The lease contract may specify that the lessee pays an additional amount to cover the lessors expected tax costs. Property tax that is reimbursable by the lessee to the lessor as the owner of the office building, according to the contract, does not transfer any goods or services to the lessee and as such it is not a separate component of the contract. Rather, it is part of the total consideration and should be allocated to the separately identified components of the contract. Unlike the non-recoverable VAT payments discussed above, the property tax reimbursable by the lessee to the lessor is not a collection of tax by the lessor on behalf of the tax authority. The obligation to pay the property tax rests with the lessor as the owner (regardless of whether the lessee ends up making any payments to the lessor). That is, the property tax is a cost of ownership and the lessee's payment to the lessor simply compensates the lessor for the use of the office building.

4.5.11 Reassessment of the lease liability

IFRS 16 contains specific requirements about how to remeasure the lease liability to reflect changes to the lease payments (see 5.4 below). A lessee recognises the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset. However, if the carrying amount of the right-of-use asset is reduced to zero and there is a further reduction in the measurement of the lease liability, a lessee recognises any remaining amount of the remeasurement in profit or loss. [IFRS 16.39].

4.5.12 Remeasurement by lessors

Lessors remeasure the lease payments upon a modification (i.e. a change in the scope of a lease, or the consideration for a lease that was not part of its original terms and conditions) that is not accounted for as a separate contract. See 6.4 below.

4.6.1 Determination of the incremental borrowing rate by a subsidiary with centralised treasury functions

Some groups maintain centralised treasury functions and all funding requirements for the group are managed by the parent entity. Under IFRS 16, subsidiaries participating in a centralised treasury function cannot default to their parent's incremental borrowing rate. Rather all facts and circumstances should be considered to determine the subsidiary/lessee's incremental borrowing rate. The existence of guarantees of the subsidiary's obligations may result in a rate that is similar to the parent's rate as if the parent had entered into the lease directly.

4.7.1 Directly attributable costs other than initial direct costs incurred by lessees

Certain costs associated with acquiring an asset within the scope of IAS 16 are required to be capitalised upon initial recognition. See Chapter 18 at 4.1. However, IFRS 16 does not address the accounting for lessees' costs incurred directly attributable to bringing a right-of-use asset to the location and condition necessary for it to be capable of operating in the manner intended by management. To the extent that costs related to acquiring a right-of-use asset are not subject to capitalisation under other IFRS (e.g. IAS 16), it remains to be seen in practice whether they are charged to profit or loss when incurred or capitalised by analogy to IAS 16. For example, a lessee may incur costs when leasing an asset, by paying a third party to ship the asset, prepare the site and install the underlying asset. We believe lessees may analogise to IAS 16 to determine if such costs can be capitalised.

5.1.1 Short-term leases

A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less. A lease that contains a purchase option is not a short-term lease. [IFRS 16 Appendix A].

The short-term lease exemption can be made by class of underlying asset to which the right of use relates. A class of underlying asset is a grouping of underlying assets of a similar nature and use in an entity's operations. [IFRS 16.8].

A lessee that makes this accounting policy election does not recognise a lease liability or right-of-use asset on its balance sheet. Instead, the lessee recognises the lease payments associated with those leases as an expense on either a straight-line basis over the lease term or another systematic basis. The lessee applies another systematic basis if that basis is more representative of the pattern of the lessee's benefit. [IFRS 16.6].

When determining whether a lease qualifies as a short-term lease, a lessee evaluates the lease term in the same manner as all other leases. That is, the lease term includes the non-cancellable term of the lease, periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option and periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option. As the determination is made at commencement date, a lease cannot be classified as short-term if the lease term is subsequently reduced to less than 12 months. In addition, to qualify as a short-term lease, the lease cannot include an option to purchase the underlying asset.

A lease that qualifies as a short-term lease at the commencement is a new lease if there is a lease modification or a change in a lessee's assessment of the lease term (e.g. the lessee exercises an option not previously included in the determination of the lease term). [IFRS 16.7]. The new lease is evaluated to determine whether it qualifies for the short-term exemption, similar to any other new lease.

The short-term lease accounting policy election is intended to reduce the cost and complexity of applying IFRS 16. However, a lessee that makes the election must make certain quantitative and qualitative disclosures about short-term leases (see 5.8.2 below).

Once a lessee establishes a policy for a class of underlying assets, all future short-term leases for that class are required to be accounted for in accordance with the lessee's policy. A lessee evaluates any potential change in its accounting policy in accordance with IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors.

5.1.2 Leases of low-value assets

Lessees can also make an election for leases of low-value assets, which can be made on a lease-by-lease basis. [IFRS 16.8]. A lessee that makes this accounting policy election does not recognise a lease liability or right-of-use asset on its statement of financial position. Instead, the lessee recognises the lease payments associated with those leases as an expense on either a straight-line basis over the lease term or another systematic basis. The lessee applies another systematic basis if that basis is more representative of the pattern of the lessee's benefit. [IFRS 16.6].

A lessee assesses the value of an underlying asset based on the value of the asset when it is new, regardless of the age of the asset being leased. [IFRS 16.B3]. The assessment of whether an underlying asset is of low value is performed on an absolute basis. Leases of low-value assets qualify for the exemption regardless of whether those leases are material to the lessee. The assessment is not affected by the size, nature or circumstances of the lessee. Accordingly, different lessees are expected to reach the same conclusion about whether a particular underlying asset is of low-value. [IFRS 16.B4]. At the time of reaching its decisions about the exemption, the IASB had in mind leases of underlying assets with a value, when new, of US$5,000 or less. [IFRS 16.BC100]. Examples of low-value assets include desktop and laptop computers, small items of office furniture, telephones and other low-value equipment [IFRS 16.B8] and excludes cars because a new car would typically not be of low value. [IFRS 16.B6].

An underlying asset can only be of low-value if both:

• the lessee can benefit from use of the assets on their own, or together with, other resources that are readily available to the lessee; and
• the underlying asset is not dependent on, or highly interrelated with, other assets. [IFRS 16.B5].

For example, an entity may lease a truck for use in its business and the lease includes the use of the tyres attached to the truck. To use the tyres for their intended purpose, they can only be used with the truck and therefore are dependent on, or highly interrelated with the truck. Therefore the tyres would not qualify for the low-value asset exemption.

A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value. [IFRS 16.B6].

An intermediate lessor who subleases, or expects to sublease an asset, cannot account for the head lease as a lease of a low-value asset. [IFRS 16.B7].

5.2.1 Right-of-use assets

At commencement date, a lessee measures the right-of-use asset at cost. [IFRS 16.23].

The cost of a right-of-use asset comprises:

• the amount of the initial measurement of the lease liability;
• any lease payments made at or before the commencement date, less any lease incentives received;
• any initial direct costs incurred by the lessee; and
• an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period. [IFRS 16.24].

A lessee recognises dismantling, removal and restoration costs above as part of the cost of the right-of-use asset when it incurs an obligation for those costs. A lessee applies IAS 2 – Inventories – to costs that are incurred during a particular period as a consequence of having used the right-of-use asset to produce inventories during that period. The obligations for such costs are recognised and measured applying IAS 37 – Provisions, Contingent Liabilities and Contingent Assets. [IFRS 16.25].

In certain retail property leases, a lessee may sign a lease contract with a lessor and also make a payment to the existing lessee in return for vacating the property. This is sometimes referred to as key money. The existing lessee is released from all obligations under the lease contract with the lessor (i.e. this is not a sublease arrangement). The new lessee also has the right to sell the lease contract to another party in exchange for payment, which would also release the new lessee from all obligations with the lessor. On initial recognition of the lease contract, the payment to the previous lessee is accounted for as an initial direct cost and is included in the measurement of the ROU asset. The payment is not in the scope of IAS 38. The new lessee applies the requirements described at 5.3.1 below to the subsequent measurement of the right-of-use asset.

5.2.2 Lease liabilities

At the commencement date, a lessee measures the lease liability at the present value of the lease payments that are not paid at that date. The lease payments are discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee uses the lessee's incremental borrowing rate. [IFRS 16.26].

At the commencement date, the lease payments included in the measurement of the lease liability comprise the following payments for the right to use the underlying asset during the lease term that are not paid at the commencement date:

• fixed payments (including in-substance fixed payments), less any lease incentives receivable;
• variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date;
• amounts expected to be payable by the lessee under residual value guarantees;
• the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
• payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. [IFRS 16.27].

5.3.1 Right-of-use assets

After the commencement date, a lessee measures the right-of-use asset applying a cost model, unless it applies either of the measurement models described at 5.3.1.B below. [IFRS 16.29].

5.3.2 Lease liabilities

After the commencement date, a lessee measures the lease liability by:

1. increasing the carrying amount to reflect interest on the lease liability;
2. reducing the carrying amount to reflect the lease payments made; and
3. remeasuring the carrying amount to reflect any reassessment or lease modifications specified, or to reflect revised in-substance fixed lease payments. [IFRS 16.36].

Interest on the lease liability in each period during the lease term is the amount that produces a constant periodic rate of interest on the remaining balance of the lease liability. The periodic rate of interest is the discount rate described at commencement, unless a reassessment requiring a change in the discount rate has been triggered. [IFRS 16.37].

5.3.3 Expense recognition

After the commencement date, the lessee recognises depreciation and impairment of the right-of-use asset in profit or loss, unless depreciation is permitted to be capitalised (e.g. to inventory) under other IFRS (or the lessee applies the fair value model described in at 5.3.1.B above).

A lessee also recognises in profit or loss, unless the costs are included in the carrying amount of another asset applying other IFRS, both:

1. interest on the lease liability; and
2. variable lease payments not included in the measurement of the lease liability in the period in which the event or condition that triggers those payments occurs. [IFRS 16.38].

When a lessee depreciates the right-of-use asset on a straight-line basis, the total periodic expense (i.e. the sum of interest and depreciation expense) is generally higher in the early periods and lower in the later periods. Because a constant interest rate is applied to the lease liability, the interest expense decreases as cash payments are made during the lease term and the lease liability decreases. Therefore, more interest expense is incurred in the early periods and less in the later periods. This trend in the interest expense, combined with straight-line depreciation of the right-of-use asset, results in a front-loaded expense recognition pattern. This expense pattern is consistent with the subsequent measurement of finance leases under IAS 17.

If a lessee determines that a right-of-use asset is impaired, it recognises an impairment loss and measures the right-of-use asset at its carrying amount immediately after the impairment. A lessee subsequently depreciates, generally on a straight-line basis, the right-of-use asset from the date of the impairment to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, the depreciation period is the remaining useful life of the underlying asset if the lessee is reasonably certain to exercise an option to purchase the underlying asset or if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term. See 5.6.1 below for additional discussion of impairment of right-of-use assets.

The following journal entries would be recorded in the first year:

5.5.1 Determining whether a lease modification results in a separate lease

A lessee accounts for a lease modification as a separate lease when both of the following conditions are met:

• the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
• the consideration for the lease increases commensurate with the stand-alone price for the increase in scope and any adjustments to that stand-alone price reflect the circumstances of the particular contract. [IFRS 16.44].

If both of these conditions are met, the lease modification results in two separate leases, the unmodified original lease and a separate new lease. Lessees account for the separate contract that contains a lease in the same manner as other new leases. If either of the conditions are not met, the modified lease is not accounted for as a separate lease (see 5.5.2 below).

5.5.2 Lessee accounting for a modification that does not result in a separate lease

For a lease modification that is not accounted for as a separate lease, at the effective date of the lease modification the lessee:

1. allocates the consideration in the modified contract;
2. determines the lease term of the modified lease; and
3. remeasures the lease liability by discounting the revised lease payments using a revised discount rate. The revised discount rate is determined as the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or the lessee's incremental borrowing rate at the effective date of the modification, if the interest rate implicit in the lease cannot be readily determined. [IFRS 16.45].

For a lease modification that is not accounted for as a separate lease, the lessee accounts for the remeasurement of the lease liability by:

1. decreasing the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease for lease modifications that decrease the scope of the lease. The lessee recognises in profit or loss any gain or loss relating to the partial or full termination of the lease; or
2. making a corresponding adjustment to the right-of-use asset for all other lease modifications. [IFRS 16.46].

IFRS 16 contains a number of illustrative examples on modifications, which are reproduced below. [IFRS 16.IE7].

At the effective date of the modification (at the beginning of Year 6), Lessee remeasures the lease liability on the basis of: (a) a three-year remaining lease term, (b) annual payments of CU150,000 and (c) Lessee's incremental borrowing rate of 7 per cent per annum. The modified liability equals CU393,647, of which (a) CU131,216 relates to the increase of CU50,000 in the annual lease payments from Year 6 to Year 8 and (b) CU262,431 relates to the remaining three annual lease payments of CU100,000 from Year 6 to Year 8.

Decrease in the lease term

At the effective date of the modification (at the beginning of Year 6), the pre-modification right-of-use asset is CU368,004. Lessee determines the proportionate decrease in the carrying amount of the right-of-use asset based on the remaining right-of-use asset balance for the original 2,000 square metres of office space (i.e. a remaining three-year lease term rather than the original five-year lease term). The remaining right-of-use asset for the original 2,000 square metres of office space is CU220,802 (i.e. CU368,004 ÷ 5 × 3 years).

At the effective date of the modification (at the beginning of Year 6), the pre-modification lease liability is CU421,236. The remaining lease liability for the original 2,000 square metres of office space is CU267,301 (i.e. present value of three annual lease payments of CU100,000, discounted at the original discount rate of 6 per cent per annum).

Consequently, Lessee reduces the carrying amount of the right-of-use asset by CU147,202 (CU368,004 – CU220,802), and the carrying amount of the lease liability by CU153,935 (CU421,236 – CU267,301). Lessee recognises the difference between the decrease in the lease liability and the decrease in the right-of-use asset (CU153,935 – CU147,202 = CU6,733) as a gain in profit or loss at the effective date of the modification (at the beginning of Year 6).

At the effective date of the modification (at the beginning of Year 6), Lessee recognises the effect of the remeasurement of the remaining lease liability reflecting the revised discount rate of 7 per cent per annum, which is CU4,870 (CU267,301 – CU262,431), as an adjustment to the right-of-use asset.

Increase in the leased space

At the commencement date of the lease for the additional 1,500 square metres of space (at the beginning of Year 6), Lessee recognises the increase in the lease liability related to the increase in scope of CU131,216 (i.e. present value of three annual lease payments of CU50,000, discounted at the revised interest rate of 7 per cent per annum) as an adjustment to the right-of-use asset.

The modified right-of-use asset and the modified lease liability in relation to the modified lease are as follows.

IFRS 16 Example 19 – Modification that is a change in consideration only

Lessee enters into a 10-year lease for 5,000 square metres of office space. At the beginning of Year 6, Lessee and Lessor agree to amend the original lease for the remaining five years to reduce the lease payments from CU100,000 per year to CU95,000 per year. The interest rate implicit in the lease cannot be readily determined. Lessee's incremental borrowing rate at the commencement date is 6 per cent per annum. Lessee's incremental borrowing rate at the beginning of Year 6 is 7 per cent per annum. The annual lease payments are payable at the end of each year.

At the effective date of the modification (at the beginning of Year 6), Lessee remeasures the lease liability based on: (a) a five-year remaining lease term, (b) annual payments of CU95,000, and (c) Lessee's incremental borrowing rate of 7 per cent per annum. Lessee recognises the difference between the carrying amount of the modified liability (CU389,519) and the lease liability immediately before the modification (CU421,236) of CU31,717 as an adjustment to the right-of-use asset.

In some cases, the lessee and lessor may agree to a modification to the lease contract that starts at a later date (i.e. the terms of the modification take effect at a date later than the date when both parties agreed to the modification). For example, a lessee enters into a lease arrangement with a lessor to lease an asset for 10 years. At the beginning of year 8 the lessee and lessor agree to a modification to the contract that will take effect from the beginning of year 9.

• If the modification is an increase in the scope that does not result in a separate lease, the lessee will re-allocate the consideration in the modified contract to each existing lease component and non-lease component and remeasure the lease liability at the date both parties agreed to the modification (the beginning of year 8).
• If the modification results in a separate lease component, the lessee will allocate the consideration in the modified contract to each existing and new lease and non-lease component at the date both parties agreed to the modification (the beginning of year 8). The lessee will remeasure the lease liability for the existing lease components at that date as well. However, recognition of the lease liability and right-of-use asset for any new lease component occurs at the commencement date of the new lease component (the beginning of year 9).
• If the modification is a decrease in the scope, the lessee will re-allocate the consideration in the modified contract to each existing lease and non-lease component and remeasure the lease liability and right-of-use asset at the effective date of the modification (the beginning of year 8).

5.6.1 Impairment of right-of-use assets

A lessee applies IAS 36 to determine whether the right-of-use asset is impaired and to account for any impairment loss identified. [IFRS 16.33].

IAS 36 requires an impairment indicator analysis at each reporting period. If any indicators are present, the entity is required to estimate the recoverable amount of the asset (or the cash-generating unit of which the asset is a part – the CGU). The entity has to recognise an impairment loss if the recoverable amount of the CGU is less than the carrying amount of the CGU. After an impairment loss is recognised, the adjusted carrying amount of the right-of-use asset would be its new basis for depreciation.

Subsequent reversal of a previously recognised impairment loss needs to be assessed if there is any indication that an impairment loss recognised in prior periods may no longer exist or may have decreased. In recognising any reversal, the increased carrying amount of the asset must not exceed the carrying amount that would have been determined after depreciation, had there been no impairment.

Lessees currently apply the same impairment analysis to assets held under finance leases. This analysis would be new for leases currently accounted for as operating leases and could significantly affect the timing of expense recognition.

5.6.2 Leases denominated in a foreign currency

Lessees apply IAS 21 – The Effects of Changes in Foreign Exchange Rates – to leases denominated in a foreign currency. As they do for other monetary liabilities, lessees remeasure the foreign currency-denominated lease liability using the exchange rate at each reporting date. Any changes to the lease liability due to exchange rate changes are recognised in profit or loss. Because the right-of-use asset is a non-monetary asset measured at historical cost, it is not affected by changes in the exchange rate.

The IASB acknowledged in the Basis for Conclusions that this approach could result in volatility in profit or loss from the recognition of foreign currency exchange gains or losses, but it will be clear to users of financial statements that the gains or losses result solely from changes in exchange rates. [IFRS 16.BC199].

5.6.3 Portfolio approach

IFRS 16 specifies the accounting for an individual lease. However, as a practical expedient, an entity may apply it to a portfolio of leases with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying IFRS 16 to the portfolio would not differ materially from applying it to the individual leases within that portfolio. If accounting for a portfolio, an entity uses estimates and assumptions that reflect the size and composition of the portfolio. [IFRS 16.B1].

A decision to use the portfolio approach would be similar to a decision some entities make today to expense, rather than capitalise, certain assets when the accounting difference is, and would continue to be, immaterial to the financial statements.

5.6.4 Income tax accounting

IFRS 16 could affect lessees' accounting for income taxes. For lessees, IFRS 16 requires recognition of lease-related assets and liabilities that could change the measurement of other lease-related assets and liabilities. These changes affect certain aspects of accounting for income taxes such as the following:

1. recognition and measurement of deferred tax assets and liabilities; and
2. assessment of the recoverability of deferred tax assets.

Deferred tax assets and liabilities are further discussed in Chapter 33 at 7 and 8.

5.8.1 Disclosure objective

The objective of the disclosures is for lessees to disclose information in the notes that, together with the information provided in the statement of financial position, statement of profit or loss and statement of cash flows, gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee. [IFRS 16.51].

A lessee discloses information about its leases for which it is a lessee in a single note or separate section in its financial statements. However, a lessee need not duplicate information that is already presented elsewhere in the financial statements, provided that the information is incorporated by cross-reference in the single note or separate section about leases. [IFRS 16.52].

5.8.2 Disclosures of assets, liabilities, expenses and cash flows

To meet the disclosure objective, IFRS 16 includes a number of required disclosures.

Paragraph 53 of IFRS 16 includes the following disclosure requirements for lessees, for the reporting period:

1. depreciation charge for right-of-use assets by class of underlying asset;
2. interest expense on lease liabilities;
3. the expense relating to short-term leases. This expense need not include the expense relating to leases with a lease term of one month or less;
4. the expense relating to leases of low-value assets. This expense does not include the expense relating to short-term leases of low-value assets included in paragraph (c) above;
5. the expense relating to variable lease payments not included in the measurement of lease liabilities;
6. income from subleasing right-of-use assets;
7. total cash outflow for leases;
8. additions to right-of-use assets;
9. gains or losses arising from sale and leaseback transactions; and
10. the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset. [IFRS 16.53].

A lessee provides the disclosures specified in paragraph 53, as shown above, in a tabular format, unless another format is more appropriate. The amounts disclosed include costs that a lessee has included in the carrying amount of another asset during the reporting period. [IFRS 16.54].

In Extract 32.1 below Deutsche Post presents disclosures of right-of-use assets in the notes to the accounts.

A lessee discloses the amount of its lease commitments for short-term leases if the portfolio of short-term leases to which it is committed at the end of the reporting period is dissimilar to the portfolio of short-term leases to which the short-term lease expense disclosed applying paragraph 53(c) of IFRS 16 relates. [IFRS 16.55].

If right-of-use assets meet the definition of investment property, a lessee applies the disclosure requirements in IAS 40. In that case, a lessee is not required to provide the disclosures in paragraph 53(a), (f), (h) or (j) of IFRS 16, for those right-of-use assets. [IFRS 16.56].

If a lessee measures right-of-use assets at revalued amounts applying IAS 16, the lessee discloses the information required by paragraph 77 of IAS 16 for those right-of-use assets. [IFRS 16.57]. Those disclosures include the effective date of the revaluation, whether an independent valuer was involved, the carrying amount of the class of asset that would have been recognised under the cost model and the revaluation surplus. These disclosures are discussed further in Chapter 18 at 8.2.

A lessee also discloses a maturity analysis of lease liabilities applying paragraphs 39 and B11 of IFRS 7 – Financial Instruments: Disclosures – separately from the maturity analyses of other financial liabilities. [IFRS 16.58]. The IASB indicated in the Basis for Conclusions to IFRS 16 that because the lessee accounting model is based on the premise that a lease liability is a financial liability, it is appropriate for lessees to apply the same maturity analysis disclosure requirements to lease liabilities as to those applied to other financial liabilities. [IFRS 16.BC222].

IFRS 16 requires disclosure of the total cash outflow for leases. [IFRS 16.53(g)]. It does not explicitly state that leases of low-value assets and short-term leases are excluded. Therefore, we believe the cash outflows related to those leases should be included in the disclosure.

5.8.3 Additional disclosures

In addition to the disclosures described above, a lessee may need to disclose additional qualitative and quantitative information about its leasing activities necessary to meet the disclosure objective discussed at 5.8.1 above. Specifically, additional information relating to variable lease payments, extension options or termination options and residual value guarantees that, depending on the circumstances, may be needed to satisfy the disclosure objective. The additional information may also include, but is not limited to, information that helps users of financial statements to assess:

1. the nature of the lessee's leasing activities;
2. future cash outflows to which the lessee is potentially exposed that are not reflected in the measurement of lease liabilities. This includes exposure arising from:
   1. variable lease payments;
   2. extension options and termination options;
   3. residual value guarantees; and
   4. leases not yet commenced to which the lessee is committed;
3. restrictions or covenants imposed by leases; and
4. sale and leaseback transactions. [IFRS 16.59].

In Extract 23.2 below Nestle describe the nature of its leasing activities.

In determining whether additional information about leasing activities is necessary to meet the disclosure objective, a lessee is required to consider:

1. whether that information is relevant to users of financial statements. A lessee shall provide additional information specified in paragraph 59 of IFRS 16 only if that information is expected to be relevant to users of financial statements. In this context, this is likely to be the case if it helps those users to understand:
   1. the flexibility provided by leases. Leases may provide flexibility if, for example, a lessee can reduce its exposure by exercising termination options or renewing leases with favourable terms and conditions;
   2. restrictions imposed by leases. Leases may impose restrictions, for example, by requiring the lessee to maintain particular financial ratios;
   3. sensitivity of reported information to key variables. Reported information may be sensitive to, for example, future variable lease payments;
   4. exposure to other risks arising from leases; and
   5. deviations from industry practice. Such deviations may include, for example, unusual or unique lease terms and conditions that affect a lessee's lease portfolio; and
2. whether that information is apparent from information either presented in the primary financial statements or disclosed in the notes. A lessee need not duplicate information that is already presented elsewhere in the financial statements. [IFRS 16.B48].

Additional information relating to variable lease payments that, depending on the circumstances, may be needed to satisfy the disclosure objective could include information that helps users of financial statements to assess, for example:

1. the lessee's reasons for using variable lease payments and the prevalence of those payments;
2. the relative magnitude of variable lease payments to fixed payments;
3. key variables upon which variable lease payments depend and how payments are expected to vary in response to changes in those key variables; and
4. other operational and financial effects of variable lease payments. [IFRS 16.B49].

Additional information relating to extension options or termination options that, depending on the circumstances, may be needed to satisfy the disclosure objective could include information that helps users of financial statements to assess, for example:

1. the lessee's reasons for using extension options or termination options and the prevalence of those options;
2. the relative magnitude of optional lease payments to lease payments;
3. the prevalence of the exercise of options that were not included in the measurement of lease liabilities; and
4. other operational and financial effects of those options. [IFRS 16.B50].

Optional lease payments are payments made by a lessee to a lessor for the right to use an underlying asset during periods covered by an option to extend or terminate a lease that are not included in the lease term. [IFRS 16 Appendix A].

Additional information relating to residual value guarantees that, depending on the circumstances, may be needed to satisfy the disclosure objective could include information that helps users of financial statements to assess, for example:

1. the lessee's reasons for providing residual value guarantees and the prevalence of those guarantees;
2. the magnitude of a lessee's exposure to residual value risk;
3. the nature of underlying assets for which those guarantees are provided; and
4. other operational and financial effects of those guarantees. [IFRS 16.B51].

5.8.4 Disclosures required by IAS 1

In addition to the disclosure requirements under IFRS 16 described above, an entity is required to make disclosures in accordance with IAS 1. An entity is required to disclose its significant accounting policies comprising:

1. the measurement basis (or bases) used in preparing the financial statements; and
2. the other accounting policies used that are relevant to an understanding of the financial statements. [IAS 1.117].

An entity discloses, along with its significant accounting policies or other notes, the judgements, apart from those involving estimations (see below), that management has made in the process of applying the entity's accounting policies and that have the most significant effect on the amounts recognised in the financial statements. [IAS 1.122]. An entity discloses information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of:

1. their nature, and
2. their carrying amount as at the end of the reporting period. [IAS 1.125].

There are a number of judgements and estimates that entities may make in applying IFRS 16, which may require disclosure in accordance with IAS 1. These include, but are not limited to, application of the definition of a lease, determination of the lease term and determination of the incremental borrowing rate.

6.1.1 Criteria for lease classification

The classification of leases is based on the extent to which the lease transfers the risks and rewards incidental to ownership of an underlying asset. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the underlying asset's economic life and of gain from appreciation in value or realisation of a residual value. [IFRS 16.B53].

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

1. the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
2. the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised;
3. the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;
4. at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and
5. the underlying asset is of such a specialised nature that only the lessee can use it without major modifications. [IFRS 16.63].

IFRS 16 does not provide quantitative indicators or thresholds for the assessment of the terms ‘major part’ and ‘substantially all’ to determine that a lease should be classified as a finance lease rather than as an operating lease. Under IFRS 16 entities apply qualitative, rather than quantitative assessments to determine whether the risks and rewards incident to ownership of a leased asset lie with the lessor or the lessee. Accordingly, assessing whether a lease term is for the major part of the economic life of an asset or whether the present value of the minimum lease payments amounts to at least substantially all of the fair value of a leased asset is a matter of judgement.

Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:

1. if the lessee can cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee;
2. gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
3. the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. [IFRS 16.64].

The examples and indicators above are not always conclusive. If it is clear from other features that the lease does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset, the lease is classified as an operating lease. For example, this may be the case if ownership of the underlying asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are variable lease payments, as a result of which the lessor does not transfer substantially all such risks and rewards. [IFRS 16.65].

In our view, other considerations that could be made in determining the economic substance of the lease arrangement include the following:

1. Are the lease rentals based on a market rate for use of the asset (which would indicate an operating lease) or a financing rate for use of the funds, which would be indicative of a finance lease?
2. Is the existence of put and call options a feature of the lease? If so, are they exercisable at a predetermined price or formula (indicating a finance lease) or are they exercisable at the market price at the time the option is exercised (indicating an operating lease)?

A lease contract may include terms and conditions to adjust the lease payments for particular changes that occur between the inception date and the commencement date (such as a change in the lessor's cost of the underlying asset or a change in the lessor's cost of financing the lease). In that case, for the purposes of classifying the lease, the effect of any such changes is deemed to have taken place at the inception date. [IFRS 16.B54].

6.1.2 Lease classification test for land and buildings

When a lease includes both land and buildings elements, a lessor assesses the classification of each element as a finance lease or an operating lease separately. In determining whether the land element is an operating lease or a finance lease, an important consideration is that land normally has an indefinite economic life. [IFRS 16.B55].

Whenever necessary in order to classify and account for a lease of land and buildings, a lessor allocates lease payments (including any lump-sum upfront payments) between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception date. If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease. [IFRS 16.B56].

For a lease of land and buildings in which the amount for the land element is immaterial to the lease, a lessor may treat the land and buildings as a single unit for the purpose of lease classification and classify it as a finance lease or an operating lease. In such a case, a lessor regards the economic life of the buildings as the economic life of the entire underlying asset. [IFRS 16.B57].

6.1.3 Residual value guarantees included in the lease classification test

In evaluating IFRS 16's lease classification criteria, lessors are required to include in the ‘substantially all’ test any (i.e. the maximum obligation) residual value guarantees provided by both lessees and any other third party unrelated to the lessor.

6.1.4 Reassessment of lease classification

Lease classification is made at the inception date and is reassessed only if there is a lease modification. Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the underlying asset), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes. [IFRS 16.66].

Lessors reassess lease classification as at the effective date of the modification using the modified conditions at that date. Lease modifications are discussed at 6.4 below. If a lease modification results in a separate new lease, that new lease would be classified in the same manner as any new lease. See 6.1.1 above.

6.2.1 Initial measurement

At lease commencement, a lessor accounts for a finance lease, as follows:

1. derecognises the carrying amount of the underlying asset;
2. recognises the net investment in the lease; and
3. recognises, in profit or loss, any selling profit or selling loss.

The lessor uses the interest rate implicit in the lease to measure the net investment in the lease. In the case of a sublease, if the interest rate implicit in the sublease cannot be readily determined, an intermediate lessor may use the discount rate used for the head lease (adjusted for any initial direct costs associated with the sublease) to measure the net investment in the sublease. [IFRS 16.68].

Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included in the initial measurement of the net investment in the lease and reduce the amount of income recognised over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs are included automatically in the net investment in the lease; there is no need to add them separately. [IFRS 16.69].

At the commencement date, the lease payments included in the measurement of the net investment in the lease comprise the following payments for the right to use the underlying asset during the lease term that are not received at the commencement date:

1. fixed payments (including in-substance fixed payments), less any lease incentives payable;
2. variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date;
3. any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee;
4. the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
5. payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. [IFRS 16.70].

6.2.2 Manufacturer or dealer lessors

At the commencement date, a manufacturer or dealer lessor recognises the following for each of its finance leases:

1. revenue being the fair value of the underlying asset, or, if lower, the present value of the lease payments accruing to the lessor, discounted using a market rate of interest;
2. the cost of sale being the cost, or carrying amount if different, of the underlying asset less the present value of the unguaranteed residual value; and
3. selling profit or loss (being the difference between revenue and the cost of sale) in accordance with its policy for outright sales to which IFRS 15 applies. A manufacturer or dealer lessor recognises selling profit or loss on a finance lease at the commencement date, regardless of whether the lessor transfers the underlying asset as described in IFRS 15. [IFRS 16.71].

Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor gives rise to profit or loss equivalent to that resulting from an outright sale of the underlying asset, at normal selling prices, reflecting any applicable volume or trade discounts. [IFRS 16.72].

Manufacturer or dealer lessors sometimes quote artificially low rates of interest in order to attract customers. The use of such a rate would result in a lessor recognising an excessive portion of the total income from the transaction at the commencement date. If artificially low rates of interest are quoted, a manufacturer or dealer lessor restricts selling profit to that which would apply if a market rate of interest were charged. [IFRS 16.73].

A manufacturer or dealer lessor recognises as an expense costs incurred in connection with obtaining a finance lease at the commencement date because they are mainly related to earning the manufacturer or dealer's selling profit. Costs incurred by manufacturer or dealer lessors in connection with obtaining a finance lease are excluded from the definition of initial direct costs and, thus, are excluded from the net investment in the lease. [IFRS 16.74].

6.2.3 Subsequent measurement

After commencement a lessor recognises finance income over the lease term, based on a pattern reflecting a constant periodic rate of return on the lessor's net investment in the lease. [IFRS 16.75]. A lessor aims to allocate finance income over the lease term on a systematic and rational basis. A lessor applies the lease payments relating to the period against the gross investment in the lease to reduce both the principal and the unearned finance income. [IFRS 16.76]. Thus, the lessor reduces the net investment in the lease for lease payments received (net of interest income calculated above).

The lessor also recognises income from variable payments that are not included in the net investment in the lease (e.g. performance or usage based variable payments) separately in the period in which the income is earned.

A lessor applies the derecognition and impairment requirements in IFRS 9 to the net investment in the lease. The lessor reviews regularly estimated unguaranteed residual values used in computing the gross investment in the lease. If there has been a reduction in the estimated unguaranteed residual value, the lessor revises the income allocation over the lease term and recognise immediately any reduction in respect of amounts accrued. [IFRS 16.77].

A lessor that classifies an asset under a finance lease as held for sale (or includes it in a disposal group that is classified as held for sale) applies IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations. [IFRS 16.78].

6.2.4 Remeasurement of the net investment in the lease

After lease commencement, the net investment in a lease is not remeasured unless:

• the lease is modified (i.e. a change in the scope of the lease, or the consideration for the lease, that was not part of the original terms and conditions of the lease) and the modified lease is not accounted for as a separate contract (see 6.4 below); or
• the lease term is revised when there is a change in the non-cancellable period of the lease (see 4.4 above).

6.4.1 Determining whether a modification to a finance lease results in a separate lease

A lessor accounts for a modification to a finance lease as a separate lease if both:

1. the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
2. the consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract. [IFRS 16.79].

If both of the conditions above are met, the lease modification results in two separate leases, the unmodified original finance lease and a separate lease. Lessors account for the separate lease in the same manner as other new leases. If either of the conditions is not met, the lease modification does not result in a separate lease.

6.4.2 Lessor accounting for a modification to a finance lease that does not result in a separate lease

For a modification to a finance lease that is not accounted for as a separate lease, a lessor accounts for the modification as follows:

1. if the lease would have been classified as an operating lease had the modification been in effect at the inception date, the lessor:
   1. accounts for the lease modification as a new lease from the effective date of the modification; and
   2. measures the carrying amount of the underlying asset as the net investment in the lease immediately before the effective date of the lease modification;
2. otherwise, the lessor applies the requirements of IFRS 9. [IFRS 16.80].

6.4.3 Modification to an operating lease

A lessor accounts for a modification to an operating lease as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease. [IFRS 16.87].

6.5.1 Portfolio approach

IFRS 16 specifies the accounting for an individual lease. However, as a practical expedient, an entity may apply it to a portfolio of leases with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying IFRS 16 to the portfolio would not differ materially from applying it to the individual leases within that portfolio. If accounting for a portfolio, an entity uses estimates and assumptions that reflect the size and composition of the portfolio. [IFRS 16.B1].

A decision to use the portfolio approach would be similar to a decision some entities already make to expense, rather than capitalise, certain assets when the accounting difference is, and would continue to be, immaterial to the financial statements.

6.7.1 Disclosure objective

The objective of the disclosures for lessors is to disclose information in the notes that, together with the information provided in the statement of financial position, statement of profit or loss and statement of cash flows, gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessor. [IFRS 16.89].

6.7.2 Disclosures for all lessors

A lessor discloses the following amounts for the reporting period:

1. for finance leases:
   1. selling profit or loss;
   2. finance income on the net investment in the lease; and
   3. income relating to variable lease payments not included in the measurement of the net investment in the lease;
2. for operating leases, lease income, separately disclosing income relating to variable lease payments that do not depend on an index or a rate. [IFRS 16.90].

The disclosures specified above are provided in a tabular format, unless another format is more appropriate. [IFRS 16.91].

A lessor discloses additional qualitative and quantitative information about its leasing activities necessary to meet the disclosure objective discussed at 6.7.1 above. This additional information includes, but is not limited to, information that helps users of financial statements to assess:

1. the nature of the lessor's leasing activities; and
2. how the lessor manages the risk associated with any rights it retains in underlying assets. In particular, a lessor discloses its risk management strategy for the rights it retains in underlying assets, including any means by which the lessor reduces that risk. Such means may include, for example, buy-back agreements, residual value guarantees or variable lease payments for use in excess of specified limits. [IFRS 16.92].

6.7.3 Disclosures for finance leases

A lessor provides a qualitative and quantitative explanation of the significant changes in the carrying amount of the net investment in finance leases. [IFRS 16.93].

A lessor discloses a maturity analysis of the lease payments receivable, showing the undiscounted lease payments to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessor reconciles the undiscounted lease payments to the net investment in the lease. The reconciliation must identify the unearned finance income relating to the lease payments receivable and any discounted unguaranteed residual value. [IFRS 16.94].

6.7.4 Disclosures for operating leases

For items of property, plant and equipment subject to an operating lease, a lessor applies the disclosure requirements of IAS 16. In doing so, the lessor disaggregates each class of property, plant and equipment into assets subject to operating leases and assets not subject to operating leases. Therefore, a lessor provides the disclosures required by IAS 16 for assets subject to an operating lease (by class of underlying asset) separately from owned assets held and used by the lessor. [IFRS 16.95].

A lessor applies the disclosure requirements in IAS 36, IAS 38, IAS 40 and IAS 41 for assets subject to operating leases. [IFRS 16.96].

A lessor discloses a maturity analysis of lease payments, showing the undiscounted lease payments to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. [IFRS 16.97].

8.2.1 Accounting for the sale

If the transfer of an asset by the seller-lessee satisfies the requirements of IFRS 15 to be accounted for as a sale of the asset:

1. the seller-lessee measures the right-of-use asset arising from the leaseback at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee. Accordingly, the seller-lessee recognises only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor; and
2. the buyer-lessor accounts for the purchase of the asset applying applicable Standards, and for the lease applying the lessor accounting requirements in this Standard. [IFRS 16.100].

Although not explicitly stated in IFRS 16, we believe that if the sale and leaseback transaction results in a loss to the seller-lessee, that loss will not be deferred. In addition, the seller-lessee may also need to consider whether this would require the asset to have been classified as held-for-sale under IFRS 5 (see Chapter 4) and hence subject to potential impairment prior to the transaction.

Entities that have sale and leaseback transactions will need to determine the gain or loss that relates to the rights transferred to the buyer-lessor in accordance with paragraph 100(a) of IFRS 16. Example 23.5 below is taken from IFRS 16 Illustrative Example 24 and shows a methodology for determining the gain on sale. The example assumes that the lease payments are fixed. This methodology seems to suggest that the gain or loss recognised up front may be based on the proportion of fixed payments, however, there is no further guidance in IFRS 16. Entities that have sale and leaseback transactions with variable lease payments will need to determine a methodology to determine the gain or loss in accordance with paragraph 100(a). It remains to be seen how practice will develop in this area.

8.2.2 Accounting for the leaseback

When a sale occurs, both the seller-lessee and the buyer-lessor account for the leaseback in the same manner as any other lease, with adjustments for off-market terms. Specifically, a seller-lessee recognises a lease liability and right-of-use asset for the leaseback (subject to the optional exemptions for short-term leases and leases of low-value assets).

8.2.3 Adjustment for off-market terms

The sale transaction and the ensuing lease are generally interdependent and negotiated as a package. Consequently, some transactions could be structured with a negotiated sales price that is above or below the asset's fair value and with lease payments for the ensuing lease that are above or below the market rates. These off-market terms could distort the gain or loss on the sale and the recognition of lease expense and lease income for the lease. To ensure that the gain or loss on the sale and the lease-related assets and liabilities associated with such transactions are neither understated nor overstated, IFRS 16 requires adjustments for any off-market terms of sale and leaseback transactions, on the more readily determinable basis of the difference between the fair value of the consideration for the sale and the fair value of the asset and the difference between the present value of the contractual payments for the lease and the present value of payments for the lease at market rates. [IFRS 16.102]. An entity is required to account for any below-market and above-market terms as a prepayment of lease payments and additional financing provided by the buyer-lessor to the seller-lessee, respectively. [IFRS 16.101].

IFRS 16 defines fair value solely for the purpose of applying lessor accounting requirements but not for the purpose of applying sale and leaseback accounting in the standard. [IFRS 16 Appendix A]. Since IFRS 16 does not address fair value outside of lessor accounting, we believe it is appropriate to look to IFRS 13 – Fair Value Measurement, for sale and leaseback accounting (i.e. for determining the fair value of the asset sold and determining the resulting gain or loss), given IFRS 13 is also applicable to the measurement of fair value under IFRS 15. The IASB also acknowledged this linkage between IFRS 13 and IFRS 15 in IFRS 16's Basis for Conclusion paragraph 266.

10.3.1 Full retrospective approach

Under the full retrospective approach, an entity applies IFRS 16 as if it had been applied since the inception of all lease contracts that are presented in the financial statements. If the standard was applied at 1 January 2019, this means that, in the 31 December 2019 financial statements, the comparative period to 31 December 2018 (assuming that this is the only comparative period presented) must have been restated. A restated opening balance sheet at 1 January 2018 would also need to have been disclosed as required by IAS 1.

10.3.2 Modified retrospective approach

When applying the modified retrospective approach, a lessee does not restate comparative figures. Instead, a lessee recognises the cumulative effect of initially applying IFRS 16 as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of initial application. [IFRS 16.C7].

10.4.1 Subleases

An intermediate lessor (an entity that is both a lessee and a lessor of the same underlying asset):

• reassesses subleases that were classified as operating leases applying IAS 17 and are ongoing at the date of initial application, to determine whether each sublease should be classified as an operating lease or a finance lease. The intermediate lessor performs this assessment at the date of initial application on the basis of the remaining contractual terms and conditions of the head lease and sublease at that date; and
• for subleases that were classified as operating leases applying IAS 17 but finance leases applying IFRS 16, account for the sublease as a new finance lease entered into at the date of initial application. [IFRS 16.C15].

10.5.1 Sale and leaseback transactions

An entity does not reassess sale and leaseback transactions entered into before the date of initial application to determine whether the transfer of the underlying asset satisfies the requirements in IFRS 15 to be accounted for as a sale. [IFRS 16.C16].

If a sale and leaseback transaction was accounted for as a sale and a finance lease applying IAS 17, the seller-lessee:

• accounts for the leaseback in the same way as it accounts for any other finance lease that exists at the date of initial application; and
• continues to amortise any gain on sale over the lease term. [IFRS 16.C17].

If a sale and leaseback transaction was accounted for as a sale and operating lease applying IAS 17, the seller-lessee:

• accounts for the leaseback in the same way as it accounts for any other operating lease that exists at the date of initial application; and
• adjusts the leaseback right-of-use asset for any deferred gains or losses that relate to off-market terms recognised in the statement of financial position immediately before the date of initial application. [IFRS 16.C18].

10.5.2 Amounts previously recognised in a business combination

If a lessee previously recognised an asset or liability applying IFRS 3 relating to favourable or unfavourable terms of an operating lease acquired as part of a business combination, the lessee derecognises that asset or liability and adjusts the carrying amount of the right-of-use asset by a corresponding amount at the date of initial application. [IFRS 16.C19]. As discussed at 10.5 above, this paragraph applies to all entities. Therefore, even when an entity applies the standard retrospectively (in accordance with IFRS 16.C5(a)), the acquirer does not reopen the purchase price allocation for a business combination, but rather goes back to the date of acquisition of the acquiree and determines the lease liability and right of use asset as if the lease were a new lease at that date.

10.5.3 References to IFRS 9

If an entity applies IFRS 16 but does not yet apply IFRS 9, any reference in IFRS 16 to IFRS 9 should be read as a reference to IAS 39 – Financial Instruments: Recognition and Measurement. [IFRS 16.C20].