TFRS 16 largely retains the definition of a lease in TAS 17 but changes the guidance on how to apply it. This refinement was necessary, as the removal of ‘off-balance sheet’ operating leases created a greater need for distinguishing between a lease and a service contract.
TFRS 16 defines a lease as "a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”. A contract can be (or contain) a lease only if the underlying asset is 'identified'. Having the right to control the use of the identified asset requires having the right to:
- obtain all of the economic benefits from use of the identified asset; and
- direct the use of the identified asset.
Applying the new definition therefore requires three key evaluations.
- Is there an identified asset?
- an asset is 'identified' if it is explicitly specified in the contract, or implicitly specified when made available to the customer
- as asset is not identified if the supplier has a substantive right to substitute another asset
- a physically distinct portion of an asset can be an identified asset but a portion of an asset's capacity cannot
- Does the customer have the right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use?
- considers direct and indirect benefits such as using, holding, or sub-leasing the asset
- considers only the economic benefits within the defined scope of a customer’s rights to use an asset
- Does the customer have the right to direct the use of the identified asset throughout the period of use?
- normally present if the customer has the right to decide how and for what purpose the asset is used
- if relevant decisions about use of the asset are predetermined, the customer has control if (i) has the right to operate the asset; or (ii) designed the asset (or aspects of it) in a way that predetermines its use
Determining who has control over the use of the underlying asset is important. In a lease, the 'customer' has control, whereas in a service contract the supplier has control over the use of the underlying asset.
The main impact of the new lease definition in practice will be on contracts that are not in the legal form of a lease, but involve the use of a specific asset and therefore might contain a lease. Currently, this evaluation is based on TFRIC 4. TFRS 16 replaces TFRIC 4 with new guidance that differs in some respects.
One of the changes from TFRIC 4 is the relevance of pricing when evaluating whether a contract to supply goods or services contains a lease. Under TFRIC 4, such contracts do not contain leases if the unit price paid by the customer is either fixed or at fair value at the time of delivery. TFRS 16 does not include this 'pricing exemption'. As a result, some contracts that do not contain a lease today may fall under TFRS 16, and vice versa. If a contract contains a lease, the lease component is accounted for on-balance sheet in the same way as a standalone lease (unless it is a short-term or low-value asset lease).
Subject to the optional accounting simplifications for short-term and low-value asset leases,
a lessee will be required to recognise all of its leases on the balance sheet. This involves recognising:
- a 'right-of-use' asset; and
- a lease liability
Under TFRS 16, the lease liability is accounted for similarly to a financial liability using the effective interest method. The right-of-use asset is accounted for similarly to a purchased asset and depreciated or amortised.
While total expense recognised over the lease term for an individual lease will be the same as the TAS 17 accounting for off-balance sheet leases, the total expense recognised in any individual reporting period will be different. Under TFRS 16, the expense recognition would generally be 'front-loaded'. This is because the depreciation of the lease asset will typically be recognised on a straight-line basis, while the interest expense generally decreases over the lease term as the lease liability decreases. However, when a company has a portfolio of leases that is constantly evolving, with leases expiring and new leases being added, there may be relatively little effect on profit or loss through the application of TFRS 16.
Let's take a closer look at the measurement requirements for the lease liability and the right-of-use asset. As mentioned earlier, the lessee recognises a lease liability and a right-of-use asset.
The liability is initially measured at the present value of future lease payments. For this purpose, lease payments include fixed, non-cancellable payments for lease elements, amounts due under residual value guarantees, certain types of contingent payments, and amounts due during optional periods that are 'reasonably certain'. Termination penalties are included if the lease term reflects the exercise of a termination option.
The lease liability does not include:
- payments for non-lease elements (unless the practical expedient permitting non-separation of non-lease elements is applied)
- payments in optional extension periods unless extension is 'reasonably certain'
- future changes in variable payments that depend on an index or rate
- variable payments linked to the lessee's future sales or usage of the underlying asset
The discount rate is the rate implicit in the lease, if readily determinable. If not, the lessee’s incremental borrowing rate is used.
In subsequent periods, the right-of-use asset is accounted for similarly to a purchased asset. The lease liability is accounted for similarly to a financial liability.
In general, the accounting is similar to today's accounting for finance leases.
Let's now have a brief look at TFRS 16's guidance on variable lease payments and lease modifications.
The accounting for variable lease payments depends on the nature of the variability. Payments that vary based on an index or rate are included in lease payments for classification and measurement purposes based on the prevailing index or rate at the measurement date. The lease liability is re-measured when the index or rate changes and the lease payments are revised. Note that the revised lease payments for the reminder of the lease term are determined based on the revised contractual payments.
Payments that vary based on future usage of the leased asset are not included in lease payments for classification and measurement purposes. However, variable payments that are in-substance fixed payments are included in the lease payments.
TFRS 16’s requirements for lessor accounting are fairly similar to TAS 17’s. In particular:
- the distinction between finance and operating leases is retained
- the definitions of each type of lease, and the supporting indicators of a finance lease, are substantially the same as TAS 17’s
- the basic accounting mechanics are also similar, but with some different or more explicit guidance in a few areas. These include variable payments, sub-leases, lease modifications, the treatment of initial direct costs, and lessor disclosures