The current standard IAS 17 differentiates leases between finance and operating dependent on certain characteristics.
The new standard IFRS 16 will come into effect for periods commencing after 1st January 2019. Leases will no longer be distinguished between finance and operating. Read on to understand the changes, or fill out our quick contact form if you have questions about how this will affect you that you would rather chat about over the phone.
Finance Lease
A finance lease in substance means all of the risks and rewards of the assets have been transferred to the lessee.
Indicators of a finance lease are:
- The lease transfers ownership to the lessee by the end of the lease term
- The lessee has the option to purchase the asset at a price expected to be sufficiently lower than its fair value (i.e. market price)
- The lease term is for the major part of the asset’s useful economic life
- At inception, the present value of minimum lease payments is substantially all of the fair value of the asset
- The asset is of a specialist nature such that only the lessee can use it without major modification
The non-current asset is then recognised at the lower of fair value and present value of minimum lease payments.
The asset is depreciated over the shorter of the lease term or its useful economic life.
Lastly, the liability is recognised at amortised cost.
Operating Lease
The definition of an operating lease is that it is not a finance lease i.e. the terms of the lease contain none of the indicators outlined above.
Lease payments are recognised in the profit and loss over a straight line basis and any incentives are spread over the life of the lease.
The only disclosure of operating leases is a note to the accounts showing the split of outstanding payments between less than 1 year, 2 to 5 years and more than 5 years.
Land and Building Leases
Land and building leases must be split into their separate component parts and treated accordingly.
Land is usually treated as an operating lease due to its indefinite useful economic life whereas the treatment of the building element is dependent on the lease terms.
IFRS 16. What’s changing?
The new standard IFRS 16 will come into effect for periods commencing after 1st January 2019. Leases will no longer be distinguished between finance and operating.
On commencement of the lease, the lessee recognises two things; a right of use asset and a lease liability.
The right of use asset is calculated as:
- Initial liability
- Plus payments made before commencement
- Plus direct costs
- Plus dismantling costs
- Less incentives received
The lease liability is measured as an obligation, very similar to IAS 17. The initial measurement is the present value of future cash flows discounted at the rate implicit in the lease.
However, if the lease is for less than 12 months or if it is of low value, a company can choose to record payments on a straight line basis to the profit and loss over the lease term.
Egan Roberts Chartered Accountants and Financial Advisers Ribchester, Lancashire.
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