IFRS

IFRS 9 was issued in 2014 and replaced the notoriously complex requirements of IAS 39 Financial Instruments: Recognition and Measurement. It was mandatorily effective for accounting periods beginning on or after 1 January 2018. 

Whilst the adoption of IFRS 9 significantly impacted financial institutions, many non-financial institutions were also materially affected by the changes.

— Initial measurement 

— Financial Assets

— Financial Liabilities

— Hedge accounting

IFRS 9 - financial instruments: overview

Initial measurement 

Financial instruments are initially measured at fair value, adjusted for transaction costs in some cases. The only exception to this is trade receivables that do not contain a significant financing component, as defined by IFRS 15.  These are measured at the transaction price.

Financial Assets

IFRS 9 categorises all financial assets within its scope into two: those measured at amortised cost and those measured at fair value with changes in fair value either recognised in profit and loss (FVPL) or other comprehensive income (FVOCI).

A financial asset that meets the following conditions must be measured at amortised cost, unless the asset is irrevocably designated at fair value through profit and loss to eliminate an accounting mismatch:

a. Business model test – objective of the entity’s business model is to hold the financial asset to collect contractual cash flows; and

b. Cash flow characteristics test - its contractual terms must give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

A financial asset that meets the following conditions must be measured at fair value through other comprehensive income (FVOCI), unless the asset is irrevocably designated at fair value through profit and loss to eliminate an accounting mismatch:

a. Business model test – financial asset is held within the business model whose objective is achieved by both collecting contractual cash flows and selling financial assets; and

b. Cash flow characteristics test - the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding

Note that for both instances above, assessment of whether contractual cash flows are solely payments of principal and interest is made in the currency in which the financial asset is denominated.

Any financial asset that does not qualify for amortised cost measurement or measurement at FVOCI must be subsequently measured at fair value through profit or loss (FVPL), except if it is an investment in an equity instrument designated at FVOCI. At initial recognition, an entity may make an irrevocable election to present subsequent changes in the fair value of an investment in an equity instrument (that is not held for trading, nor contingent consideration recognised by an acquirer in a business combination) in other comprehensive income.

Impairment

IFRS 9 applies an ‘expected loss’ model which requires the recognition of an allowance for losses based on expected credit losses. 

Financial instruments that are in scope of the impairment requirements are as follows:

• financial assets measured at amortised cost or debt instruments measured at FVOCI;
• lease receivables under IFRS 16 Leases;
• contract assets recognised under IFRS 15 Revenue;
• loan commitments not measured at FVPL; and
• financial guarantee contracts not measured at FVPL and in scope of IFRS 9

IFRS 9 establishes 2 approaches for measuring impairment losses:

• the simplified approach applicable to trade receivables, contract assets and lease receivables; and
• the general approach applicable to all other in scope instruments

General approach

The measurement of the loss allowance under this approach depends on whether there has been a significant increase in credit risk in respect of the financial asset since initial recognition.

If the credit risk has not significantly increased, the loss allowance is measured at amount equal to the 12-month expected credit losses. This equates to the expected credit losses that result from default events on the instrument that are possible within 12 months of the reporting date.

If the credit risk has significantly increased, the loss allowance is measured at amount quality to the lifetime expected credit losses.  This equates to the expected credit losses that result from all possible default events over the expected life of a financial instrument.

Simplified approach

This must be used to measure loss allowances in respect of trade receivables and contract assets which do not contain a significant financing component.  However, this approach is optional for trade receivables and contract assets which contain a significant financing component as well as lease receivables.

The simplified approach measures the loss allowance at an amount equal to lifetime expected credit losses.

The expected credit loss is the weighted average of credit losses with the respective risks of default occurring as the weights.  The measurement should reflect:

• an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes;
• the time value of money; and
• reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions.

Whilst an entity need not necessarily identify every possible scenario it must consider the risk or probability that a credit loss occurs by reflecting the possibility that a credit loss occurs and the possibility that no credit loss occurs, even if the possibility of a credit loss occurring is very low whether on an individual or collective basis. 

IFRS 9 imposes a restriction on the maximum period that can be considered when measuring expected credit losses as the maximum contractual period (including extension options) over which the entity is exposed to credit risk and not a longer period, even if that longer period is consistent with business practice. 

However, where the financial instrument includes both a loan and an undrawn commitment component and the entity’s contractual ability to demand repayment and cancel the undrawn commitment does not limit the entity’s exposure to credit losses to the contractual notice period, the expected credit losses are measured over the period that the entity is exposed to credit risk and expected credit losses would not be mitigated by credit risk management actions, even if that period extends beyond the maximum contractual period. 

Derecognition

A financial asset is derecognised when and only when the contractual rights to the asset’s cash flows expire, or the asset is transferred, and the transfer qualifies for derecognition. 

Reclassification

Reclassifications of financial assets will only arise when an entity changes its business model for managing financial assets and therefore it is not a choice. 

If a reclassification is appropriate, it must be applied prospectively following the change in business model. This means that previously recognised gains, losses (including impairment gains or losses) or interest are not restated. 

Financial Liabilities

Subsequent measurement

Financial liabilities are measured at amortised cost except those that are measured at fair value through profit and loss (FVPL) which include:

• Financial liabilities classified as held for trading and derivative liabilities that are not designated as effective hedging instruments;
• Financial liabilities that arise when a transfer of a financial assets does not qualify for derecognition or when continuing involvement approach applies;
• Financial guarantee contracts;
• Commitments to provide a loan at below-market interest rate; and 
• Contingent consideration recognised by an acquirer in a business combination to which IFRS 3 applies.

Designation at Fair Value

IFRS 9 includes an option to designate financial liabilities at FVPL when:

• doing so eliminates an ’accounting mismatch’ i.e., significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases; or
• a group of financial liabilities or financial assets and financial liabilities are managed and their performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity's key management personnel.

The FVPL option is also allowed when a financial liability contains one or more embedded derivatives that are not closely related to the non-derivative host contract and sufficiently modifies the cash flows.

Embedded Derivatives in financial liability host contracts

A hybrid contract is a non-derivative host contract with a derivative component embedded within it. The effect being that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

For instruments where the economic characteristics and risks of the embedded derivative are not closely related to those of the host and a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative, the host and the embedded derivative should be treated as separate instruments unless the combined instrument has been designated as FVPL.

Derecognition

A financial liability is derecognised when and only when it is extinguished i.e. when the obligation specified in the contract is discharged, cancelled or expires.

Complexity arises when an exchange of instruments between an existing borrower and lender occurs.  The accounting treatment depends on whether the terms of the agreement are substantially different or substantially modified.  Where this is the case, the original liability is derecognised, and the new liability is recognised.  The difference between the carrying value of original liability and the consideration paid is recognised in profit or loss including any costs or fees incurred.  When the terms of the new arrangement are not substantially different, any costs or fees incurred are adjusted against the carrying value of the liability and amortised over the remaining term of the liability.

The 10% test

The original drafting of IFRS 9 did not provide any guidance or definition as to what constituted “substantially different or modified”.  However, the application guidance to IFRS 9 was updated as part of the Annual Improvements to IFRS Standards project in May 2020 to clarify that the terms would be substantially different if the net present value of the cash flows under the new liability, including any fees paid and received is at least 10% different from the net present value of the remaining cash flows of the existing liability, both discounted at original effective interest rate.

The amendment became effective for periods commencing on or after 1 January 2022.

Hedge accounting

The objective of hedge accounting is to represent in the financial statements, the effect of risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss or OCI.

Hedge accounting is an accounting policy choice and whilst it may be avoided due to the complexity involved, if done correctly, is a technique that modifies the normal basis for recognising gains and losses arising on hedging instruments and hedged items meaning they are offset in the same accounting period thereby eliminated or reducing volatility in performance.

IFRS 9 sets out 3 different types of hedge and the associated accounting treatment of each as follows:

• Fair value hedge 

The hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

• Cash flow hedge

The hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable-rate debt) or a highly probable forecast transaction and could affect profit or loss.

• Hedge of a net investment in foreign operations (under IAS 21)

To qualify for hedge accounting certain criteria must be met including:

• the hedging relationship must consist of eligible hedging instruments and eligible hedged items;

• formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy must be in place at the inception of the hedging relationship;

• the hedging relationship meets certain hedge effectiveness requirements.

Hedge accounting must apply throughout the duration of the hedge unless the qualifying criteria is no longer met.  In such circumstances hedge accounting must be discontinued prospectively.

How RSM can help

RSM has the experience and the expertise to help:

• interpret and apply the requirements of the Standard, the impact on tax cash flows and distributable profits;
• assess the available options for the presentation of fair value gains or losses, the impact these will have and the actions that will need to be taken;
• value your financial instruments; and
• assess whether hedge accounting could be applied and if so develop procedures for measuring hedge effectiveness. 

For more information on IFRS 9, please get in touch with your usual RSM contact.

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IFRS 15 became effective for periods commencing on or after 1 January 2019.  It provides accounting requirements for all revenue arising from contracts with customers and replaced all of the legacy revenue standards and interpretations including IAS 18 Revenue, IAS 11 Construction Contracts, 

SIC 31 Revenue – Barter Transactions Involving Advertising Services and IFRIC 13 Customer Loyalty Programmes and IFRIC 18 – Transfers of Assets from Customers. 

—  Step 1: identify the contract(s) with a customer

—  Step 2: identify the performance obligations in the contract

—  Step 3: determine the transaction price

—  Step 4: allocate the transaction price to the performance obligations in the contract

—  Step 5: recognise revenue when (or as) the entity satisfies a performance obligation

—  How we can help

IFRS 15 Revenue from contracts with customers: overview

The core principle of IFRS 15 is that an entity recognises revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

IFRS 15 sets out five key steps:

Step 1: identify the contract(s) with a customer

A contract with a customer will be within the scope of IFRS 15 if all the following conditions are met:

• the contract has been approved by the parties to the contract;
• each party’s rights in relation to the goods or services to be transferred can be identified;
• the payment terms for the goods or services to be transferred can be identified;
• the contract has commercial substance; and
• it is probable that the consideration to which the entity is entitled to in exchange for the goods or services will be collected.

Some contracts with customers may have no fixed duration and can be terminated or modified by either party at any time. Other contracts may automatically renew on a periodic basis that is specified in the contract.

A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties). A contract is wholly unperformed if both of the following criteria are met:

• the entity has not yet transferred any promised goods or services to the customer; and
• the entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.

Step 2: identify the performance obligations in the contract

Once a contract is established, the next step is to assess whether there are goods or services promised in the contract that represent separate performance obligation, which can be either:

• a good or service (or bundle of goods or services) that is ‘distinct’; or
• a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Goods and services are “distinct” if both of the following are met:

• the customer can benefit from the good or services on its own or in conjunction with other readily available resources; and 
• the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.

In assessing whether the promises to transfer goods or services are separately identifiable, the following factors can be used:

• the entity provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted;
• one or more of the goods or services significantly modifies or customises, or are significantly modified or customised by, one or more of the other goods or services promised in the contract;
• The goods or services are highly interdependent, or highly interrelated.

Step 3: determine the transaction price

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding those amounts collected on behalf of third parties (e.g. some sales taxes). It may include fixed amounts, variable amounts, or both. 

If the consideration includes a variable amount, an estimate of the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer should be made.

In determining the transaction price, adjustment for the effects of time value of money should be considered if the timing of payments agreed by both parties provided a significant benefit of financing the transfer of goods or services. Any non-cash consideration or promise of non-cash consideration are measured at fair value.

Any consideration payable to the customer is accounted for as a reduction of the transaction price and therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service that the customer transfers to the entity. Any variable element of consideration payable is also estimated.

Step 4: allocate the transaction price to the performance obligations in the contract

If there are multiple performance obligations identified (or distinct good or service), the transaction price is allocated to each performance obligation identified in the contract generally done in proportion to the stand-alone selling prices.

Stand-alone selling price

The stand-alone selling price is the price at which an entity would sell a promised good or service separately to a customer. The best evidence of a stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers. If a stand-alone selling price is not directly observable, an estimation of the stand-alone selling price is required at an amount that would result in the allocation of the transaction price meeting the allocation objective. Some suitable methods used for estimating stand-alone selling price include:

• Adjusted market assessment approach – this approach might include referring to prices from competitors for similar goods or services and adjusting the price to reflect the entity’s own costs and margins.
• Expected cost plus margin – forecast of expected costs of satisfying a performance obligation and then add the appropriate margin.
• Residual approach – this involves estimating the stand-alone selling price by reference to the total transaction price less the sum of the observable stand-alone selling prices of other goods or services promised in the contract. This method is only used if an entity sells the same goods or services to different customers (at or near the same time) for a broad range of amounts (i.e. the selling price is highly variable) or an entity has not yet established a price for the good or service and it has not been previously sold on a stand-alone basis. 

After the inception of the contract, the transaction price can change for various reasons, including the resolution of uncertain events or other changes in circumstances. Other than for a contract modification, any subsequent changes to the transaction price are allocated to the performance obligations on the same basis as at contract inception. The transaction price is not reallocated to reflect changes in stand-alone selling prices after contract inception. Amounts allocated to a satisfied performance obligation are recognised as revenue, or as a reduction of revenue, in the period in which the transaction price changes.

Step 5: recognise revenue when (or as) the entity satisfies a performance obligation

Revenue is recognised when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to the customer. An asset is transferred when (or as) the customer obtains control of that asset.

Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. When evaluating whether a customer obtains control of an asset, any agreement to repurchase the asset should also be considered.

The determination of satisfaction of performance obligation is performed at inception of the contract.

Performance obligations satisfied over time

An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time, if one of the following criteria is met:

• the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
• the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; or
• the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

For each performance obligation satisfied over time, revenue is recognised over time by measuring the progress towards complete satisfaction of that performance obligation. The objective is to depict an entity’s performance in transferring control of goods or services promised to a customer (i.e. the satisfaction of an entity’s performance obligation).

A single method of measuring progress for each performance obligation satisfied over time should be applied and should be consistently applied to similar performance obligations and in similar circumstances. At the end of each reporting period, progress towards complete satisfaction of a performance obligation satisfied over time should be remeasured.

Appropriate methods of measuring progress include output methods and input methods. In determining the appropriate method for measuring progress, consideration of the nature of the good or service that the entity promised to transfer to the customer should be made.

Whilst there is no preferable measure of progress, in the Basis for Conclusions, the IASB stated that conceptually an output measure is the most faithful depiction of an entity’s performance because it directly measures the value of the goods or services transferred to the customer.  However, it discussed two output methods that may not be appropriate. Units of delivery and units of production may not result in the best depiction of an entity’s performance over time if there is material work in progress at the end of the reporting period.  

In these cases, these output methods would distort the entity’s performance because it would not recognise revenue for the customer-controlled assets that are created before delivery or before construction is complete.  The IASB also noted that these methods may also not be appropriate if the contract provides both design and production services because each item produced “may not transfer an equal amount of value to the customer” because it is likely that units produced earlier will have a higher value attracted to them than those that are produced later.

Performance obligations satisfied at a point time

If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time. 

To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, an entity should consider the requirements of the standard in assessing whether control has been transferred to the customer.  

Contract costs

IFRS 15 provided guidance on how to account for costs associated with a contract and distinguishes between:

• the cost of obtaining a contract – expensed as incurred unless these are explicitly chargeable to the customer irrespective of whether the contract is obtained; and
• the cost of fulfilling a contract – recognised as an asset if and only if, the costs relate directly to a contract or to an anticipated contract that the entity can specifically identify, the costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future and the costs are expected to be recovered.

Presentation and Disclosure

Contracts with customers will be presented in the statement of financial position as a contract asset or a contract liability, depending on the relationship between the entity’s performance and the customer’s payment.

If a customer pays consideration, or an entity has a right to an amount of consideration that is unconditional (ie a receivable), before the entity transfers a good or service to the customer, the entity shall present the contract as a contract liability when the payment is made or the payment is due (whichever is earlier). A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.

If an entity performs by transferring goods or services to a customer before the customer pays consideration or before payment is due, the entity shall present the contract as a contract asset, excluding any amounts presented as a receivable. An entity shall assess a contract asset for impairment in accordance with IFRS 9. An impairment of a contract asset shall be measured, presented, and disclosed on the same basis as a financial asset that is within the scope of IFRS 9.

Disclosure requirements include qualitative and quantitative information about the following:

• its contracts with customers;
• the significant judgements, and changes in the judgements made in applying this Standard to those contracts; and
• any assets recognised from the costs to obtain or fulfil a contract with a customer

Other required disclosures include judgments and changes in the judgment made in applying IFRS 15 that significantly affect the determination of the amount and timing of revenue from contracts with customers. In particular, the judgements, and changes in the judgements, used in determining both of the following:

• the timing of satisfaction of performance obligations; and
• the transaction price and the amounts allocated to performance obligations

How we can help

RSM has the experience and expertise to:

• guide you through IFRS 15, highlighting where key judgements will be required and making you aware of practical alternatives (eg valuing customer options) if you are applying IFRS 15 for new / modified contract terms.

In addition, if you are a first-time adopter of the standard we can:

• compare and contrast the requirements of IFRS 15 with existing accounting policies if you are applying IFRS 15;
• develop an implementation plan that will ensure a smooth and cost-effective transition and, if required, assist in project managing the implementation;
• support you in the data capture of your contracts, processing and presentation of the results;
• explain the transition methods and practical expedients available when implementing IFRS 15, together with their comparative advantages and disadvantages and the disclosure implications; and
• assist in reviewing material prepared for communication with stakeholders about the impact of implementing IFRS 15, including the costs of the implementation process.

For more information on IFRS 15, please get in touch with your usual RSM contact.

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IFRS 16 became effective for periods commencing on or after 1 January 2019 eliminating off balance sheet accounting by lessees in respect of their operating leases. In most cases, this resulted in the recognition of a lease liability on the balance sheet (reflecting the present value of the future rental payments) and a corresponding asset referred to as a 'right of use' asset. 

IFRS 16 applies to all leases except:

• Leases to explore for or use of mineral oils, natural gas and similar non-regenerative resources;
• Leases of biological assets (IAS 41) held by lessee;
• Service concession arrangements under IFRS 12;
• Licences of intellectual property granted by lessor under IFRS 15; and
• Rights held by a lessee under licensing agreements under IAS 38, which include motion picture films, video recordings, plays, manuscripts, patents and copyrights.

IFRS 16 does provide an exemption in respect of short-term leases and leases for which the underlying asset has a low value should the lessee choose to elect not to apply the recognition requirements.  In these circumstances, 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. 

— Arrangements containing a lease

— Lessee accounting

— How we can help

Arrangements containing a lease

Assessment of whether a contract contains a lease is done at inception of the contract and only reassessed if the terms and conditions of the contract change. In many cases, the assessment will be straightforward.  However, in some circumstances the assessment may require judgement and determining whether the contract conveys the right to direct the use of an identified asset may be challenging particularly for contracts that contain significant services.

When a non-lease component exists or an arrangement contains a lease, this should be accounted for separately. The Standard (paragraphs B32-B33) provides detailed guidance on separating this component of the contract. However, as a practical expedient, an election by the lessee may be made, by class of underlying asset, not to separate non-lease components from lease components and instead account for all components as a lease. 

Lessee accounting

At commencement of the lease, the lessee recognises a right of use asset (ROUA) and lease liability.

Initial measurement

The lease liability is measured at the present value of the future lease payments that are not paid at the commencement date of the lease less any incentives receivable.  These payments include fixed payments (including in-substance fixed payments and variable payments that depend on an index or a rate initially measuring using the index or rate at the commencement date. Additional payments may also need to be adjusted for such as amounts expected to be paid under a residual guarantee, the exercise price of a purchase option where the lessee is reasonably certain that such option will be exercised and any termination penalties if the lease term reflects a lessee’s option to exercise a termination right.  

The lease payments are discounted using the interest rate implicit in the lease, if that rate can be readily determined. If not, the incremental borrowing rate is used.

The right-of-use asset is initially measured at the amount of the lease liability plus any lease payments made at or before commencement of the lease plus any initial direct costs incurred by the lessee. Adjustments for lease incentives, restoration obligations and other similar obligations may also be required. 

Subsequent measurement 

The carrying value of the lease liability is subsequently remeasured to reflect the:

• interest on the lease liability;
• lease payments made;
• impact of lease modifications or revisions due to in-substance fixed lease payment

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 applied at commencement, unless a reassessment requiring a change in the discount rate has been triggered.

After the commencement date, a lessee remeasures the lease liability to reflect changes to the lease payments and adjusts the carrying amount of the ROUA accordingly.

The lease liability is remeasured by discounting the revised lease payments using a revised discount rate, if: 

• there is a change in the lease term; or 
• there is a change in the assessment of an option to purchase the underlying asset.

The revised discount rate applied is the rate implicit in the lease for the remainder of the lease term or if that rate cannot be readily determined, the incremental borrowing rate at the date of reassessment. After lease commencement, a lessee shall measure the right-of-use asset using a cost model, unless:

• the ROUA is an investment property and the lessee fair values its investment property under IAS 40; or
• the ROUA relates to class of property, plant and equipment accounted for under IAS 16’s revaluation model

Under the cost model the ROUA is depreciated over the earlier of:

• the lease term; and
• the useful life of the underlying asset

The only exception to this is where legal ownership of the asset is transferred to the lessee at the end of the lease term, or the cost of the ROUA reflects the lessee’s right to exercise a purchase option. In these circumstances the ROUA is depreciated over the useful live of the asset.

The lease term is the non-cancellable period of the lease, which includes:

• 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 

Expense recognition

Depreciation and impairment of the ROUA is recognised in profit or loss unless it is permitted to be capitalised under another IFRS.

In addition, the interest on the lease liability and variable lease payments not included in the measuring of the lease liability in the period in which the event or condition that triggers those payments occurs, is also recognised in profit or loss unless the costs are capitalised under another IFRS.

Lease modifications

A lease modification is a change in the scope of the lease or the consideration for a lease, that was not part of the original terms and conditions of the lease.  Examples include extending or shortening the contractual term of the lease.

Lease modifications are initially reassessed to evaluate whether the contract still meets the definition of a lease or contains a lease.  If a lease continues to exist, the modification can result in:

• a separate lease; or
• a change in the accounting for the existing lease.

The original contract and the modification are accounted for separately if both:

• 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 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.

If these conditions are not met the lessee remeasures the lease liability by discounting the revised lease payments using a revised discount rate.

Lessor

IFRS 16 did not substantially change the lessor accounting model applied under IAS 17. The main changes arose from consequential changes made to the lessee accounting model.  Notwithstanding this, the accounting for subleases, initial direct costs and lessor disclosures did change with the introduction of IFRS 16.

Finance or operating lease?

At the inception of the lease a lessor classifies a lease as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Otherwise, it is classified as operating lease.

Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

• the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
• 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;
• the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;
• 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
• the underlying asset is of such a specialised nature that only the lessee can use it without major modifications.

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.

Finance Leases

At the commencement date, a lessor recognises assets held under a finance lease in its statement of financial position and presents them as a receivable at an amount equal to the net investment in the lease.

Net investment in the lease is defined as “the gross investment in the lease discounted at the rate implicit in the lease”.  The gross investment is the sum of the receivable lease payments and any unguaranteed residual value accruing to the lessor.   

In case of sublease, if the implicit rate cannot be determined, an intermediate lessor may use the discount rate used for the head lease adjusted for any initial indirect costs associated. 

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.  The lease payments are applied against the gross investment in the lease to reduce both the principal and the unearned finance income.

The same definition of a lease modification is applied to lessors and lessees.  The evaluation process is also the same to determine if a separate lease should be recognised or if it should be accounted for as a change to the existing lease.

Modifications that do not meet the criteria to be accounted for as a separately lease should be accounted for as follows:

• if the lease would have been classified as an operating lease had the modification been in effect at the inception date, the lease modification is accounted for as a new lease from the effective date of the modification and measures the carrying amount of the underlying asset as the net investment immediately before the effective date of the lease modification; 
• otherwise, the modification requirements of IFRS 9 are applied.

The derecognition and impairment requirements of IFRS 9 also apply to finance leases. 

Operating Leases

The net investment in the lease is not recognised on the balance sheet.  Instead, the underlying asset continues to be recognised and accounted for in accordance with the applicable accounting standard.  The lease payments are recognised as income on a straight-line basis unless another systematic basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished.

Lease modifications

A modification to an operating lease is accounted for 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.

Sale and Leaseback transactions

In determining whether the transfer of an asset is to be accounted for as a sale, the principles of IFRS 15 should be applied to determine when a performance obligation is satisfied. If control of an underlying asset passes to the buyer-lessor, the transaction is accounted for as a sale or purchase of the asset and a lease.  IFRS 15 provides the following as indicators of the transfer of control:

• the entity has a present right to payment for the asset;
• the customer has legal title to the asset;
• the entity has transferred physical possession of the asset;
• the customer has the significant risks and rewards of ownership of the asset
• the customer has accepted the asset.

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:

• the seller-lessee shall measure 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 shall recognise only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.
• the buyer-lessor shall account for the purchase of the asset applying applicable Standards, and for the lease applying the lessor accounting requirements in this Standard.

If the fair value of the sale consideration does not equal the asset’s fair value, or if the lease payments are not market rates, the sales proceeds are adjusted to fair value, either by accounting for prepayments or additional financing. A seller-lessee subsequently measures lease liabilities arising from a leaseback in a way that it does not recognise any amount of the gain or loss that relates to the right of use it retains.

If a transfer does not satisfy the requirements of IFRS 15 to be accounted for as a sale, the seller-lessee continues to recognise the transferred asset.  The transferred proceeds are recognised as a financial liability and accounting for in accordance with IFRS 9.

How we can help

RSM has the experience and expertise to:

• help you understand the impact on your financial statements and your business if you are applying IFRS 16 for the first-time;
• assess the impact of new leasing arrangements or modifications on your key performance measures, loan and employee agreements; and
• identify, collate and analyse the data required to help you determine what financing decisions, if any, you need to make.

In addition, if you are a first-time adopter of the standard we can:

• develop an implementation plan to ensure a smooth and cost-effective transition and project manage the implementation process;
• assess whether your existing systems will be able to cope and advise on a selection of software vendors;
• establish an appropriate business process and system of internal control; and
• assess the impact of any modifications to the lease terms and how they will be accounted for.

For more information on IFRS 16, please get in touch with your usual RSM contact.