IFRS 16: Transition for lessees

IFRS 16 is effective for periods beginning on or after 1 January 2019. Entities may early adopt the standard, but if they elect to do so, they must also adopt IFRS 15 Revenue from Contracts with Customers as there can be significant interactions between the two standards. Companies incorporated in the European Union cannot early adopt IFRS 16 until it has been endorsed, which at the time of writing is expected in quarter 4 of 2017.

Significant transitional exemptions and simplifications are available to entities.

An entity is permitted to follow one of two approaches in adopting IFRS 16: the full retrospective approach or the modified retrospective approach. For entities with significant lease arrangements it will be important to give due consideration to which transition method is followed as each method will likely result in a significantly different impact on reported financial position and financial performance.

Practical expedients relating to recognition and measurement within the core body of the standard (e.g. the recognition exemptions relating to low value assets and short term leases and the expedient relating to the separation of lease components in a contract) are available to entities applying either transition approach.

Full retrospective approach

This approach requires entities to apply the provisions in IFRS 16 retrospectively in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. This means:

For all leases held at the date of transition the recognition and measurement provisions of IFRS 16 are applied in full;
Comparative financial information is restated; and
An adjustment is made to equity at the beginning of the earliest period presented.

Only limited transitional relief is available whereby an entity may assess the existence of a lease using either IFRS 16 or IAS 17 Leases and IFRIC 4 Determining whether an arrangement contains a lease (i.e. grandfather across the definition for existing contracts).

Modified retrospective approach

The modified retrospective approach does not require restatement of comparative periods. Instead the cumulative impact of applying IFRS 16 is accounted for as an adjustment to equity at the start of the current accounting period in which it is first applied, known as the ‘date of initial application’.

The below diagram summarises the approach:

There are numerous practical expedients available to entities applying this approach. On a lease-by-lease basis, a lessee may:

Apply a single discount rate to a portfolio of leases with reasonably similar characteristics
Rely on its assessment of whether a lease is onerous by applying IAS 37 immediately before the date of initial application
Not recognise leases whose term ends within 12 months of the date of initial application
Exclude initial direct costs from the measurement of the Right of Use (ROU) asset at the date of initial application
Use hindsight such as in determining the lease term if the contract contains options to extend or terminate the lease.

An entity may also grandfather across the definition of a lease from IAS 17 and IFRIC 4.

What does this mean in practice?

When the IASB issued IFRS 16 they allowed 3 years for implementation, with good reason. For an entity with a large number of leases the number of different transition options is significant. As a starting point we would recommend:

Developing a transition group with buy-in from senior management and, if relevant, the Audit Committee.
Understanding the needs of stakeholders/investors – how important is comparable data?
Modelling the different transition options using high level assumptions and/or focusing on the largest lease contracts that are likely to have the biggest impact
Considering the implementation costs of each approach
Developing a timeline through to the implementation date
Liaising with your auditor.

In next month’s Business Edge we will further consider the practical expedients available under the modified retrospective approach.