ICAJ IFRS workshop IFRS 16 – Leasing Presenter – Tricia- Ann Smith ICAJ IFRS workshop IFRS 16 – Leasing Presenter – Tricia- Ann Smith DaSilva

The new lease standard – all started with a plane! “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.” Sir David Tweedie Chairman of the IASB (25 April 2008) “… approximately $1.25 trillion in non-cancelable future cash obligations committed under operating leases …. are not recognized on issuer balance sheets…” SEC 2005 The Economist, Jan 21st 2012

IFRS 16 – and now it is flying? January 2016: Final standard Effective date: 1 January 2019 (earlier adoption in conjunction with IFRS 15 permitted)

What you need to know: Lessees have to show a lease liability for almost every lease contract so there will be a huge impact on KPIs (eg. EBIT/EBITDA; debt to equity ratio) Lessee has to identify each lease contract Clients need to put in place systems and processes to capture information/determine measurement Clients need to communicate the effect of the new standard to the outside world …. 2019 is not that far away!

What has changed? Q1: “Under IFRS 16 lessees have to recognise a lease liability for every lease contract” There are exemptions for short-term leases and leases of low-value assets Yes No

Be aware of new disclosures! What has changed? Q2: “Under IFRS 16 lessor accounting stays substantially the same” Yes Be aware of new disclosures! No

They are taken into account if they are in substance fixed! What has changed? Q3: “Under IFRS 16 lease payments that are not based on an index or a rate are never part of the lease liability.” They are taken into account if they are in substance fixed! Yes No

Overview – what it’s all about! Agenda Overview – what it’s all about! Definition of a lease Lessee accounting

Line item in which underlying asset would be presented Overview Right-of- use asset Lease liability Lessee Balance sheet Lessee recognises right- of-use asset and lease liability for almost all lease contracts Exemptions for short- term leases and leases of low-value assets Separate line item or Line item in which underlying asset would be presented Depreciation in accordance with IAS 16 (straight-line or another systematic basis)

Overview Lessee Income statement Depreciation and amortisation Depreciation expense on the right-of-use asset Finance cost Interest expense on the lease liability Lessee recognises right- of-use asset and lease liability for almost all lease contracts IAS 17 (operating lease) IFRS 16

Depending on entities’ policy for interest payments Overview Lessee Statement of cash flows Lessee recognises right- of-use asset and lease liability for almost all lease contracts Cash flows from operating activities Cash payments for the interest portion of the liability Short-term lease payments Payments for leases of low value assets Variable lease payments not included in lease liability Cash flows from financing activities Depending on entities’ policy for interest payments Cash payments for the principal portion of the liability Cash payments for the interest portion of the liability

Overview Finance lease Lessee Operating lease Lessor accounting stays substantially the same as under current guidance Lease receivable Balance sheet Lessee Operating lease Leased asset Balance sheet Right-of- use asset Lease liability Balance sheet

Overview Lessor accounting stays substantially the same as under current guidance Lessee recognises right-of-use asset and lease liability for almost all lease contracts Exemptions for short-term leases and leases of low- value assets Enhanced disclosure requirements Effective date 1 January 2019 Comprehensive guidance on the defintion of a lease Huge impact on KPI (debt/equity ratio; EBIT/EBITDA/ operating cash flow) Earlier application permitted (together with IFRS 15)

Overview – what it’s all about! Agenda Overview – what it’s all about! Definition of a lease Lessee accounting

Definition of a lease Lessee is NOT required to reassess contracts entered into before date of initial application! 1 no Is there an identified asset? yes 2 Does the customer have the right to obtain substantially all of the economic benefits from the use of the asset throughout period of use ? no yes 3 Who has the right to direct how and for what purpose the asset is used throughout the period of use ? Customer Predetermined Supplier 3A no Comment: In part the criteria as in the flowchart are shortened; flowchart has to be read together with the explanations on the previous slides. yes Customer operates the asset or has designed the asset? Contract contains a lease Contract does not contain a lease

Definition of a lease 1 Is there an identified asset? yes No identified asset if supplier has substantive right to substitute asset Practical ability (right to substitute; assets are readily available) Economic benefit Identified asset can be specified explicitly (e.g. serial number) or implicitly XY - 35255 Contracts does not contain a lease

Definition of a lease Primary output and any by-products 1 Is there an identified asset? yes 2 no Does the customer have the right to obtain substantially all of the economic benefits from the use of the asset throughout period of use ? yes 3 Who has the right to direct how and for what purpose the asset is used throughout the period of use ? Primary output and any by-products Payments from third parties relating to use of asset (e.g. renewable energy credit resulting from use of a solar farm) Excludes: Benefits relating to ownership of asset Contract does not contain a lease

Definition of a lease 3 Who has the right to direct how and for what purpose the asset is used throughout the period of use ? Right to direct how and for what purpose asset is used throughout period of use Protective rights of the supplier do not prevent the customer from having right to direct the use Customer Predetermined Supplier 3A no yes Customer operates the asset or has designed the asset? Contract contains a lease Contract does not contain a lease

Questions We will now review several scenarios and I want you to indicate based on the fact pattern whether the contract contains a lease

Concession space Coffee company enters into contract with airport operator to use space to sell goods for three-year period. Contract states exact amount of space and that the space must be located at any one of several boarding areas within the airport. Airport operator can change location at any time; minimal costs to airport operator associated with doing so. Does the contract contain a lease? Identified asset? Substantially all of the economic benefits? Right to direct the use? Substantive substitution right! no n/a n/a The contract does not contain a lease.

  Solar farm (1/2) See next slide Contract to purchase all electricity produced by new solar farm for 20 years; solar farm is explicitly mentioned in the contract; no substitution rights Customer designed solar farm before it was constructed Supplier is responsible for building solar farm to Customer’s specifications, and then operating it Supplier will receive tax credits relating to construction/ownership of the solar farm, while Customer receives renewable energy credits Relate to ownership Relate to use Does the contract contain a lease? Identified asset? Substantially all of the economic benefits? Right to direct the use?   See next slide

 Solar farm (2/2) predetermined n/a The contract contains a lease. Contract to purchase all electricity produced by new solar farm for 20 years; solar farm is explicitly mentioned in the contract; no substitution rights Customer designed solar farm before it was constructed Supplier is responsible for building solar farm to Customer’s specifications, and then operating it Supplier will receive tax credits relating to its construction /ownership of the solar farm, while Customer receives renewable energy credits Right to direct the use? How and for what purpose? Customer operates the asset? Customer has designed the asset? predetermined n/a  The contract contains a lease.

   Retail unit The contract contains a lease. Contract conveys exclusive use of explicitly specified retail unit Supplier can require Customer to move to another unit; several similar units are available Supplier benefits from relocating only if there is a new tenant that pays a certain rate; it is possible that these circumstances arise but not likely Customer makes all decisions about use of retail unit throughout period of use Payments: fixed component plus percentage of sales Does the contract contain a lease? Identified asset? Substantially all of the economic benefits? Right to direct the use? Substitution right is not substantive!    The contract contains a lease.

Network services n/a n/a no The contract does not contain a lease. Customer enters into contract with Supplier for network services for 2 years; supplier supplies network services that meet a specified quality level. Supplier installs and configures servers at Customer’s premises to supply services. Supplier determines speed/quality of data transportation and can reconfigure/replace servers when needed to continuously provide the network services. Customer does not operate servers or make any significant decisions about their use. Does the contract contain a lease? Identified asset? Substantially all of the economic benefits? Right to direct the use? n/a n/a no The contract does not contain a lease.

Recognition and measurement exemptions Short-term leases Lease term of 12 months or less (may include periods covered by options) Accounting policy choice (by class of underlying assets) Reassessment in case of modification or change in lease term Only applicable for lessee Low value assets Assets with a value, when new, of USD 5,000 or less Accounting policy choice (lease-by-lease basis) Only applicable for lessee

Portfolio approach Lease contracts with similar characteristics and No material effect Portfolio approach permitted for lessee and lessor

Overview – what it’s all about! Agenda Overview – what it’s all about! Definition of a lease Lessee accounting

Lease payments made before or at commencement date Lessee accounting Right-of-use asset Lease liability Lease liability Lease payments Discount rate Lease payments made before or at commencement date Provision Restoration costs Initial direct costs

Lease payments during the lease term Fixed payments + Variable lease payments See next slide + Residual value guarantees Expected payments lessee has to make + Exercise price of a purchase option the lessee is reasonably certain to exercise the option if + Penalties for terminating the lessee is reasonably certain to exercise the termination option if

Lessee accounting In-substance fixed payments Variable lease payments dependent on …. rate/index other variable e.g. inflation/ interest rate or market rental rates e.g. passengers on a plane e.g. payments made only if asset is proven capable of operating Part of lease liability Not part of lease liability Part of lease liability

Lessee accounting Change in index/rate used to calculate variable lease payments Entity enters into 10-year lease contract Annual lease payments of $50,000; payable at the beginning of the year Lease payments increase every two years to reflect change in Consumer Price Index (CPI); at the commencement date CPI is 125 Commencement date Beginning of second year CPI = 130 Beginning of third year CPI = 135 New lease payment: $54,000 ($50,000 × 135 / 125) Lease liability reflects nine payments of CU 50,000 Lease liability remeasured to reflect eight payments of $54,000 No reassessment as the change has not affected payments Cash flows change = Reassessment!

How do options affect lease payments? Termination penalties Exercise price of a purchase option Extension/termination/purchase options affect the lease term Contractual terms Leasehold improvements Market rates “reasonably certain to exercise” Importance of underlying asset

Subsequent measurement Lease liability Right-of-use asset Interest expense Lease payment Depreciation

Question Fact Pattern Air Jam leases a plane for a term of five years. The payments are as follows: Fixed annual payment of GBP 5,000,000 each year covering 1,800 hours of operation For each additional hour of operation the lessee must pay GBP 2,000; the lessee expects to use the plane for 250 hours each month (3,000 hours for the year) Lease payments adjusted for changes in UK CPI after three years. Index is expect to increase by 10% during that time (i.e. the CPI currently is 100, after three years it is expected to be 110)

Question Guaranteed value of plane after 3 years GBP 35,000,000 while the expected value is GBP 30,000,000 Customer can extend the lease term for another five years after initial period Lease payments during the extension will remain unchanged Identifying a new plane that is suitable for the airlines operations will result in significant costs If the lease term is extended the residual value guarantee will be dispensed What is the lease payment the lessee has to incorporate when calculating the lease liability?

Lease payments (annually) Variable lease payments Debriefing Lease payments (annually) Fixed payments GBP 5,000.000 Payments depending on the use of the underlying asset are not taken into account Variable lease payments Variable payments for hours of operation exceeding 1,800 Adjustment for inflation

Debriefing Lease term includes the extension period (lessee reasonably certain to exercise option) Total lease payments Payments during the non-cancelable period  GBP 25,000,000  Payments during the extension period GBP 25,000,000 Residual value guarantees GBP 50,000,000 Residual value guarantee will be dispensed if the lease term is extended

Overview Lessor accounting stays substantially the same as under current guidance Lessee recognises right-of-use asset and lease liability for almost all lease contracts Exemptions for short-term leases and leases of low- value assets Enhanced disclosure requirements Effective date 1 January 2019 Comprehensive guidance on the defintion of a lease Huge impact on KPI (debt/equity ratio; EBIT/EBITDA/ operating cash flow) Earlier application permitted (together with IFRS 15)

Have a good flight!