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IFRS 16 – lease and perpetual usufruct arrangements

In this post we will answer some common questions on how to recognize and manage lease and perpetual usufruct arrangements to ensure compliance with IFRS 16. We will explain the steps involved in the valuation of assets and liabilities for different types of contracts.

IFRS 16 – basic assumptions

The role of IFRS 16 is to ensure the comparability of financial statements through uniform treatment of different uses of assets. What it means in practice is that businesses can choose from a range of asset financing methods without affecting the values shown in their financial statements. The standard therefore standardizes the way the value of assets, liabilities, and costs of fixed assets and intangible assets is reported.

 

Expert commentary

Agnieszka Dziedziela
Agnieszka DziedzielaBiegła rewidentka, Ekspert ds. konsolidacji i sprawozdawczości finansowej we FlexiSolutions
When it comes to contract identification, the first thing we need to do when dealing with an agreement is to recognize it and consider whether the contract meets the characteristics of a lease and should be accounted for under IFRS 16.

We need to ask ourselves: does this contract give us the right to control the use of the asset that has been provided to us? Do we actually have control? Can the assets be easily identified? Are they clearly specified in the contract? Does the lessor retain a substantive right to substitute the asset? Are we dealing with multi-element contracts, and if so, how do we separate each lease component — should we account for them individually? And, if the contract changes in subsequent periods, should we reassess it again to determine if it still qualifies as a lease under IFRS 16?

These are key criteria that, generally speaking, any accountant can handle. But it’s worth reflecting on the process of how such contracts are identified. In practice, there can be a large number of these agreements. Typically, the accountant is the person who sees them last. The worst scenario is when they only surface at period-end closing. Then there’s stress and a heavy workload, because suddenly five to ten contracts need to be analyzed to determine if they should be recognized as leases under IFRS 16.

My recommendation is to think carefully about how to structure the process so that contracts are identified and reviewed well in advance, ensuring they are properly assessed for lease recognition under IFRS 16.

IFRS 16 requires the value of assets and liabilities to be presented in a specific manner to improve the comparability of financial results. Here’s how it works:

Assets under IFRS 16

The leased property is recognized at the value of discounted future recurring payments as the gross value of a fixed asset (equal to the value of the liability) at the commencement of the contract and gradually depreciated over its useful life.

Liabilities under IFRS 16

The liabilities side of the balance sheet reflects the discounted value of future lease payments. If easily determinable, the internal interest rate implicit in the lease is used as the discount rate. Alternatively, it is possible to use the marginal borrowing rate, i.e. the interest on a bank loan that the entity would have to take out to finance the purchase of assets.

Profit and loss account

Under IFRS 16 rules, companies do not recognize lease payments directly as expenses. Therefore, there are no costs of “third-party services”. What is recognized as expenses under IFRS 16 is the depreciation of the fixed asset and the interest accrued on the lease payment.

Thanks to this method of reporting leases and perpetual usufruct arrangements, the company’s operating profit (e.g. EBITDA, i.e. net income minus depreciation, amortization, interest and income tax) will be comparable regardless of the chosen method of asset financing (loan, lease, long-term lease).

Machinery and equipment leases under IFRS 16

IFRS 16 applies to, among other things, leases of means of transport, machinery and other equipment.

Lease contracts for that kind of property often include a fixed payment schedule with fixed monthly or quarterly lease payments. The contract may specify the applicable interest rate that can serve as the discount rate for lease valuation under IFRS 16.

What to consider when valuing a machinery or equipment lease according to IFRS 16

  • When valuing a liability, it is necessary to take into account not only lease payments, but also other payments, including the buyout price.
  • In the case of long-term lease contracts with a non-lease component, the additional services need to be properly categorized.
  • It is essential to accurately determine the economic useful life of a fixed asset as it is important for calculating depreciation, especially when the lease agreement provides for the transfer of title and the anticipated life of the asset extends beyond the lease term.

Commercial space and land leases under IFRS 16

Real property lease agreements meet the presentation requirements under IFRS 16. Companies that apply the International Accounting Standards in preparing their financial statements must present leases of office or commercial space or land leases in accordance with the requirements of IFRS 16.

Space leases are therefore governed by the same rules as asset leases. Rent payments due under the lease agreement are not recognized directly as lease expenses. The initial value of the liability is determined as the discounted value of future lease payments.

 

What is reported in financial statements is the gross value and depreciation of the land or building, as well as the liability underIFRS 16 – lease and perpetual usufruct arrangements IFRS 16, broken down into a long- and short-term portion. Depreciation and interest are charged to the profit and loss account.

What to consider when valuing a real property lease according to IFRS 16

  • Periodic rent indexation and its impact on the revaluation of the liability and the fixed asset.

  • Recognizing incentives received from the lessor as amounts that increase the value of the fixed asset, but do not affect the amount of liability under IFRS 16.

  • Proper recognition of indefinite term lease contracts (setting and updating the expected termination date for IFRS 16 valuation purposes).

  • Converting the payment schedule according to the current FX rate for lease contracts denominated in foreign currencies.

  • Adopting an appropriate discount rate for determining the value of a liability under IFRS 16 lease agreement.

  • Making adjustments for changes in the lease terms (longer or shorter lease term, increased or reduced lease space) and recognizing the changes in the records of assets, liabilities and in the profit and loss account.

Perpetual usufruct under IFRS 16

The right of perpetual usufruct of land also meets the IFRS 16 reporting criteria. As with lease arrangements, companies must recognize an asset and a liability.

In theory, when valuing perpetual usufruct rights under IFRS 16 it should not be a problem to discount the stream of annual payments. Nevertheless, in practice, the monthly reporting of the valuation result poses a challenge for many companies.

Potential difficulties in the valuation of perpetual usufruct of land under IFRS 16

  • With significant impact on the value of fixed assets and liabilities, the discounting of annual payments planned across more than 50 years can make a difference of several million in the IFRS 16 balance. Even minor differences or errors in valuation can significantly impact financial statements.

  • Calculating the IFRS 16 amounts on a monthly basis. Payments for perpetual usufruct rights are made once a year, usually in March. For a contract to be properly reported at end year it is necessary to calculate the amount of interest accrued since the last payment and the sum of depreciation expenses for the financial year. The results of simplified calculations based on aggregate annual data will differ from monthly calculations.

Software designed to facilitate lease and perpetual usufruct reporting under IFRS 16

There is no doubt that the implementation of a financial reporting system for managing leases and perpetual usufruct arrangements will offer considerable benefits to those responsible for keeping records of lease liabilities under IFRS 16.

FlexiEPM streamlines workflow, which is generally based on Excel without the need to give it up. Our user-friendly contract registers are easy to read, the integrated calculation mechanisms and automated account assignment rules make work easier, while the transparent reports guarantee compliance with the reporting requirements. As a result, FlexiEPM optimizes the work and improves the efficiency of staff responsible for IFRS 16 reporting.

About the Author

Picture of Agnieszka Dziedziela

Agnieszka Dziedziela

A certified public accountant and seasoned professional with extensive experience in finance, gained in positions such as auditor, reporting specialist, and accountant, her versatility allows her to deeply understand the challenges and nuances of finance.
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