Lease Disclosures – considerations

We published a post earlier on how to implement IFRS 16 on leases on a sustainable way. As noted there, sustainability includes that the core process provides as much data for disclosure requirements as possible. As underpinned by several comprehensive post-implementation studies, the projects were harder than expected, and the new standard considerably increased workload of annual reporting. The fact that a substantial portion of IT tools applied for lease accounting (almost half of them as per the study quoted above) further contributed to this. It might therefore be useful to have a look on these disclosure requirements now, when the preparation of the first, IFRS 16 compliant annual report preparation is knocking on our doors. We consider lessee aspects, since lessor requirements did not change significantly.

Transition method and accounting policy

Well, these sections are not likely to be binge-read by the users of the financial statements out of their sheer excitement… However, some regular stakeholders (investors, creditors) do pay specific attention to these parts exactly to have an overall impression on balance sheet and income statement have been impacted by the new standard.

  • Full retrospective approach. If you are facing with the sad decision to apply this approach for transition (present the financial statements as if IFRS 16 has always been applied), then we have the relatively good new that this section of the disclosures can be cut fairly short. There are not too much alternatives within this approach, so it is enough to present the fact of applying full restatement.
  • Modified retrospective approach. In case you belong to the “happy 98%” chosing this approach, then you have to push a bit harder here. All choices and alternatives permitted by IFRS 16 within this approach must be presented (for example, did we take advantage of the short-term and / or low value lease exemptions, how incremental borrowing rate has been determined, when expected lease term has been estimated etc.) One of the key information here is to disclose whether the company took advantage of recognizing right-of-use (ROA) assets at an amount equal to the lease liability (and for which lease categories if it did), or re-calculated them, including their depreciation. This is what the equity impact of the transition depends on.
  • Transition impact. As for every new standard, a tabular presentation of the balance sheet, income statement and equity impact are necessary. In case of the full retrospective approach, the opening balances of the comparative period are restated. As for the modified retrospective method, the key element is that the comparative period is presented according to the previous standard (IAS 17), including the comparative income statement, and IFRS 16 is applied only for the current period. Equity impact is presented as a current year adjustment to the opening balances of equity. It is a very elegant, but a bit complex requirement to reconcile the opening lease liability (as per IFRS 16) from the lease disclosures of the comparative period. This practically means that opening lease liability equals to the company’s prior year closing finance leases plus its operating lease commitments (a disclosure previously required by IAS 17) plus impact of discount. This is further adjusted by items which are not recognized in the amount of lease liabilities under IAS 17 but included under IFRS 16 or vica versa (residual value guarantee, expected extensions, low value and / or short term leases).
  • Accounting policies. A descriptive presentation of key lease accounting principles, partly coming from the standard directly (definition of a lease), and partly up to company decision (applying exemptions, determining incremental borrowing rate). Bad news for those choosing the relatively simpler modified retrospective approach is that the previous IAS 17 policy must still be part of the disclosures (as the comparative period is still prepared according to that standard).

Components of the financial statement

Of course the new standard has an impact on each key component, though no material structural changes are required.

  • Balance sheet – It is allowed but not required to present ROU assets and lease liabilities as separate line items. Instead, they might be included in property, plant and equipment or intangibles (if lease accounting is applied), as well as among financial liabilities. ROU assets are not split to current and non-current, but lease liabilities are. In our view, a separate line item should be used if leases are of material value, or if it is beneficial in the calculation of certain ratios. If we separate ROU assets, then it is worth to do the same for lease liabilities.
  • Income statement – As with the balance sheet, there is no requirement for separate line items, and honestly, there is no need either (ROU asset depreciation, interest on lease liability). They belong to operating and financial expenses, respectively, although IFRS does not define what EBIT is.
  • Movement of equity. It is adjusted for first time adoption only, depending on the transition approach applied: the opening balance of either the comparative or the current period is modified.
  • Cash-flow. Cash flow implications are often overlooked, although there are some alternatives available here, and also sometimes it is more important for certain KPIs than balance sheet. Payments (principal) on lease liabilities are part of financing cash flow, while interest thereon is presented in the same category as other interest payments (ie. at the discretion of the company as operating or financing cash outflow). Payments related to leases which are not included in the amount of lease liabilities are reported as operating cash flow (such as payments of low-value or short-term leases if exempted, and variable lease payments which are recognized in the income statement when incurred). It is important to keep in mind that payments on leases classified as operating under IAS 17 were previously included in operating cash flow. Therefore, when modified retrospective approach is applied, lease payment will be reported in different categories in the current and comparative period, so it might be useful to add some explanatory information on this.

Notes to the financial statements

Preparation of notes is always a complex task, since information must be collected from many sources. Lease disclosures are not different, so it does matter how this exercise is supported by our core process implemented and our IT tool currently applied.

IFRS 16 does not require companies to present all lease information in a single note or spread those in multiple notes; this obviously depends on whether we use a separate line item in the balance sheet for ROU assets or they are included in property, plant and equipment. In our opinion user-friendliness (and efficiency of preparation) leads to a single note (and a single point of responsibility) for lease disclosures.

Main numeric information required by IFRS 16 in a tabular format is comprised of the following:

  • Changes of ROU asset – typically presented as a movement schedule, split by asset categories, including opening and closing balances, additions and depreciation.
  • Changes of lease liabilities – a movement schedule is not required (although might be used); interest expense and total cash flow related to lease must be disclosed.
  • Maturity categories of lease liabilities – as for other financial liabilities, a separate maturity profile of outstanding lease liability is required (split for example as within 1 year, 1-3 years, 3-5 years or beyond 5 years).
  • Exemptions and variable lease payments. It was quickly noted by every IFRS financial statement preparer that small value and short-term leases can be exempted from lease accounting. However, it is often overlooked that these transactions are still leases; consequently, expenses recognized for these items must be quantified and separately disclosed in the notes even if they are exempted from recognizing a ROU asset and lease liability. Variable lease payments (unless index-based) are not included in the carrying amount of lease liability, but are expensed as incurred. An example is a lease payment component for a retail store which depends on a certain period’s turnover.

Tabular disclosures also require amounts from several specific transactions (gains or losses from sale and leaseback transactions, revenues from sub-leases). All the information above, except for the las bullet point should be provided by any basic lease tool. The last point is a tricky one, and makes it important to include information in our lease register helping us to identify how to collect variable lease payments and exemption amounts.

Disclosure requirements do not end here. Depending on our exposure and uncertainty to leases, the standard prescribes “qualitative and quantitative” information. These are of course need if and to the extent they are material for then operations of the company. Basically main lease types must be described, answering the question “Which key assets depend on lease agreements?” (for example, if all of our vehicles, facilities or offices are leased, then it must be disclosed; if only the company car of the CEO, then it should not). Furthermore, we have to provide information on potential cash outflows related to lease agreements which are not included in the carrying amount of the lease liability. Examples are extension and termination options, variable lease payments or residual value guarantees. If there are significant lease agreements we are already committed to but not yet started, then those must be noted, as well as material obligations undertaken in existing agreements (pledges on our assets, covenants). There is no specific requirement on what form shall be used for these disclosures; however, users of the financial statements must understand the quantifiable risk associated with major lease agreements. For example, in case of a turnover-based variable lease payment, a sensitivity analysis (1% increase in turnover results in an x amount of change in the lease payment) will do it; similarly, for a lease portfolio with significant extension options, an average extension ratio of prior periods could be disclosed.