The impact of IFRS 16, Leases, on lessees in the retail industry
(First of two parts)
After a long wait, the new accounting standard on leases, International Financial Reporting Standards (IFRS) 16, was finally issued by the International Accounting Standards Board (IASB) in January 2016. IFRS 16 will replace the currently used International Accounting Standards (IAS) 17, Leases. It will have a significant impact on lessees as they will be required to recognize most of their leases on their balance sheets. On the other hand, there will be little or virtually no impact for the lessors as their accounting for their lease contracts will be substantially the same.
The impact of IFRS 16 for lessees may differ from industry to industry and even from company to company within the same industry. For lessees in the retail industry (lessee retailers), IFRS 16 may have far-reaching implications on their financial statements and even their operations as these entities usually enter into many lease contracts and/or enter into high-rent contracts. Some of these implications are discussed below.
IDENTIFYING THE LEASED ASSET
IFRS 16 requires an asset to be identified (either explicitly or implicitly) in the contract and stipulates that the lessee should have the “right to use” the said asset. However, it is not enough that there is such a right over an “identified asset.” The lessee must also ensure that the lessor does not have “substantive substitution rights” (i.e., the lessor does not have the practical ability to switch one alternative asset for another during the contract period and/or there would be no economic benefit to the lessor from exercising such a right) before the contract can be accounted for as a lease contract under the requirements of IFRS 16.
IFRS 16 gives an example of a “lease” contract that will not qualify as such under IFRS 16 because of the presence of “substantive substitution rights.” For example, a lessee retailer leases a concession space from a lessor. Although the amount of the space and the general location (e.g., inside an airport) is known, the contract provides the lessor with the right to change the specific location anytime during the contract period. The lessor has several available spaces with similar specifications and only incurs minimal costs when it exercises such a right. On the other hand, the lessee can easily transfer from one space to another as it uses its own kiosk to sell its goods. An analysis of these facts would indicate that even though, in form, it is a lease contract, in substance and for accounting purposes, it will not be accounted for as such under IFRS 16. Rather, it will be merely accounted for as a service contract where the lessee-retailer will just recognize the expense as incurred. Because it does not qualify as a lease, the accounting will greatly differ from the lessee accounting requirements of IFRS.
COMMENCEMENT DATE OF THE LEASE
IFRS 16 defines the commencement date of the lease as “the date on which a lessor makes an underlying asset available for use by a lessee.” In certain cases, the actual commencement date may be even earlier than the commencement date stated in the lease agreement. For example, prior to starting its commercial operations inside the leased space, the lessee has already started to modify or to construct its own improvements inside the leased space. If this is the case, even if the contracts state another date for the start of the lease period, under IFRS 16, the lease term may have already commenced.
To illustrate, consider the arrangement when lessee retailers sign lease contracts for spaces inside a mall that is still undergoing construction. While the mall is not yet fully completed, lease contracts give these retailers a right to go in and customize or renovate their own leased spaces. Whether or not “the lessor makes the underlying asset available for use by the lessee” in this case can sometimes be defined differently by different lessee retailers. Some would decide that the underlying asset is not yet existing because the space being rented is according to them “a space inside a mall” yet the mall is not yet complete. Others would take the view that the underlying asset is already available as the lessee retailer is already allowed to gain access and start undertaking improvements.
The above arrangement, among many others, is applicable to lessee retailers. The implication of having an earlier commencement date than what is stipulated in the contract is that the lessee may be required to account for the lease contracts (i.e., recognize the leases on their balance sheets) even before they make the first lease payment to the lessor. Thus, it is critical for retail entities acting as lessees to be able to properly identify what is the commencement date of their leases.
In next week’s continuation of this article, we will extend the discussion of the impact of IFRS 16, Leases, on retail entities by considering its effect on Lessee accounting, specifically with regard to applying lease exemptions and accounting for variable lease payments.