A lessee enters into a ten years contract with a lessor( freight carrier) to transport a specified quantity of goods. Lessor uses rail wagons of a particular specification, and has a large pool of similar rail wagons that can be use to fulfill the requirements of contract. The rail wagons and engines are stored at lessor's premises when they are not being used to transport goods. costs associated with substituting the rail wagons are minimal for lessor. whether the lessor has substantive substitutions rights and whether the arrangement contains a lease?
Answers
The International Accounting Standards Board (IASB)
issued IFRS 16, Leases in January 2016. It took 10
years of discussions and deliberations for IASB to
realise its long standing goal to bring leases on-balance
sheet for lessees. In India, this standard is expected to
be applicable from 1 April 2019.
The new standard has major impact for lessees.
It eliminates the classification of leases as either
finance leases or operating leases as required by
Ind AS 17, Leases. It introduces a single on-balance
sheet accounting model that is similar to current
finance lease accounting model. Therefore, majority
of operating leases will be on-balance sheet as if the
entity has borrowed funds to purchase an interest in
the leased asset. This accounting will make entities
look asset-rich but at the same time heavily indebted
too.
The standard will impact the statement of profit and
loss of the lessees as well. Currently, operating lease
expenses are charged to statement of profit and loss
on a straight-line basis over the life of a lease. Entities
will now recognise a front-loaded pattern of expense
for most leases even when they pay constant annual
rentals.
Lessor accounting would remain similar to the current
practice i.e. lessors would continue to classify leases
as finance lease or operating lease.
Under the new standard, assessment of whether an
arrangement is, or contains, a lease is the biggest
practical issue. It introduces elaborate guidance
to explain what ‘the right to direct the use of an
asset’ means along with examples for identifying
arrangements as a lease.
We have worked with many entities across sectors
who have started to analyse the impact of the new
lease standard on their balance sheet, statement
of profit and loss and statement of cash flows.
Leveraging this experience, our publication ‘Lease
accounting is changing – An insight with sectoral
impacts’ captures the significant impact of the new
leases standard on various sectors. We have also
explained the important concepts in the standard
in a practical way, with the help of flowcharts and
examples.
The application of the new leases standard would
be more than just an accounting change. It will have
an impact on systems and processes including
substantial effort required to identify all lease
arrangements and extract all relevant lease data
necessary to apply the standard.
The change in the classification of lease in the balance
sheet and statement of profit and loss will also
affect key financial metrics of the lessees. This could
impact debt covenants, tax balances and ability to pay
dividends.
Need for judgement
This publication intends to highlight some of the
practical application issues with the help of certain
facts and circumstances detailed in the examples
used. In practice, transactions or arrangements
involving the lease arrangements may involve
exercise of judgements. Therefore, interpretation
and assessment of facts and circumstances of the
individual transactions would be required. Further,
some information contained in this publication may
change as practice and implementation guidance
continue to develop. Users are advised to read this
publication in conjunction with the actual text of the
standards and implementation guidance issued, and to
consult their professional advisors before concluding
on accounting treatments for their transactions.
References
References to relevant guidance and abbreviations,
when used, are defined within the text of this
publication.
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