Under IFRS 16 which takes effect in 2019, a lease which gives the lessee the right to use the asset is treated broadly in the same way as in the current finance lease accounting (IAS 17). The leased asset is capitalised on the balance sheet and a lease liability is raised.

One of the difficulties with this approach is how to value the leased asset. IFRS 16 says that the starting point for the initial measurement of the asset is the amount of the lease liability, which is the present value of the lease payments not yet paid. This present value is arrived at by discounting the payments using the interest rate implicit in the lease. The implicit interest rate is the one which causes the present value of the lease payments to equal the sum of the fair value of the underlying asset.

For example, the fair value of the leased asset is £100,000. The lease payments are £24,000 payable at the end of each year for five years. Therefore, the total lease payments are £120,000, which is greater than the fair value. The interest rate which will cause the present value of the minimum lease payments to be £100,000 is 6.402%.

This will be familiar to users of IAS 17. However, it clearly does not work if the fair value of the asset is significantly greater than the total of the lease payments, as it might be if the lessee were leasing a building for five years but the building had a very long useful life. In IAS 17 this would not be issue as the lease would probably be treated as an operating lease and there would be neither a leased asset nor a leased liability on the balance sheet. But in IFRS 16 the balance sheet would need to show both.

For example, the building has a fair value of £2 million but the lease payments are £100,000 per annum for five years. The implicit interest rate will then be negative. IFRS 16 (BC 160-162) says that in circumstances in which the asset has a significant residual value at the end of the lease, it will be difficult to determine the implicit interest rate. In such cases the lessee should use its incremental borrowing rate.

The lease liability would therefore be calculated by discounting the payments at the lessee’s incremental borrowing rate, and this would also be the starting point for the leased asset. The writer, who is the presenter of the forthcoming course IFRS Update Including Revenue, Financial Instruments and Leasing, has recently advised the subsidiary of a listed company which will be facing this issue in 2019.

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