IFRS 16, introduced in 2019, affects most companies with leases and reporting under the International Financial Reporting Standards (IFRS). Similarly, in December 2022, the Financial Reporting Council (FRC) announced that FRS 102 (UK GAAP) would change in order to become consistent with IFRS 16.

These regulations impact the financial statements of lessees of property and high-value equipment. Under this standard, similar to finance leases, operating leases should also be placed on the balance sheet by recognising a ‘right-of-use’ asset and a lease liability.

When do Leases Need to be Valued?

Lease liabilities and ‘right-of-use’ assets are measured at the initiation of the contracts as well as whenever there is a lease modification, which includes situations like a change in lease term, change in estimate of residual guarantee or change in index rate affecting payments, including market rents.

What are the Key Considerations for Lease Valuation?

1. Measurement: Valuing leases requires careful consideration of lease payments, discount rates, lease terms, and other relevant factors. Determining the present value for lease liabilities and right-of-use assets is crucial for accurate financial reporting.
2. Discount Rate: For a lessee, the discount rate for the lease is the rate implicit in the lease or, if that rate cannot be readily determined, the lessee’s incremental borrowing rate (IBR).
3. Compliance with Accounting Standards: Both IFRS 16 and UK GAAP require lessees to use the IBR to discount lease payments when measuring lease liabilities. Proper IBR valuation ensures compliance with these accounting standards, avoiding potential errors and penalties.

What Aspects should be considered in Assessing IBR?

The IBR is dependent on the lessee’s credit risk, lease term, underlying asset, lessee’s indebtedness, and overall economic environment. As such, its determination involves significant judgement and may have a material impact on the underlying company.