IFRS 16 has been effective for some time now. And companies including audit firms in Dubai are numerous questions regarding its implementation. This guide will highlight some common issuers company audit teams face when implementing the IFRS 16 leases.
IFRS 16 describes leases as part of a contract, which gives the right to use identified assets for some time in exchange for consideration, which in turn, provides a business in Dubai, the right to enjoy economic benefits from the use of the asset.
How does this relate to a non-standard contract, whereby assets can be replaced by the supplier for other ones or leases where rent payable relies partially on turnover, deterring the Dubai company from benefiting from the words?
Well, some assets, which are identified in agreements because of their unique ability to suit the business needs may fall under the scope of IFRS 16, while still some assets may not fall under the standard. Financial audit experts should make sure only agreements which provide a business with the right to control over the use of some assets are accounted for in IFRS 16.
Figuring Out the Discount Rate
That starting point for auditors to measure lease liability is discounting present value, the in-substance fixed and fixed payments made over the duration of the lease. A major issue encountered by most Dubai audit services, internal auditors, and external auditors alike are the quantification of the discount rate.
The standard recognizes the “interest rate implicit in the lease” as the first step. It is the rate of interest which causes the unguaranteed residual value and the present value of lease payments to equal the sum of the fair value of the underlying asset added to the initial direct costs of the lessor.
Normally, it’s the rate at which the Internal Rate of Return is zero. But, technically, it needs access to data which lessees rarely have access to it. For instance, the lessor may be unwilling to communicate their projected residual value to the lessee or sensitive data like the initial direct costs.
So, financial audit teams discount most leases using the Incremental Borrowing Rate (IBR). This is the interest amount a lessee should pay to access funds required to get an asset of similar value as opposed to the value of the right-of-use asset.
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A lease agreement may specify that other goods or services must be purchased from the lessor, such as maintenance, utilities, and insurance. Whether these additional items pertain to goods or services that benefit the lessee determines how they should be accounted for.
Assigning Restoration or Maintenance of Certain Assets During Transfer
Most lease agreements include provisions for making good or restoring the damage. In commercial leases, for instance, there may be a “make-good” provision requiring the lessee to remove their fittings at the end of the lease and return the premises to their original state. This expense is reflected in a provision for Contingent Liabilities and Contingent Assets under International Accounting Standards (IAS) 37.
IFRS 16 does not require the recognition of make-good provisions related to leases, as this requirement is already present in IAS 37. IFRS 16, however, recasts its treatment since it includes a provision for the estimated costs of repairing the underlying asset at the first recognition.
A provision may also be required if a lease contract does not contain make-good clauses, and IFRS 16 implementation uncovers them. These costs and related provisions will be treated differently based on the transition method that will be applied, and whether or not such a provision was already recognized.
Fit-Out Cost Reimbursements: Lease Incentives
Lessors often offer lease agreements with incentives to their lessees. Lease Incentives are defined as payments made or reimbursements made by lessors to lessees to facilitate leases. The definition is silent on the treatment of lease incentives where lessors reimburse lessees for fit-out costs.
When it comes to determining whether fit-out costs are incurred to build assets that benefit the lessor or the lessee, one of the major factors is whether they benefit the lessor or the lessee:
The contribution should be treated as any other cash incentive received or receivable if the assets will remain the lessee’s and are of no benefit to the lessor.
It is not within the scope of IFRS 16 to construct an asset that will be the lessor’s: the lessee does not eventually own an asset in addition to the right-of-use asset and instead makes upfront payments to the lessor for costs, and the lessor reimburses them.
In order to identify these issues early and accurately apply IFRS 16, a careful examination of the terms of the lease agreements is crucial.
Kasun Liyanage is an Audit Manager with over 7 years of experience dealing with diversified corporate clients. He not only manages the team’s work schedule but also is an expert in handling audit areas such as external audits and fraud investigation, Internal control benchmarking and best practices and well as preparation of financial statements and IFRS compliance.