IFRS 16 puts almost every lease on the balance sheet. For Saudi lessees the judgement sits in three places: whether a contract is a lease at all, the lease term, and the riyal discount rate. A practical walk-through with the numbers.
- A lessee recognises a right-of-use asset and a lease liability for every lease, except short-term and low-value leases if it elects the exemptions.
- The lease term includes extension options the lessee is reasonably certain to exercise, and that judgement often moves the liability more than the rate.
- Most Saudi lessees use an incremental borrowing rate in riyals, which needs a documented derivation.
Is it a lease?
A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Control means the customer obtains substantially all the economic benefits from use of the asset and directs how and for what purpose it is used. Office and warehouse rentals, vehicle fleets and dedicated equipment usually qualify. Capacity arrangements, where the supplier can substitute the asset or the customer receives only part of a shared asset's output, often do not.
Initial measurement
At commencement the lessee measures the lease liability at the present value of the lease payments not yet paid, discounted at the rate implicit in the lease or, if that cannot be readily determined, at the lessee's incremental borrowing rate. The right-of-use asset equals the liability plus payments made at or before commencement, initial direct costs and restoration costs, less incentives received.
Saudi leases are commonly paid annually in advance, which matters: the first payment is not part of the liability, because it is paid at commencement.
Worked example
A five-year office lease in Riyadh, SAR 500,000 a year paid in advance, incremental borrowing rate 6%.
| Item | SAR |
|---|---|
| Lease liability: present value of the four remaining payments at 6% | 1,732,553 |
| Add: first payment made at commencement | 500,000 |
| Right-of-use asset at commencement | 2,232,553 |
| Year 1 depreciation (straight line over 5 years) | 446,511 |
| Year 1 interest on the liability (6% × 1,732,553) | 103,953 |
The year 1 expense is SAR 550,464 against a cash rent of SAR 500,000. The front-loading reverses over the term as interest falls, which is why EBITDA rises on adoption while profit in early years falls.
The lease term judgement
The lease term is the non-cancellable period plus periods covered by an extension option the lessee is reasonably certain to exercise, and by a termination option it is reasonably certain not to exercise. Significant leasehold improvements, the cost of relocating and the importance of the location all point towards a longer term. In the Gulf, many contracts renew annually by default; where the entity has operated from the same premises for years and fitted them out, a one-year term is rarely supportable.
The incremental borrowing rate in riyals
The incremental borrowing rate is the rate the lessee would pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value. A defensible build-up starts from a riyal reference rate for the term, adds the entity's credit spread (from its own facilities or comparable borrowers) and adjusts for the security the leased asset provides. Using the parent's dollar rate for a Saudi subsidiary, or one rate for leases of very different terms, are the findings auditors raise most often.
Exemptions and practical expedients
- Short-term leases of 12 months or less, with no purchase option, can be expensed straight line, elected by class of asset.
- Leases of low-value assets, such as laptops and small office equipment, can be expensed, elected lease by lease.
- Non-lease components such as service charges can be separated, or combined with the lease component as an accounting policy choice by class of asset.
Modifications and reassessments
A change in scope or consideration that is not part of the original terms is a modification. A modification that adds a right of use at a price commensurate with its stand-alone price is a separate lease; otherwise the liability is remeasured using a revised discount rate, with the adjustment against the right-of-use asset. Changes in index-linked payments are remeasured using the original rate.
Disclosures
Expect auditors to test the maturity analysis of lease liabilities, the depreciation by class of right-of-use asset, interest expense, expenses for short-term and low-value leases, total cash outflow for leases and the judgements on lease term.
