IFRS 16 – The changes in leases standard and its impact
– Joseph Jefferson.
The IASB published IFRS 16 Leases in January 2016 with an effective date of January 1, 2019. The new standard will replace existing IAS 17 rule and will require lessees to recognize nearly all leases on the balance sheet which will reflect their right to use an asset for a period of time and the associated liability for payments.
Lessee: Under current rules (IAS 17), lessees account for lease transactions either as operating or as finance leases. This allows many companies who are engaged in extensive long-term assets leases (e.g. retail, airlines) to avoid reporting leasing transactions on balance sheet (also referred to as “off-balance sheet accounting”), which understates assets as well as liabilities. In order to increase transparency of information and comparability of financial statements, IASB came up with IFRS 16, which eliminates leases classification and, instead, requires all leases to be treated in a similar way to finance leases. Specifically, the new rule requires lessee to recognize:
- Assets (also referred to as right-of-use asset) and liabilities for all leases with a term of more than 12 months; and
- Depreciation of lease assets separately from interest on lease liabilities in the income statement.
There will be two exemptions to this rule:
- Assets with low underlying value (typically less than $5,000 – e.g. computers);
- Short-term leases (with term less than 12 months).
Lessor: Accounting for lessors is not expected to change from IAS 17, however, lessors’ business model and lease products will be affected by the changed needs and behaviors from customers.
IFRS 16 states that a contract contains a lease if:
- There is an identified asset; and
- The contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration, specifically:
- The customer has the right to direct how and for what purpose the asset is used;
- The customer has the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use.
Recognition and measurement
Initial recognition and measurement: At the inception of the lease, right-of-use (ROU) asset and lease liability will be measured at present value of lease payments to be made over the lease term discounted using the lessee’s interest rate implicit in the lease agreement. Similar to IAS 17, the new standard defines the lease term as: a) Non-cancellable period of lease; b) Extension option; and; c) Termination option.
The components of lease liability and right-of-use asset include:
- Lease payments (fixed, variable payments, penalties on early termination);
- Discount rate (interest rate implicit in the lease or incremental borrowing rate, if unknown)
- Restoration costs (provision for future obligation to restore the site);
- Initial direct costs (commissions, payments to existing tenants to obtain the lease)
Subsequent measurement: On the balance sheet lessees will accrete the lease liability to reflect interest and reduce the liability every reporting period to reflect lease payments made throughout a year. The lessee will need to remeasure lease liability upon occurrence of specific events, which will also result in adjustment to ROU asset. The related right-of-use asset will be depreciated according to IAS 16 Property, Plant and Equipment. Lease liability is remeasured when the following events occur:
- If the lease is modified to terminate the right of use of one or more underlying assets (e.g. remove certain components from the lease contract) or to shorten the contractual lease term;
- Increase in scope with a corresponding increase in the lease consideration (e.g. addition of components to lease contract);
- Increase in scope without a corresponding increase in the lease consideration (i.e. if the consideration paid for the increase in the scope does not increase by a commensurate amount);
- Change in the lease consideration
Presentation: On the balance sheet, ROU assets and liabilities are either presented separately from other assets and liabilities respectively or disclosed separately in the notes. On the income statement, lessee cannot combine depreciation expense and interest expense and will be required to present them separately. In the cash flow statement, lease principal payments are presented within financing activities, while interest payments are presented based on an accounting policy election according to IAS 7 Statement of Cash Flows.
Example: Company A leases equipment from Company B for a period of three years starting on January 1, 2017. The lease contract requires payments of C$6,000 per year for the duration of lease term. There is no option to renew or purchase the car and there is no residual value guarantee. The implicit borrowing rate is 5%. The net present value of the lease payments using a 5% discount rate is C$16,340. Below is presented initial recognition and subsequent measurement of the lease under IFRS 16:
- Information about lease assets (by class being leased) and expenses and cash flows related to leases;
- A maturity analysis of lease liabilities; and
- Information about extension options and termination options, variable lease payments and sale and leaseback transactions
- Full retrospective approach: Entities are required to retrospectively apply the new standard to each prior reporting period presented by adjusting equity at the beginning of the earliest comparative period presented.
- Modified retrospective approach: Lessee is not required to restate comparative information. The standard will be initially applied on the first day of the annual reporting period, on which lessee will recognize the cumulative effect of initial application as an adjustment to the opening balance of equity as of January 1, 2019.
- Financial information: The new standard will gross up balance sheets and change income statement as well as cash flow presentation. Given the fact that lease expense will be replaced by depreciation and interest expense, this will result in front-loaded lease expense, which might decrease earnings and equity in the early years after new standard implementation.
- Financial ratios and performance metrics: The new standard will impact gearing, current ratio, asset turnover, interest coverage, EBITDA, operating profit, net income, EPS, ROE, and operating cash flows. Change in ratios may trigger breach of debt covenants, possibly affect credit ratings and may lead to change in stakeholders’ behavior.
- Tax considerations: The increase in depreciable base due to inclusion of lease assets may result in adjustments to deferred taxes and may add complexity to tracking of book/tax differences.
- IT systems: The change of standard will increase the IT system requirements due to additional complexities related to restatement of comparative reporting periods (under full retrospective approach – see below) where separate books for external reporting, local statutory requirements and tax purposes might need to be maintained.
- Lease procurement: Some lessees may reassess whether buying an asset will appear to be more advantageous than leasing it.
- Conduct diagnostic through understanding of current state.
- Understand what is changing and estimate the effect of the change.
- Prepare your team and IT system/processes.