IFRS 16 – Applicable from 1 January 2019
From 1 January 2019, the long-awaited accounting standard on leases, IFRS 16, became mandatory and therefore replaced IAS 17.
IFRS 16 was originally issued in January 2016 and has already been covered in Financial Accounting and Financial Reporting because early adoption was permitted. However, many companies will only be using this standard for the first time now.
Leases provide an important and flexible source of ﬁnancing whereby the lessee obtains the use of an asset and incurs a liability when it enters into a lease.
However, IAS 17 made it difficult for investors and other users of financial statements to get an accurate picture of a company’s leased assets and liabilities, particularly for industries such as the airline, retail and transport sectors.
This situation arose because of the distinction in IAS 17 between ‘operating’ and ‘finance’ leases – assets and liabilities were recognised for finance leases but not for operating leases. This gave rise to ‘off-balance sheet finance’ for operating leases.
When IFRS 16 was originally issued, the International Accounting Standards Board (IASB) estimated that listed companies who used IFRS or US GAAP had US$3.3 trillion of lease commitments, of which 85% did not appear on the statement of financial position of these companies.
IAS 17 made it difficult for users of financial statements to compare companies. It also meant that investors and other users of the financial statements had to estimate the effects of a company’s off-balance sheet lease obligations, which, in practice, often led to overestimating the liabilities arising from those obligations.
IFRS 16 solves this problem by requiring that all leases (except for those that have assets classified as low-value or contracts with length of up to 12 months) are reported on a company’s statement of financial position as assets and liabilities.
Despite being off-balance sheet, there can be no doubt that operating leases create real liabilities. During the financial crisis, some major retail chains went bankrupt because they were unable to adjust quickly to the new economic reality. They had significant long-term operating lease commitments on their stores and yet had deceptively lean balance sheets. In fact, their off-balance sheet lease liabilities were up to 66 times greater than their reported debt. Clearly, the accounting does not reflect economic reality.
To compensate for this “missing information”, many investors use various techniques to add operating leases back onto the balance sheet.
In addition, the current accounting for leases leads to a lack of comparability. An airline that leases most of its airplane fleet looks very different from its competitor that borrows to buy most of its fleet, even when in reality their financing obligations may be very similar. There is no level playing field between these companies.
To address these problems, the International Accounting Standards Board, which sets the IFRS Standards for financial reporting around the world, has issued a new standard on lease accounting, IFRS 16.
Some changes imposed by IFRS 16
According to the current rules, only financial leasing should be recorded in the Statement of Financial Position, with the effects of the other (operating) restricted to the impacts on the cash. As from 2019, all leases must be included in the Statement of Financial Position, except for those that have assets classified as low-value or contracts with length of up to 12 months.
The definition of leasing refers to contracts that give the right to use and control an identifiable asset, such as leasing contracts and contents of service contracts.
- The new rule will directly influence the Statement of Financial Position and the Income Statements.
- All leases where the standard should be applied must be recorded in assets and liabilities.
- With new disclosure requirements, leasing assets and liabilities should be separately disclosed in the financial statements.
- The leasing instalments will be accounted for as interest expenses and amortization of the assets set up, and the total expense will be higher in the first years of the agreement.
- The amortization will take place according to the term of the contract. With this, the companies will no longer have a rent expense and will have the record of the amortization of the right to use. This change will directly influence the companies’ EBITDA.
- Liabilities must be recorded at present value. The definition of the discount rate for the calculation needs to be evaluated and discussed in order to maintain the correct joining to the standard.
- The asset (right of use) must pass through the impairment test. The basis for the test will be the current leasing market value.
It is noteworthy that this is a significant change from what is provided by the current standard, especially for leaseholders. Treatment for lessors does not change in any relevant way.
IFRS 16 will increase the visibility of companies’ lease commitments and better reflect economic reality. The Standard will also make it easier for users of financial statements to compare companies that lease their assets with companies that borrow money to buy their assets, creating a more level playing field.
FSMO team will be glad to assist you with the applications of IFRS 16.
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