IFRS 16: Anticipating Changes in Lease Accounting

IFRS 16 Leases comes into effect from 1 January 2019. As the standard will bring about wide-reaching changes to the way businesses account for leases, we highlight what you need to know below.

The existing rules will change

Currently, leases are primarily accounted for by reference to IAS 17 and IFRIC 4. IFRS 16 will replace these standards and interpretations. Although IFRS 16 will mainly impact lessees, there are some items that lessors should be aware of.

Lessees

At present, lessees use different accounting treatments for their leases, depending on whether they are classified as an operating lease or finance lease. Generally-speaking, finance leases are reported on the balance sheet whilst operating leases are held off-balance sheet.

Under IFRS 16, lessees will be required to report most of their leases on the balance sheet. However, some exceptions remain, such as leases of biological assets and licences of intellectual property granted by a lessor, among others. Additionally, a lessee can elect for IFRS 16 to apply to leases of intangible assets, provided that it is not an exempted lease, such as the above two examples.

Additionally, there are two optional recognition exemptions available for:

• Short-term leases (generally for a term of 12 months or less); or
• Leases of items with a low value, such as personal computers or telephones.

If an exemption is elected into, then the lease payments for those items would be recognised on a straight-line basis over the period of the lease term.

Lessors

When it comes to lessors, the good news is that accounting treatments will remain similar to current practice. Although significant changes are not expected for lessors, they should nevertheless be aware that their lessees’ needs may change following the implementation of the new standard.

Additionally, the new definition of control may change which contracts are considered leases under IFRS 16, and which are not, so lessors should still take time to review the new standard.

Balance sheets will grow

Lessees will see their balance sheets grow under the new standard. Although a company’s reported assets will increase as it recognises an increased number of leases, its liabilities will also rise as the company reflects those outstanding lease payments.

There will also be changes to the income statement, leading to front-loaded expenses for many leases. This is due to the need to recognise depreciation and interest expenses for leased assets. For example, your rent payments may be replaced by interest and depreciation expenses.

As a result of the above changes under IFRS 16, businesses will also see changes in common financial ratios, such as gearing, interest cover, operating profit, and EBITDA, among others.

Transitioning to the new standard

Although IFRS 16 is not effective until 1 January 2019, early adoption is permitted provided that the entity has also adopted IFRS 15 Revenue from Contracts with Customers.

There are two adoption approaches that a lessee can take – the full retrospective approach or the modified retrospective approach.

The full retrospective approach

An entity using this method would restate comparatives as required under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

Equity would also need to be adjusted at the start of the comparative period if this method is used.

The modified retrospective approach

This method does not require comparatives to be restated. Instead, the effect of adopting IFRS 16 is shown as an adjustment to equity at the date of its application.

Please note that under this method additional calculations are also required to determine the amount of lease assets and liabilities at the beginning of the period.

Take time to get your business ready

IFRS 16 will have wide-ranging implications for almost all businesses, and especially those that currently hold high-value leased assets off-balance sheet.

It is essential that businesses take time well in advance of January to identify which contracts will be identified as leases under IFRS 16 and whether there is currently a central database that collects information on all lease contracts, even those that are currently held off-balance sheet.

By knowing in advance whether you have the IT systems and processes in place to meet the new demands of IFRS 16, you will be able to meet any gaps as and when they arise.

Finally, it is worth thinking about which transition method you should adopt, and how these changes will impact your business’ financial ratios.

Although the implementation of IFRS 16 will be demanding, it’s important to stay on top of the standard’s requirements and how they will impact your business.