14 June 2017
IFRS 16 Leases - Impact of implementation compared with existing standards
The new standard IFRS 16 for lease accounting was released on 13 January 2016 by IASB together with the US standard FASB. The history of the development of IFRS 16 goes back to 2006. The new regulations replace the previous standard IAS 17, the related interpretations IFRIC 4, SIC 15 and SIC 27.
IFRS will take effect on January 1, 2019. An early adoption is permitted (IFRS 15 Revenue from Contracts with Customers). Why the new implementation? A large number of listed companies (IFRS Standards or US GAAP) hold US$ 3.3 trillion in obligations arising from lease agreements which are “off-balance sheet.”. Or to be more exact, more than 85% of lease obligations (operating leases) are "offbalance sheet", because they do not appear on their balance sheets and are only disclosed in the notes attached to their financial statements.
In accordance with the leasing standards IAS 17 (IFRS) and FAS 13 (US GAAP), lessees and lessors classify all leasing transactions in finance as operating leases. The lessor does not recognize them as an asset or liability on its balance sheet, but merely as an expense recorded in the income statement on a straight-line basis over the lease period. This is economically incorrect. The adjustments to effects of the offbalance leases must be clearly stated in the analysis of the annual reports.
In line with the currently valid IAS 17, IFRS 16 also defines a leasing contract as a contract, in which the right of use (underlying asset – ROU) will be transferred to the customer against payment. However, according to IFRS 16.9, the customer must be entrusted not only with the right to use the underlying asset, but also with the right to control it. This specification makes the definition of a leasing term in IFRS 16 more rigorous than in IAS 17 and allows a clearer delineation of service contracts.
With the exception of contracts which are generally excluded from the scope of application according to IFRS 16.3, the standard is to be applied principally to all contracts / parties which meet the leasing definition of IFRS 16. Optionally, the lessee and lessor may choose to combine the leases with similar characteristics in portfolios which comply with the requirements of IFRS 16. However, this consolidation may not lead to any substantially different results when compared with the individual review (IFRS 16.63). Another option for using the standard is to apply it to leases, which are associated with intangible assets.
The classification of leases in finance and operating will continue to exist in IFRS 16, but only for the lessor. This means the regulations of IFRS (16.61-81) for the classification and accounting of leasing transactions with the lessor are largely consistent compared to the current IAS 17.
The leasing company omits all leasing transaction in finance and operating leases, and, consequently they will not appear on the balance sheet, unlike with the current IAS 17. In the initial valuation, the lease liability (present value) will be released by the lessee for the future lease payments and through the right of use of the leased object will also be activated in the amount of the leasing liability (plus any initial incurred costs) (IFRS 16).
In the subsequent valuation, the right of use will be depreciated (IFRS 16.29) and the leasing liability will be reduced by the amortization of the leasing rate (IFRS 16.36). The interest rate resulting from interest compounded will be recognized as a leasing liability in the income statement (IFRS 16.38).
In order to facilitate the first utilization of the new leasing standard, IASB has provided two options for the transition from IAS 17 to IFRS 16:
- firstly, lessors and lessees do not have to use the new definition of a lease for present existing standards in transition, but rather they can apply the standard to the contracts defined as lease agreements according to IAS 17 (grandfathering);
- secondly, in addition to the retrospective approach, the lessee also can choose to modify the retrospective approach, through various simplified ways of determining leasing liability and the right (ROU) to use the assets by applying former operating leases.
The accounting for these former operating leases leads to an extension of the balance sheet by the lessee. This also leads to a growth of the debt ratio and a decrease in the equity ratio.
The shift within the expense categories - from pure leasing expenses to depreciation and interest expenses - results in an increase in EBIT / EBITDA and in an implementation of an uniform distribution of expenses over the leasing period. Due to the serious impact of the new accounting rules, it is advisable to carry out an inventory analysis of leases at an early stage with a significant volume of off-balance transactions. In doing so, the relevant contract components and options should be identified and analyzed, as well as the possibilities of using options and derogations. On this basis a preliminary study of the effects on the balance sheet figures is recommended, in order to decide whether the model of a leasing object is still useful to the company or whether alternative financing models should be considered. Due to the negative impact on the attractiveness of the leasing model, the new IFRS 16 has an indirect effect on the lessor, even if it is not directly affected by these changes in the accounting regulations.
In conclusion: With the implementation IFRS 16 from January 1, 2019 and additionally of the accounting registry on
• balance sheet (ROU and lease liabilities);
• income statement (operating leases);
• financial ratios (financial liabilities, debts and interests: EBIDTA);
• cash-flow (separated disbursements (financial activity) and interest (operational or financial activity); the financial results of the companies will be considerably improved when compared with existing standards.
The new standard will also provide greater and much more needed transparency when dealing with the lease assets and liabilities of companies.
Patricia Heineken, International Accounting Advisory, Auren Stuttgart, Germany