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IFRS 16 - An Analysis

Leases have always been one of the important sources of financing. Listed companies around the world are estimated to have around US$ 3.3 trillion lease commitments but over 85 percent of these commitments are not represented in the balance sheet.

Consequently, it has been difficult for investors and others to:

  • Develop an accurate picture of a company’s leased assets and liabilities
  • Compare companies that lease assets with those that buy assets
  • Estimate the amount of off balance sheet obligations: often overestimated

The International Accounting Standards Board (IASB) has developed a new Leases Standard, IFRS 16- Leases which supersedes IAS 17-Leases.  The IASB worked jointly with the Financial Accounting Standards Board (FASB) on this project responding to concerns about the lack of transparency of information about lease obligations.

IFRS 16 – Leases, eliminates the classification of leases as either operating lease or finance lease for a lessee. Instead, all leases are treated in a similar way to finance leases as applied by IAS 17- Leases.

A company is required to apply IFRS 16 - Leases from 1st January 2019. However, earlier application is permitted provided the company also applies IFRS 15 Revenue from Contracts with Customers.

IFRS 16 - Leases establishes principles for the recognition, measurement, presentation and disclosure of leases, with the objective of ensuring that lessees and lessors provide relevant information that faithfully represents those transactions.

Identifying a Lease

A contract is, or 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 is conveyed where the customer has both the right to direct the identified asset’s use and to obtain substantially all the economic benefits from that use.

Scope

IFRS 16 will apply to all lease contracts except for:

  1. Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
  2. Leases of biological assets within the scope of IAS 41, Agriculture, held by lessees;
  3. Service concession arrangements within the scope of IFRIC 12, Service Concession Arrangements; licenses of intellectual property granted by a lessor within the scope of IFRS 15, Revenue from  Contracts with Customers; and
  4. Rights held by lessee under licensing agreements within the scope of IAS 38, Intangible Assets, for items such as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

IFRS 16 - Leases does not require a company to capitalize leases of low-value assets and or assets whose maturity of lease is less than one year.

Effects

The change to lease accounting does not affect a company’s economic position or commitments to pay cash, which are typically already considered by lenders.

For entities with significant leases, the application of IFRS 16 is likely to have significant effects on the following financial metrics:

Metrics

Calculation

Effect

 Leverage

 Liabilities / Equity

 Increase

 Asset turnover

 Sales / Total assets

 Decrease

 EBIT / Operating profit

 Earnings before interest and tax / Operating profit

 Increase

 EBITDA

 Earnings before interest, tax, depreciation and  amortization

 Increase

 EBITDAR

 Profit before interest, tax, depreciation, amortization and  rent

 No change

Accounting

IFRS 16 substantially carries forward lessor accounting from IAS 17 - Leases. However, significant changes in the accounting treatment of financial statement items of lessees will arise which are as follows:

Balance Sheet

Recognition

Measurement

Presentation

 IFRS 16 : As financed leased  assets with exemption for low  value and short term leases.

 IAS 17 : Either finance lease or  operating lease.

 IFRS 16 : Lease liability is recorded at discounted  rate

 IAS 17: Present value of minimum lease  payment or fair value , whichever is lower.

 IFRS 16: It is presented in  property, plant and equipment  as leased assets or own line  item and liability is presented in  accordance with IAS 1 -  Presentation of Financial  Statements.

 IAS 17: In accordance with para  31 and 35.

Income Statement

Operating Cost

Finance Cost

 IFRS 16: The depreciation expense is reflected in income  statement.

 IAS 17 : Depreciation or lease rental is reflected in  income statement.

 IFRS 16 : Financial charge on leased asset is reflected in  income statement.

 IAS 17: Same as above.

Cash Flow Statements

Operating Activities

Financing Activities

 IFRS 16: No effect on operating activities related to  leases since there is no operating lease.

 IAS 17: Rental expense form part of operating activities.

 IFRS 16: Principal repayments and related financial  charges are reflected in financing activities.

 IAS 17: Same as above

Changes and Transition

The IASB acknowledges that the change in lease standard would bring more transparency in lease accounting. The major change introduced by the new standard is that all leases will be brought onto companies’ balance sheet, increasing the visibility of the (off balance sheet lease commitments) in companies’ financial position. IFRS eliminates the classification of leases as operating or finance lease for lessee and treating all the leases as finance lease. However, the IASB expects that IFRS 16 will exclude from its scope a number of service contracts that may have been considered to be leases applying IAS 17 (for example, some supply contracts).

IFRS 16 does not change the accounting for services. Although leases and services are often combined in a single contract, amounts related to services are not required to be reported on the balance sheet.

Lessee

Lessor

Changes

 Leases formerly recognized as operating  leases will now be capitalized with the  exceptions of short-term leases and leases of  low-value items, thus affecting its financial  statements in the following manner:

 No substantial change from IAS 17. However,  there are some additional disclosure  requirements.

 

 Balance sheet: Increase in lease assets and  financial liabilities, and decrease in equity.

 Income statement: Decrease in operating  expenses and increase in finance cost.

 Cash flow statement: Decrease in operating  cash outflows and increase in financing cash  outflows.

Transition

 A lessee applies IFRS 16 to its leases either:

  1. retrospectively to each prior reporting period presented applying IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors; or

  2. retrospectively with the cumulative effect of initially applying IFRS 16 being recognized at the date of initial application.

 

 This election is required to be applied  consistently to all of an entity’s leases in which  it is a lessee.

 A lessor is not required to make any  adjustments on transition for leases in which  it is a lessor and accounts for those leases by  applying IFRS 16 from the date of initial  application (unless it is an intermediate  lessor).

Conclusion

IFRS 16 will result in a more faithful representation of a company’s assets and liabilities and greater transparency about the company’s financial leverage and capital employed. This is expected to:

  1. reduce the need for investors and analysts to make adjustments to amounts reported on a lessee’s balance sheet and income statement;
  2. provide a richer set of information than was available applying IAS 17, giving further insight into a company’s operations;
  3. improve comparability between companies that lease assets and companies that borrow to buy assets; and
  4. create a more level playing field in providing transparent information about leases to all market participants.

 

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