IFRS 16 comes into effect for periods commencing on or after 1 January 2019. All businesses that have contracts which are currently treated as operating leases in their financial statements (i.e. any business who pays rent) will definitely be affected by the forthcoming changes.
The International Accounting Standards Board (“the IASB”) recognises that leases are important to many businesses. Leases can be used to provide access to valuable assets without significant upfront costs. If these leased assets are not recognised in the financial statements (along with the corresponding liability), users can neither see all the assets that the entity is benefiting from, nor easily compare their financial position to entities that have chosen to either buy the asset outright, or have entered into alternative financing arrangements.
The predecessor to IFRS 16 (IAS 17, Leases), required entities to classify their contracts as either operating leases or finance leases, based on the extent to which risks and rewards incidental to ownership of the leased asset lie with the lessor or the lessee. However, IFRS 16 removes the ‘operating’ and ‘finance’ lease classifications and replaces them with the concept of ‘right-of-use’ assets and associated financial liabilities. Put simply, this change results in the recognition of a lease liability on the balance sheet for operating leases (which reflects the present value of the future rental payments) and a corresponding asset which is referred to in the standard as a “right-of-use” asset.
Therefore companies who, for example, rent property may be significantly affected as these assets and corresponding liabilities will now have to be recognised. This will impact on current gearing levels and potentially on covenants provided to lenders and others. It is important to determine the impact sufficiently early to ensure that stakeholder expectations are managed.
There will also be an impact on the profit or loss. On adoption of the new standard, EBITDA (earnings before interest and tax) is likely to rise because the lease expense (i.e. the rent) will now be removed and replaced with additional depreciation and finance costs. The profit profile of the business will also change as more expense is recognised in earlier periods and less in later periods compared to the constant amount that was usually recognised under IAS 17.
If you are uncertain as to what the impact of IFRS 16 will be on your business, please contact us to discuss this further.