IFRS 16 is a new International Financial Reporting Standard for lease accounting which came into force on 1 January 2019. It replaced the existing IAS 17 accounting standard and was introduced by the International Accounting Standards Board (IASB). At first glance, it’s a complicated piece of accounting legislation which could potentially be difficult to navigate. On closer examination, however, it’s fairly straightforward to understand, but could be less so to implement. Here we try to make it easier for you to understand the pros, cons, and implications of IFRS 16 for your business accounting and even come up with a suggestion or two to make it simpler still.
What is IFRS 16?
IFRS 16 is the most significant change to lease accounting in over 30 years. Since its introduction on 1 January 2019, this new standard will affect most companies reporting under IFRS and will have a major impact on the financial statements of lessees of property and high-value equipment.
IFRS 16 takes a totally new approach to accounting for leases, called the ‘right-of-use’ model. This means that if a company has control over, or right to use, an asset they are renting, it is classified as a lease for accounting purposes and, under the new rules, must be recognized on the company’s balance sheet. This no longer allows for significant financial liabilities to be held off-balance sheet, as permitted for certain types of leases (operating leases) under the previous rules. The objective is to ensure that companies report information for all of their leased assets in a standardized way and bring transparency on companies’ lease assets and liabilities
As with other changes to accounting standards, companies will also need to produce a set of comparative accounts for the prior year.
What’s changed under IFRS 16?
Basically, the changes apply to the accounting treatment for lease agreements. Previously, these were split into finance leases and operating leases. Generally, operating leases were not included on balance sheets but were simply accounted for via profit and loss accounts.
The biggest IFRS 16 change is that now most leased items have to be included as an asset in the company books, following the new ‘right-of-use’ model which says: ‘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’ (IFRS 16, par.9)'
In addition, the lease payments you make on the agreement have to be reported as a lease liability on your balance sheet.
One ‘pro’ for IFRS 16 is that, if your company carries a number of lease agreements, it can be possible to combine them into a portfolio, instead of having to individually report them. This can only be done if you can show that there is no financial advantage for you in doing this.
It’s worth noting that lessor accounting is basically unaffected by the introduction of IFRS 16.
What is IFRS 16 replacing?
IFRS 16 replaces IAS 17 accounting standard.
Why the change?
The objective of the change is to make sure that companies all return information for leased items in the same way, making their existence more transparent financially. Previously, businesses could hold large financial liabilities on their operating leases but keep them off the balance sheets, giving a skewed view of their overall financial status.
The IASB Chairman Hans Hoogervorst says of the new requirements:
"(They) bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy."
Who does IFRS 16 apply to?
Initially, at least, these changes will only apply to organizations that already report using IFRS, typically international companies or PLCs. If IFRS 16 does apply to your organization then you need to first determine whether your rental contracts are actually considered to be IFRS 16 leases under the new standard, or are some other kind of contractual or service agreement.
What does this mean for financial reporting?
For companies affected by the changes, this will work in a similar way to the reporting of other non-financial assets (such as property, plant and equipment) and financial liabilities:
Balance sheets: lessees will need to show their right-of-use asset as an asset and their obligation to make lease payments as a liability.
P&L accounts: lessees will show depreciation of the asset as well as interest on the lease liability. The depreciation would usually be on a straight-line basis.
As interest charges are higher in the early years of the lease, the total impact on the P&L account is front-loaded even though rentals remain constant throughout the term of the lease.
Rather than having to account for all asset leases individually, there is scope to combine these into a portfolio. This can only be applied if the company can demonstrate that there would be no financial advantage to them taking this approach.
Affected companies will broadly have to go through three stages to be able to complete their IFRS 16 financial reporting:
Identification of all their assets which will be defined as leases under the new regulations (property, equipment, vehicles, etc).
Collecting all the information on these leases – term, options at end of lease, rentals payable, interest rate of the lease (if available; for operating leases this will not usually be available) so the lessee will need to think about their incremental borrowing cost (this could be the rate they internally borrow at).
The accounting for their leases to recognize assets and liabilities – once all the information is assembled the calculation is actually relatively easy – it’s just finding the inputs that could be challenging.
It is expected that step 2 will be the most difficult, and potentially time-consuming, for organizations with a large number of assets. Efficient lessors should be able to assist companies with this stage by anticipating needs and communicating proactively.
If you need more help with any aspect of IFRS 16, contact us and we will provide you with the necessary tools to comply to this standard.
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