The IASB has finally finished its long-standing project on lease accounting and released IFRS 16 Leases. Holger Meurer from Accounting Consulting Services looks into the details.
Almost eight years after Sir David Tweedie, then IASB chairman, expressed his wish to fly in an aircraft that is on an airline’s balance sheet at least once before he dies, the IASB has introduced a new accounting model for lessees and made his wish come true – just a few days after Christmas.
However, it actually was a long-distance flight and one might argue whether it really ended with a soft landing…
What has changed?
Under IFRS 16 lessees no longer distinguish between a finance lease (on balance sheet) and an operating lease (off balance sheet). Instead, for virtually all lease contracts the lessee recognises a lease liability reflecting future lease payments and a ‘right-of-use’ asset. The new model is based on the rationale that economically a lease contract is equal to acquiring the right to use an asset with the purchase price paid in instalments.
Lessees recognise interest expense on the lease liability and a depreciation charge on the ‘right-of-use’ asset. Compared to the accounting for operating leases under IAS 17, this does not only change the presentation within the income statement (under IAS 17 lease payments are presented as a single amount within operating expenses) but also the total amount of expenses recognised in each period. Straight-line depreciation of the right-of-use asset and application of the effective interest rate method to the lease liability will result in a higher total charge to profit or loss in the initial years, and decreasing expenses during the latter part of the lease term. The graph below illustrates this effect:
Click here to view the graph.
In the cash flow statement, lease payments relating to contracts previously classified as operating leases will no longer be shown in full within operating cash flow. The parts of the lease payments that reflect the repayment of the principal portion of the lease liability will be included in financing activities. The presentation of the interest portions depends on the entity’s general accounting policy regarding interest paid (that is, either within operating or within financing activities). Payments for short term leases, for leases of low-value assets and variable lease payments not included in the measurement of the lease liability are part of operating activities.
For short-term leases (12 months or less) and leases of low-value assets (assets with a value of USD 5,000 or less when new) the IASB has included optional exemptions. If an entity elects one of these exemptions, the lease contract is accounted for in a way that is similar to current operating lease accounting (that is, payments are recognised on a straight-line basis or another systematic basis that is more representative of the pattern of the lessee’s benefit).
Lessor accounting stays almost the same as under IAS 17. However, IFRS 16 adds significant new disclosure requirements. IFRS 16 requires further information about how the lessor manages its risk related to the residual interest in the underlying asset. Furthermore, a lessor now has to disaggregate the disclosures required in IAS 16 for each class of property, plant and equipment into assets subject to an operating lease and not subject to an operating lease.
Comprehensive guidance on the definition of a lease
IFRS 16 defines a lease as a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. This definition looks quite straightforward at first glance. In practice, however, it will be challenging to assess what makes a leased asset an ‘identified’ asset and what it takes to convey a ‘rightof-use’.
To facilitate this analysis the IASB has included comprehensive guidance on the definition of a lease that goes into far more detail than the current guidance in IAS 17 and IFRIC 4.
…and what are the effects om KPIs?
For lessees that have entered into lease contracts classified as operating leases under IAS 17, the new standard may have a huge impact. Obviously, the recognition of a lease liability for almost all lease contracts results in an increase of debt to equity ratios.
Balance sheet related ratios are only one part of the story. As the interest element of lease payments will now be presented as finance costs, earnings before interest and tax (EBIT) are expected to be higher under the new standard. Earnings before interest, tax, depreciation and amortization (EBITDA) are even higher still because of the depreciation of the right-of-use asset.
IFRS 16 shall be applied for annual reporting periods beginning on or after 1 January 2019. Earlier application is permitted. However, as there are several interactions between IFRS 16 and IFRS 15 Revenue from contracts with customers, early application is restricted to entities that also (early) apply IFRS 15.
For lessees, IFRS 16 includes several expedients and reliefs on transition. In particular, the IASB allows a simplified approach as an alternative to a full retrospective application in accordance with IAS 8. Under that approach, the cumulative effect of initial application is recognised as an adjustment to the opening balance of retained earnings at the date of initial application. Comparative information is not restated.
Existing leases are grandfathered. Lessees and lessors do not need to reassess whether a contract already on their books at the date of transition meets the definition of a lease.
The final standard is effective from 1 January 2019. This new guidance might require changes to systems, processes and controls. Management will need to assess implications as early as this year to ensure ample time to embrace the change and capture information needed for transition.