IFRS 16: Leases on the Loose

“Special report on leases concludes that the distinction between operating leases and finance leases that is required by present standards is arbitrary and unsatisfactory. The main deficiency being that they do not provide for the recognition in lessees’ balance sheets of material assets and liabilities arising from operating leases”

Date: 1996 and published by the G4+1 group of international standard setters (being Australia, Canada, New Zealand, the UK and the USA).

Sir David Tweedie, a previous Chairman of the International Accounting Standards Board, often quipped that “One of my great ambitions is to fly in an aircraft that is on an airline’s balance sheet”.  Because they very rarely have been.

Twenty years on and the revised international standard on leases (IFRS16 – Leases) was finally published in January 2016, largely to deal with these long recognised deficiencies.

There has been some delay but perhaps Sir David can now achieve his ambition!

This is significant as the IASB has estimated that listed companies using IFRS or US GAAP had almost US$3 trillion of off balance sheet lease commitments in 2014.

Why is this so important?

Leasing is an important and widely used financing solution. It enables companies to access and use property and equipment without incurring large cash outflows at the start.

It also provides flexibility and enables lessees to address the issue of obsolesce and residual value risk. Also sometimes, leasing is the only way to obtain the use of a physical asset that is not available for purchase.

The most obvious difference is how operating leases will be brought onto the balance sheet. Under IAS 17, a lessee is not obligated to report assets and liabilities from operating leases on their balance sheet and they are instead referred to in the notes to the accounts. This has typically provided financial statement users an inaccurate account of a company’s outstanding expenses.

Analysts, who are generally smart people, were aware of these anomalies, so they often adjusted balance sheets to allow for this – typically by multiplying the annual rental payment by a factor of, say, eight and adding the resulting total to both the asset and liability sides of the balance sheet.  However wise they may be, we can be certain that this rough and ready approach will not give the right answer! It’s far more complicated and the holder of the detailed information necessary to carry out the calculation is the company leasing the assets. From 1 January 2019 companies will have to do the more detailed calculations and capitalise the vast majority of the assets and liabilities associated with leases.

Hans Hoogervorst, the chairman of the International Accounting Standards Board says, “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.”

The key proposals are that, applying the new single lessee accounting model, a lessee is required to recognise:

  1. Assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is low value; and
  2. Depreciation of lease assets separately from interest on lease liabilities in the income statement.

The new standard will affect virtually all commonly used financial ratios and performance metrics such as gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows. These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes. These impacts may compel many organisations to reassess certain ‘lease versus buy’ decisions.

Research shows that the average company will see a 13% increase in EBITDA and 22% increase in interest-bearing debt. For companies in some industries, the impact will be even greater. For example, the average expected increases for retail business are 41% and 98% respectively.

Balance sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will also be a change to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (‘frontloaded’).

Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships and technology – are expected to be greatly affected.

To qualify for exemption, a short term lease of 12 month or less period must not contain purchase options and the substance of a series of one year leases or similar structure would need to be assessed.  The low value leases are likely to relate to items such as a personal computers or items of office furniture and equipment.  There is no monetary threshold in the standard but the IASB have indicated a level of around $5,000.

The cost to implement and continue to comply with IFRS 16 could be significant for most lessees. Particularly if they do not already have an in-house lease information system.

The pervasive impact of these rules requires companies to transform their business processes in many areas, including finance and accounting, IT, procurement, tax, treasury, legal, operations, corporate real estate and HR.

From 2019, if your organisation is accounting for leases, as a lessee, under International Financial Reporting Standards (IFRS) then the distinction between operating leases and finance leases will be no more. Note this has been written carefully as changes are not yet being fed through to UK GAAP under Financial Reporting Standard (FRS) 102, and the distinction is still relevant to lessor accounting under IFRS.  So as of this moment, private UK companies (who will be reporting under FRS 102) will not be applying this standard.

In addition, the US FASB and IASB have not fully converged on this standard and it’s likely that the distinction will affect how lease rentals are charged to the income statement under the soon to be published US standard.

Well it was never going to be that easy – even with a twenty year head of steam!

To learn more about these issues, including the practical issues to consider, BPP offers relevant courses including:

IFRS 16 – Leases (The New Leases Standard)

IFRS –Keeping up to date

IFRS – New & Revised Standards

IFRS – A Comprehensive Refresher

For a wider view of BPP’s Financial Reporting portfolio please click here.

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