Steve Collings examines the ramifications of the new accounting standard, called IFRS 16, and explains what these changes mean.
In January 2016, the International Accounting Standards Board (IASB) issued their long-awaited new leasing standard. The issuance of this standard marked the end of approximately 10 years of work by the IASB and the US standard-setters (the Financial Accounting Standards Board) to develop an accounting standard that stopped off-balance sheet finance from taking place. At the outset it is worth emphasising that the UK’s Financial Reporting Council (FRC) has not indicated whether FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland will reflect the provisions of IFRS 16 Leases, and indeed, FRS 102 is not due for its first comprehensive review by the FRC until 2019.
The new standard applies to accounting periods starting on or after 1 January 2019, but an entity reporting under IFRS can choose to apply the new standard before that date. However, if the entity chooses to early-adopt IFRS 16, it must then also early-adopt the provisions in the new revenue recognition standard, IFRS 15 Revenue from Contracts with Customers.
No finance v operating lease distinction
One of the most notable changes brought about in lease accounting by IFRS 16 is that the standard eliminates the concept of ‘operating’ and ‘finance’ leases from the perspective of the lessee. It introduces a single model which requires a lessee to recognise:
assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value; and
depreciation of lease assets separately from interest on lease liabilities in the income statement.
For lessors, there is no change to the accounting requirements and lessors will continue as normal classifying leases as operating leases or finance leases.
IFRS 16 will supersede IAS 17 Leases and IAS 17 requirements focused on identifying when a lease is economically similar to an entity purchasing the asset being leased (a ‘risks and rewards’ approach). Indeed, FRS 102 follows similar principles where the economic substance of the leasing transaction is reported and where a finance lease is concerned, the economic substance (i.e. the commercial reality) of the transaction is that the lessee has acquired an asset which has been funded through a leasing transaction, hence the asset is reported as a fixed asset with a corresponding finance lease creditor. This concept is the way in which UK accounting standards work and the concept has been carried over into FRS 102.
Operating leases are not reported on the balance sheet and these are accounted for similarly to service contracts with the company recognising a rental expense on a straight-line basis over the life of the lease.
The development of a new leasing standard by the IASB has been a long journey; indeed, the project was initially started in 2005. Both the IASB and the US Financial Accounting Standards Board (FASB) recognised that most leasing transactions were not reported on the balance sheet and hence assets and liabilities were both conceptually understated. In 2014 companies listed on a recognised stock exchange disclosed almost US$3 trillion worth of off-balance sheet lease commitments in 2014.
The IASB concluded that in the absence of information concerning leases on the balance sheet this gave rise to the users of the accounts not having a complete picture of the overall financial position of the entity and therefore they were unable to compare companies that borrow to buy assets with those that lease similar assets, without adjustments having to be made.
Changes to the definition of a lease
The definition of an asset has been changed to confirm that a lease is ‘… a contract that conveys to the customer (‘lessee’) the right to use an asset for a period of time in exchange for consideration’.
A lease will exist when a customer has the right to control the use of an identified asset for a period of time. Whilst the definition of a lease has changed, the IASB acknowledge that this was done on the basis of feedback and that the changes made to the definition are not expected to change the conclusions about whether contracts contain a lease for the vast majority of contracts.
Changes to the balance sheet
In respect of lessees, the notable change comes in the form of the elimination of leases as either operating or finance leases. IFRS 16 regards all leases as finance leases (with a couple of exceptions) and hence they are capitalised by recognising the present value of the lease payments and showing them as either ‘lease assets’ (right-of-use assets) or combined with property, plant and equipment. Where lease payments are made over a period of time, a finance lease liability is recognised within creditors representing the lessee’s obligation to make future lease payments.
Clearly the most significant change to an entity’s balance sheet will be an increase in lease assets and finance lease liabilities. It is fair to say that many entities are not happy about the new leasing standard because some do lease assets through genuine operating leases and critics of the new standard suggest bringing these assets on the balance sheet will distort the reported figures.
Change to the profit and loss account
For entities that have material off-balance sheet leases (i.e. operating leases), IFRS 16 will bring a change to the nature of expenses which relate to those assets. As mentioned earlier, the concept of operating leases is eliminated and therefore IFRS 16 replaces the straight-line operating lease rental with a depreciation charge for leased assets, which is to be included within operating costs. There will also be an interest expense (recognised in finance costs) in respect of the leasing liabilities.
Depreciation charges will generally be even throughout the life of the lease, but the interest expense will not. This is because the interest expense under IFRS 16 will reduce over the life of the lease as lease payments are made. This results in a reducing total expense as an individual lease matures. The IASB have said that they do not expect the expense profile between IFRS 16 and IAS 17 to be significant for many companies which hold a portfolio of leases which start and end in different accounting periods.
The impact on profit or loss can be seen in the following table:
|Finance lease||Operating lease||All leases|
|Operating costs (excluding depreciation and amortisation)||-||SingleExpense||-|
|Depreciation and amortisation||Depreciation||-||Depreciation|
|Profit before tax||↔|
Changes to the cash flow statement
The actual cash flows involved in leasing transactions will not change because the same amount of money will be involved as was the case under IAS 17. However, the presentation of some cash flows associated with leasing will change.
Operating cash flows are expected to reduce under IFRS 16 principles with a corresponding increase in financing cash flows. This is because under IAS 17 principles, companies presented cash outflows on former off-balance sheet leases as operating activities. Under IFRS 16, capital repayments on all lease liabilities are included in financing activities. Interest payments can also be included within financing activities under IFRS.
Exemptions from IFRS 16
IFRS 16 does not require a lessee to recognise lease assets and lease liabilities on the balance sheet in two situations:
the leases are short-term (i.e. 12 months or less); and
the leases are in respect of low value assets (such as a computer lease).
Whilst UK and Republic of Ireland companies reporting under FRS 102 will not be affected, the significance of this change is worth noting because some companies will be affected. Whilst the FRC have not suggested the requirements of IFRS 16 will be reflected in FRS 102 at present, given the significance of the change, it might be something which could affect UK GAAP in the future.