Leases are contracts that convey the right to use an asset for a
period of time in exchange for consideration. A lessee currently
classifies them on the financial statements as either finance or
operating leases, depending on the nature of the lease.
A finance lease is "a lease that transfers
substantially all the risks and rewards incidental to ownership of
an asset"1. An operating lease is "a
lease other than a finance lease"2. It is used
to finance the asset for less than its useful life.
The distinction is sometimes put colloquially: a long-term
lease, versus a mere rental.
Under current rules a finance lease results in the asset and
finance liability being recorded on the lessee's balance sheet.
In the income statement, the payments over the term of the lease
are split between depreciation and interest. This reflects
one aim of accounting which is to record substance, rather than
form: a long-term lease might encompass so much of the life
and value of an asset that, in substance if not form, the
arrangement is a purchase and sale. One consequence of this (that
often surprises lawyers) is that a balance sheet will include
assets to which the entity has no legal title.
Operating leases, on the other hand, are currently not recorded
at all on the balance sheet. Lease payments are charged to the
income statement on a single line.
However, with effect from 1 January 2019, significant changes
are being made to the accounting for leases, superseding the
existing IAS 17.
So what is changing?
Recording operating leases off-balance sheet hides information.
It is unclear how much of the lease expense is depreciation or
IFRS 16 will require reporting entities to record, on the
balance sheet, assets that are the subject of operating leases; and
lease expense to be split between depreciation and
Operating leases relate to assets that are owned neither
legally or in substance. So why record them on the balance
sheet? The answer lies in understanding that the main purpose
of financial statements is to assist their users to make economic
decisions. The IASB's Effects Analysis on the new
standard4 explains that "The absence of
information about leases on the balance sheet meant that investors
and analysts were not able to properly compare companies that
borrow to buy assets with those that lease assets, without making
adjustments". The new standard, therefore, focuses more
on the liability side of lease arrangements than the asset side:
the lease payment obligation should be on the balance sheet; and
since there are two sides to every accounting entry, the asset must
be recorded too!
How will this affect the balance sheet?
A lessee will be required to recognise assets and liabilities
for both operating and finance leases5. The diagram
below portrays this change:
Instead of a single line for the operating lease expense, IFRS
16 will now require entities to recognise two separate components -
a depreciation charge for lease assets and an interest expense on
However, there are two exceptions – leases of 12 months or
less; and leases of low-value assets.
As shown above, the change will result in an increase in assets
and liabilities. This will affect key liquidity ratios (such as
debt/equity ratio) which could cause problems with debt
In the context of valuation, the split of operating leases from
a single expense to depreciation and interest expenses separately
will result in a higher EBIT and EBITDA, due to the exclusion of
the depreciation component of operating expenses for EBIT and both
the depreciation and interest component in EBITDA.
It will therefore become important to know that operating leases
will be presented differently from 2019, especially when
considering historical performance and comparability.
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