Worldwide: IFRS 16 Leases - What It Means For You

IFRS 16 Leases, published by the International Accounting Standard Board (IASB) in January 2016, has introduced new requirements that organizations with leased assets must pay attention to. The requirements set out principles for the recognition, measurement, presentation and disclosure of all leases and will take effect in January 2019. Earlier application is permitted.

Impact

Previously, only finance leases were recorded on the balance sheet; going forward operating leases must be recorded as well. For some companies, such as retailers, airlines, transportation, and energy, this could potentially become the one of the most material items on the balance sheet.

IFRS 16 will cause significant changes to balance sheets, profit & loss (P&L), and cash flow statements in certain industries, as well as EBITDA and credit ratios, and consequently may affect market sentiment, share prices, analyst coverage, and credit ratings.

Companies should already be evaluating impact of transition options and practical expedients. Companies should also consider communication to the market as early as possible, especially if there are likely to be surprises or unexpected results. There will be a greater scrutiny of lease contracts which will systematically hit the face of the balance sheets, rather than just being recorded in the notes (off-balance sheet) of the financial statements.

Measurement by Lessees:

  • At the commencement of the lease, the lessee recognizes a right-of-use asset equal to the lease liability (present value of the lease payments)
  • The discount rate is set at the start of each lease and applied to future expected lease payments
  • The lease commitment is unwound as payments are made
  • The right-of-use asset needs to be adjusted, while the lease liability needs to be remeasured using a revised discount rate when there is a change in:
    • The lease payments related to a lease modification (provided the modification is not accounted for as a separate lease)
    • The lease payments resulting from a change in an index or rate (e.g., floating rate indexed on LIBOR)
    • The lease term
    • The assessment of whether the lessee will exercise the option to purchase the underlying asset

IFRS 16 allows two ways to determine discount rates:

  1. Rate implicit in the lease (this may be difficult to obtain historically for all lease contracts)
  2. Incremental borrowing rate for each lease, if implicit rate cannot be readily determined

Factors that must be considered when estimating the lease liability:

  • Lease term
  • Economic environment
  • Company's credit standing (or rating)
  • Nature and quality of collateral provided
  • Country risk
  • Currency

Other Notes

  • The balance sheet liability can potentially be highly sensitive to small changes in the discount rate applied to lease payments
  • Companies with material off-balance sheet leases should analyse measurement options early to assess the potential liability and minimize the impact of adopting the new standard
  • Consider aggregating similar leases based on economic and other characteristics, as allowed by the standard (for instance, leases in similar geographies and vintages)
  • Consider differences to disclosure requirements under IAS 17 Leases

Transition:

IFRS 16 allows some practical expedients when applying the standard for the first time. In addition, upon transition a lessee has the option to apply one of the following:

Full retrospective approach:

Cumulative catch-up approach:

  • Lessee must restate the comparative reporting periods, as if IFRS 16 had always been applied
  • Lessee goes back to the point in time when each lease agreement commenced and gathers the necessary information to measure the associated lease liability and right-of-use asset. The discount rate used can be based on either:
    • Implicit rate in the lease
    • Incremental borrowing rate when lease commenced (if implicit rate is not readily determinable)
  • Lessee does not restate comparative information
  • Date of initial application becomes the first day of the annual reporting period when the standard is adopted (e.g., 1 January 2019 for a calendar-year company adopting the standard in 2019)
  • Lease liability is measured as the present value of remaining lease payments using the incremental borrowing rate on date of initial application
  • Two options for measuring the right-of-use asset, on a lease-by-lease basis:
  1. Carrying amount as if IFRS 16 had been applied since the lease commencement date, but using a discount rate based on the lessee's incremental borrowing rate at the date of initial application; or
  2. Amount equal to the lease liability (adjusted by the amount of any previously-recognized prepaid or accrued lease payments)

Timing

IFRS 16 is effective for annual reporting periods beginning on or after 1 January 2019, with early adoption permitted. For those entities with significant operating leases, the impact will be significant and it becomes crucial to start preparing for adoption as soon as possible.
  • 2017: Companies to start providing market guidance on the impact of capitalizing off-balance sheet leases
  • 2018: Companies to prepare comparatives from January 2018 (only if electing to apply the Full Retrospective Approach)
  • 2019: IFRS 16 is effective for accounting periods beginning on or after January 1, 2019

Act now to:

  • Understand how your balance sheet, P&L and Cash Flow statement will change
  • Consider the options on measurement upon transition
  • Consider the impact when communicating with analysts and rating agencies

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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