The new accounting standard dealing with leases has now been
with us for nearly a year. Interesting, one may say, the words the
International Accounting Standards Board (IASB) chose as a heading
to its press release announcing the issuance of IFRS 16 on 13
January of this year: "IASB shines light on leases by bringing
them onto the balance sheet". The latter part of the heading
is very true; lessees will have to bring all leases on balance
sheet as the standard comes into force in reporting periods
commencing in 2019. I'm not so sure on the shining light as, 11
months down the line, there are still some important questions for
which lessees are still seeking answers.
In a nutshell, the two lease classifications – finance
lease and operating lease – allowed under the extant standard
will be a thing of the past. Instead, a single lease accounting
model will be implemented. Lessees will be recognising a right of
use (ROU) asset, denoting the lessee's right to use a
particular asset, and a lease liability representing the obligation
to pay future lease payments to the lessor over the lease term.
But I suspect this is no longer news for those who are reading
Lessees are more preoccupied by the practical implications that
the abolition of the operating lease model and the recognition of a
new asset and liability on balance sheet will bring.
Some still question the measurement of the lease liability. As
the lease liability at inception includes the present value of
lease rentals over the lease term, the determination of the lease
term is key. It includes, of course, the non-cancellable (di fermo)
period, but would also consider optional renewals or termination if
the lessee is reasonably certain to exercise these options –
a judgemental determination in itself.
The pattern of expense recognition in profit or loss may also
change significantly. While lessees are used to straight line
expense recognition in P/L for their operating leases, the total
expense that will be recognised for a similar lease under the new
standard will be higher in the earlier years, when interest cost on
the liability will be at its highest, and lower in later years. EPS
will therefore decrease in earlier years.
Certain financial ratios may be impacted significantly. EBITDA
will increase due to the new 'geography' of lease expenses
(ROU amortisation and interest expense below EBITDA, rather than
the 'old' lease expense on a straight-line basis above).
Total assets will increase due to the new ROU asset recognised and
gearing increases due to the increase in lease liabilities.
Other ratios are likely to decrease. Net assets will decrease
since each individual lease is a net liability for most of its life
as the ROU asset decrease faster than the lease liability. Interest
cover and asset turnover are expected to decrease as well.
When the impact of the above is significant, lessees are left
with no option but to bring the lease vs buy decision back to the
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Many Free Zone Companies incorporated in DMCC, DWC and JAFZA are leaving themselves exposed to potential fines and the non-renewal of their trading licence for failure to comply with one particular regulatory requirement.
With European governments needing to increase their tax collection, the Organisation for Economic Co-operation and development and other organisations are looking to standardise the reporting and filing of annual financial statements for companies across the world.
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