International accounting standards on treatment of leases became effective on 1 January 2019. It is vital that companies understand the serious impact this can have on their finance and operations.
The International Accounting Standards Board (IASB) continues to undertake major projects to improve its International Financial Reporting Standards (IFRS). The IFRS 16 directive, announced in January 2016, became effective 1 January 2019, replacing IAS 17. This new standard for reporting on leases provides greater transparency on companies' lease assets and liabilities and shines a light on arrangements that were previously accounted for as off balance sheet financing under IAS 17.
What is IFRS 16?
IFRS 16 is the new IASB accounting standard concerning the treatment of leases. It provides a new definition of what a lease is, and also outlines the principles for recognition, measurement, presentation and disclosure of all leases, with the exception of leases for exploration of oil, natural gas, minerals and similar commodities, licences of intellectual property granted by a lessor and rights held by a lessee under licensing arrangements of all types, including copyrights, and service concession arrangements, all covered by other accounting standards.
Under IFRS 16, subject to certain recognition exemptions, companies must bring operating leases onto the balance sheet (only finance leases were accounted for as such previously) and can no longer leave them as off balance sheet items subject to often unexplained analysis and adjustment. For lessees, the distinction between operating and finance leases under IAS 17 is eliminated. This provides transparency of all major leases held by a company but has a potentially significant impact to the financials and operations of a company.
It should be noted that IFRS 16 does not fully converge with the equivalent standard under US GAAP (ASC 842), so those companies doing business in APAC countries and the US ("dual reporters") must continue to apply different lease accounting models.
Major Impact is on Lessees
With all major leases now being reflected on the balance sheet, lessees will appear to have increased their assets, with a right of use ("ROU" – the contractual right to use an asset held under a lease) asset, but will be impacted on the liabilities side with an increase in indebtedness due to the present value of forward lease payments being recognised as a liability.
Profit & loss (P&L) is also significantly impacted. Rental expenses will be:
- front-loaded because of the "unwinding" of interest on the lease liability, even if the cash payments over the lease term remain constant. Consequently, net profit, and measures such as Earnings Per Share (EPS), will fall during the early years of a lease.
- classified as depreciation expense (against the ROU asset) and interest expense. Hence, Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) will increase as rental expense, which was previously classified "above the line" as operating costs, are now excluded from the EBITDA measure.
Companies with internal KPIs or external treasury metrics, such as loan covenants, built around these P&L measures will be impacted.
IFRS 16 will also have a significant impact on the company's cash flow classifications and the demands of its extensive disclosure requirements in financial statements.
Application of relevant accounting guidance, particularly in relation to the identification of a lease, the accounting for renewal options, measurement of variable lease payments, and choice of discount rate used to discount the lease liability, is inherently complex and requires a significant degree of input and judgment by not just accounting or finance professionals, but other stakeholders from operations, procurement, IT and treasury.
What is the impact on key industry sectors?
This will have a serious impact on any businesses that use lease arrangements as a means to access assets, particularly those heavily involved in the retail, shipping, property and aviation sectors; indeed, any industry sector where leased assets are of high value.
Lessors should also remain alert as lessees may wish to renegotiate lease terms and structure future leases differently.
How does this affect investors?
In reality, nothing has changed: the affected companies have always held these lease commitments. However, the commitments will now be reflected on the balance sheet for all to see.
This will create a shift in both assets and liabilities during the 2019 reporting period.
Companies must carefully explain this sudden change in their financial position and key financial measures to investors, to avoid damaging investor confidence and to manage investors' expectations.
Transition from IAS 17 to IFRS 16
Lessees may apply two different transition methods:
- Apply the IFRS 16 standard retrospectively to each prior accounting period presented
- Take a "big bang" approach at the initial date of application of IFRS 16 and not restate comparatives.
Both methods require a significant amount of work and companies should obtain a detailed understanding of the resources, costs and stakeholders' needs in selecting the most appropriate transition method.
Why talk about IFRS 16 again now
Based on our interaction with market participants in 2019, many companies are still struggling with implementation or are just starting to understand how they will be affected.
Common pitfalls and challenges seen thus far:
- Companies have no IT or manual system in place to collect lease data and perform bookkeeping
- Companies incorrectly assume the definition of "lease" remains unchanged
- Companies are unclear on the specifics and costs involved for each transition option
- Companies with operations in multiple countries unclear on whether the standards are applicable in all relevant jurisdictions
- Companies are not yet engaged with stakeholders (internal and external) to communicate direct and indirect impact that IFRS 16 has on KPIs, remuneration, bank covenants, internal processes, lease strategy and tax reporting
Firms can no longer say "let's worry about IFRS 16 later". For most, the standard is already effective and has real consequences on finance and operations – are you sure you are ready?
Talk to us
The details behind IFRS 16 are complex and must be carefully implemented and clearly explained in company financial reports throughout 2019. TMF APAC can help you to comply with IFRS 16 and with future changes to the accounting standards of the IASB, allowing you to focus on your company's growth and innovation whilst we take care of the technical implementation. To learn more about TMF Group and our services, talk to us.
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.