IFRS 16: Leases, is the new accounting standard for recognizing, measuring, presenting and disclosing lease transactions under IFRS. The new standard eliminates nearly all off-balance sheet lease accounting and will have significant and wide impact on financial reporting and commonly used performance metrics such as, gearing ratios and EBITDA. IFRS 16 is effective January 1. 2019, early adoption is permitted for entities that apply IFRS 15: Revenue from Contracts with Customers.
- Most commonly used accounting ratios and performance metrics will be impacted, these include; gearing ratios, current ratios, asset ratios, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE, operating cash flows etc.
- Changes in commonly used accounting ratios and performance metrics will in turn impact debt/loan covenants, credit ratings, borrowing costs and will affect how stakeholders view the entity’s financial standing.
- The character and pattern of recognition for expenses will be impacted. Operating lease expenses will be replaced by depreciation and interest expenses, while lease expenses will be generally front-loaded even though lease payments remain constant. The timing of expense recognition will be accelerated under finance leases as compared to operating leases.
- Accounting systems and IT systems will need to be updated to gather, process and report lease information under the new standard. This will take considerable effort and resources to implement.
Key Principles of IFRS 16
IFRS 16 will supersede IAS 17: Leases, IFRIC 4: Determining whether an arrangement contains a lease, SIC 15: Operating leases – Incentives, and SIC 27: Evaluating the substance of transactions involving the legal form of a lease.
IFRS 16 presents a significant departure from the current guidance on accounting for leases, it introduces a single accounting model for all leases.
Determining whether a contract contains a lease
IFRS 16 defines a lease as a contract or part of a contract that conveys the right to use an asset for a period in exchange for consideration. To qualify as a lease, a contract must convey the right to control the use of an identified asset. A contract conveys the right to control the use of an identified asset if throughout the period of use, the customer has the right to:
- Obtain substantially all of the economic benefits from the use of the identified asset, and
- Direct the use of the identified asset
This new “right of use” approach replaces the current “risks and rewards” approach in IAS 17.
Separating lease and non-lease components
An entity must assess whether a contract is a lease or contains a lease at the inception of the contract. Many Lease arrangements are imbedded in contracts to purchase or sell other goods and services (e.g. maintenance service). In such situations, an entity must separate the lease component from the non-lease component and account for them separately. To apply this requirement an entity must:
- Determine whether the lessee benefits from the use of the underlying asset either on its own or with other resources readily available to the lessee.
- Determine whether the underlying asset is neither highly dependent, nor highly interrelated with the other underlying assets in the contract
In the event of a lease component, the entity has a policy election by class of underlying asset to account for both the lease component and the non-lease component as a single lease component, or account for each lease component separately from non- lease components of the contract.
When allocating consideration to separate lease components, an entity must allocate each consideration to each lease component on the basis of the relative stand-alone price of the lease component and the aggregate stand-alone price of the non-lease components.
Short-term Leases and Leases with low value assets
The standard defines the lease term as the noncancelable period for which the lessee has the right to use an underlying asset including optional periods when an entity is reasonably certain to exercise an option to extend a lease.
- Entities my elect not to recognize assets and liabilities for leases with a lease term of 12 months or less.
- Entities my elect not to recognize assets and liabilities for leases of low asset value such as laptops and small office furniture items. IASB guidance is that assets under $5,000 are considered to be low value assets.
Entities may choose between a full retrospective application of the new standard or a modified retrospective application. The entity’s selected approach must be applied to all leases. While the modified retrospective approach may initially look attractive, entities must carry out a detailed assessment to determine the impact of both approaches under the entity’s specific set of facts and circumstances to arrive at the appropriate selection.
Clearly IFRS 16 has far reaching consequences for most entities, careful consideration of the implementation and starting early will be key to a successful implementation of the new standard. Implementations of IFRS 15 and IFRS 9 may add to the complexity and increased competition for both internal and external resources, thereby challenging the effective implementation of IFRS 16.
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