IFRS 16- Key changes and impact

Lease accounting is covered by IAS 17, but is being replaced by IFRS 16 which is effective for annual reporting period beginning on or after 1 January 2019. This post looks into the key changes in IFRS 16, as compared to IAS 17. There are several important changes in IFRS 16 compared to IAS 17, especially in relation to recognizing lease contracts in financial statement by the lessee.

Changes for the lessee

  1. Recognition of Lease assets

The current IAS 17 requires differentiation between operating lease and finance lease for the lessee. If the lease does not meet the criteria of finance lease, it is regarded as operating lease and does not form part of SOFP, and is treated as off balance sheet item. One of the major changes in IFRS 16 is that the lessee now follows a single accounting model and is required to recognize all leases with the term of more than 12 month in its financial statement, unless the underlying assets is of low value. So, the need for differentiation between finance leases and operating leases is now eliminated. As per IFRS 16, once lease contract is entered into, lessee is required to calculate the cost of right-of-use assets at cost, as per Para 24 of IFRS 16, and show the lease as lease assets (right-of-use assets). Similarly, lease liability is recognised at present value of the lease payments.

2. Depreciation and Interest for lease liabilities

In current IAS 17, the lease payments for operating leases are accounted as lease rental expenses and charged to income statement. But under IFRS 16, the nature of expense for lease would change. Once right-of-use assets are accounted in fair value as discussed above, the assets are depreciated using IAS 16 Property, Plant and Equipment, and interest expense should be recognized for lease liability. The interest component is calculated using effective interest rate method. Hence, under IFRS 16 the statement of comprehensive income will now have finance cost and depreciation on right of use assets, instead of the lease rental expense that is seen under IAS 17.

Investor perspective published by IFRS foundation (2016) reports that around 85% of the lease are off balance sheet item as per current IAS 17 because the leases do not meet the criteria of financial lease. Further, IFRS 16 Project Summary of IFRS foundation (2016) notes that listed companies using IFRS or US GAAP disclosed almost US$3 trillion of off balance sheet lease commitments in 2014 and so long-term liabilities of off balance sheet leases were understated from 22% to 45%, across continents.  This means for the off-balance sheet operating leases, only rent expenses are reported for those assets, and the investors had to adjust the figures to understand the actual financial position of the company.

The new changes would address this issue and provide more useful information to investors. All leases will now be accounted for and investors will know the value of lease contracts and associated liabilities and so also promotes transparency. When right to use assets and lease liabilities are recognized, the balance sheet size of the companies will be larger. This will have more impact on industries that is more dependent on leased assets. A global lease capitalization study conducted by PWC (2016) revealed that with the new standard the retailers would see median increase in debt of 98%, as compared to 22% for all companies. Changes in nature of lease expenses (Depreciation and interest instead of lease rental) and its accounting would have impact on the profitability of the company.

Changes for the lessor

IFRS 16 does not have much change for the lessor and the lessor continue to classify its leases as financial lease and operating lease. However, para 92 of IFRS 16 requires additional disclosure regarding the risk management strategy which did not exist in IAS 16. This means the lessor are encouraged to disclose how they manage their risk in the underlying lease assets

To conclude, IFRS 16 has some significant improvement over IAS 17, particularly the need to account for right-of-use assets and so is expected to improve the overall quality of financial disclosures in the financial statement with respect to leases accounting. The impact could differ between industries depending on extent of use of lease and those entities with significant leases will see distortion of key balance sheet and profitability ratio because of capitalization of all leases and change in nature of expenses.