Understanding Accounting Standards: IFRS 16 Leases

Background and Overview

First published by IASB in January 2016, IFRS 16 Leases will replace the existing IAS 17 Leases. IFRS 16 has to be adopted for reporting periods beginning on or after 1 January 2019, with early adoption permitted, for entities applying IFRS 15 Revenue from Contract with Customers.


Basically, the aim of IFRS 16 is to ensure that most of the leases entered into between the Company (lessee) and another party (lessor) are taken up and presented in the financial statements of the Company. This will be reflected by the recognition of a right-to-use asset and a corresponding lease liability in the balance sheet of the Company, which will be flushed out to the profit and loss over the lease term.


Under IAS 17, Company’s (lessee) have the ability to classify leases and operating leases (no asset and liability sitting in the balance sheet, only expenses recorded as incurred) or finance leases (asset and liability recognised in the balance sheet), depending on fulfilling certain requirements specified in IAS 17. However, these requirements include complex rules and tests which are not so clear-cut, and allows Company’s to get away with not recognising lease commitments in their books.


Hence, IFRS 16 was published to address this issue and ensure that leases and other similar contractual arrangements are accounted for accordingly, and standardised across all entities and industries.


Analysis

1. Impact towards lessee

Due to the recognition of right-to-use assets and corresponding lease liabilities for existing leases, we can expect that the assets and liabilities sitting on the balance sheet of lessees to increase. Depending on the number of leases entered and the contract sum, the impact could be minimal, or material to the financial statements as a whole. As such, Company’s should watch their performance metrics, e.g. EBITDA, EPS, operating cash flows, gearing ratio and capital ratios, as there will definitely be fluctuations in these numbers. This is especially important if your business have loans and borrowings with financial covenants relating to financial performance and ratios. If your Company has leases currently classified as operating leases and obtain financing from external parties, it is best that you discuss with your financier to iron out IFRS 16 adoption matters beforehand, to avoid conflicts and penalties upon mandatory adoption in 2019.


Furthermore, if the Company has multiple leases, e.g. manufacturers leasing production equipment, transportation company leasing vans and lorries, management should start considering the need to implement or update their current accounting or ERP system to allow easier tracking of lease assets which will have to be capitalised. It can be really tedious to trace the movement of right-to-use assets and corresponding lease liabilities if the Company has hundreds of leases. Hence, it is advisable to start consulting your IT solution providers now to discuss the available options to address the impact of IFRS 16.


2. Impact towards lessor

Generally, there is minimal impact if your Company is a lessor, as you will continue to account for leases similarly to IAS 17. However, there will definitely be requests from customers (lessee) to revise their lease agreements and rental contracts for it to be more favourable for their books. Lessors should not sit back and wait for their lessees to come to them to renegotiate their contract, as it will be a mad rush closer towards the implementation date. As such, lessors should also take initiative and start contacting customers to revise their contracts so both parties are able to continue profitable business relationship.


3. Exemptions from recognition of lease assets and liabilities

IFRS 16 provides recognition exemptions for leases which fall into any of the following two categories, i.e. short-term leases and leases with a low value underlying asset.


Short-term leases are defined as leases with a term of 12 months or less. To determine whether a lease qualifies as a short-term lease, options to extend and the likelihood of accepting the lease term extension should be taken into consideration. Also, any lease contract with an option to purchase cannot be a short-term lease.


As for low value underlying assets, these are usually for generic computer and office equipment which are individually low in value. IFRS 16 does not mention a specific threshold or amount to qualify as a low value underlying asset, but IASB has mentioned in their reports that an indicative amount would be assets which are less than $5,000 would qualify for this exemption.


If exempted from IFRS 16, the accounting treatment for these eligible leases will be similar to the current treatment under IAS 17, whereby lease expenses will be recorded in the profit or loss on a straight-line basis over the lease term or another systematic basis.


Conclusion

From the above, we can conclude that IFRS 16 will mainly impact lessees, and minimal changes are expected from the lessor’s perspective. As mentioned above, despite the adoption date in 2019, management should be proactive and start looking into the new standard to determine how existing leases will affect the financial statements of the Company. Similar to our other “Understanding Accounting Standards” articles, this write-up only covers the key points in IFRS 16. There are other more complex considerations like sale and leaseback transactions which have not been discussed here. If you have any queries or comments on the write-up on IFRS 16 above, or if you would like to check on something which has not been discussed above, please feel free to contact us.


Published by : Leanne Chong - Marketing Counselor of Rockwell Global Solution


Disclaimer: The example above is for illustrative purposes only, and might not be applicable for all business contracts. For further understanding of IFRS 15, please read up on available publications and consult your financial accountant/consultant. The material and information contained on this website is for general information purposes only. Rockwell makes no representations or warranties of any kind, express or implied about the completeness, accuracy, reliability, suitability or availability with respect to the website or the information, products, services or related graphics contained on the website for any purpose. Any reliance you place on such material is therefore strictly at your own risk. Rockwell will not be liable for any false, inaccurate, inappropriate or incomplete information presented on the website.You should always refer to latest update or revision of relevant law and regulations, or contact your accountant more details. If you need professional advise, ROCKWELL is always here to assist you. Please contact us.