The International Accounting Standard Board’s new leasing standard – IFRS 16, Leases – will require companies to bring most leases on-balance sheet from 1 January 2019, the standard’s implementation date.
Under IFRS 16 lessees will recognise new assets and liabilities. This is designed to add transparency to the balance sheet since currently many analysts adjust financial statements to reflect lease transactions that companies hold off-balance sheet.
Such a major change to lease accounting throws up many business challenges and this article summarises the key areas management should be considering in advance of the implementation date.
The accounting treatment of leases by lessees will change fundamentally. Under the current standard – IAS 17, Leases – lessees must distinguish between on-balance sheet finance leases and off-balance sheet operating leases. IFRS 16 will eliminate this dual accounting model for lessees and replace it with a single, on-balance sheet accounting model that is similar to current finance lease accounting.
To simplify matters a little, there are two exemptions to the accounting requirements: IFRS 16 does not require a lessee to recognise assets and liabilities for short-term leases (i.e. leases of 12 months or less) or leases of low-value assets (for example, a lease of a personal computer).
Lessors are much less impacted – accounting remains akin to current practice, so lessors continue to classify leases as either finance or operating leases.
This is summarised in the table below:
|Current – IAS 17||To be – IFRS 16||Comment|
|– Classification||Classify leases as Finance leases or Operating leases||Unitary model – no finance or operating lease distinction||Treatment under IFRS 16 will be akin to finance leases per IAS 17|
|– Balance sheet||Finance leases on balance sheet
Operating leases off-balance sheet
|For all leases: capitalise present value of lease payments as an asset; any obligation to make future lease payments recognised as a liability||Most operating leases will come onto the balance sheet under IFRS 16, with certain exceptions|
|– Income statement||Operating lease expense, usually recognised on a straight-line basis||Depreciation charge and lease expense replace the operating lease expense||Income statement changes: Operating costs will decrease and finance costs will increase|
|Lessor||Classify leases as Finance leases or Operating leases||Classify leases as Finance leases or Operating leases||Lessor accounting substantially unchanged.
Some additional disclosures required under IFRS 16
Who is impacted?
Listed companies in sectors such as mining, oil and gas, telecommunications, retail and transportation are likely to be most heavily impacted due to their capital-intensive nature where leasing is a widely-used alternative to purchasing an asset. In contrast, asset-light sectors such as professional services and high-tech will see less profound changes.
For US GAAP registrants IFRS 16 acts to reduce, though not eliminate, the differences in lease accounting. The new US leasing standard, ASU 2016-02, Leases (Topic 842), was issued in February 2016 and completes the joint project by the IASB and the Financial Accounting Standards Board to improve the accounting for leases. The IASB and the FASB have reached the same conclusions in many areas, including requiring leases to be reported on the balance sheet, how to define a lease and how lease liabilities are measured. However, there remains some differences between the two standards, particularly in relation to accounting in the Income statement, so accounting convergence cannot be assumed – see Appendix 2 for a summary.
For SMEs reporting under UK GAAP it is unclear if, or when, IFRS 16 shall apply. The UK’s Financial Reporting Council has not indicated whether FRS 102 (the Financial Reporting Standard applicable in the UK and Republic of Ireland) will be changed to reflect the provisions of IFRS 16. As FRS 102 is not due for its first comprehensive review by the FRC until 2019 it is unlikely any changes will be introduced prior to then.
IFRS 16 will result in the grossing up of the balance sheet due to the capitalisation of lessees’ operating leases (which make up c85% of all leases according to research undertaken by the IASB). Most contracts currently treated as operating leases will become an on-balance sheet liability that attracts interest, together with an asset on the other side of the balance sheet. In other words, lessee balance sheets will appear more asset-rich but also more heavily indebted.
The accounting requirements will capitalise operating leases, resulting in a front-loaded pattern of expense for the associated financing liability. This is because even if cashflows are constant annual rental payments, the lease ‘loan’ (ie the contractual liability) will amortise on a reducing balance basis with interest expense declining over time as payments are made. However, this disconnect between expense recognition and cashflows will be very muted for lessees holding a portfolio of leases with multi-year terms.
Whilst the financial accounting aspects of IFRS 16 are not trivial, it is likely management will spend more time addressing the wider operational and financial implications of the new standard. Investors don’t like surprises, so consider when to announce to the market the impact of IFRS 16.
For listed entities, analysts will take a close interest in areas such as:
- The impact on financial results;
- The implementation costs of IFRS 16; and
- Any proposed changes to business practices such as pricing, contract terms, etc
- Disclosures on the impact of the new standard made in advance per IAS 8 (standards in issue but not yet effective).
For entities themselves, key business implications include:
- Use of exemptions for leases of <12 months (can exempt on an asset-class basis) and for small value leases (typically <$5k initial value, on an asset-by-asset basis)
- Transition-related disclosures should be considered, particularly the completeness of operating leases as currently disclosed
- Determining the discount rate – often not easy to identify the rate implicit in the lease as residual values, asset fair values etc often not known, so standard requires lessees to use their incremental borrowing cost – which itself is a challenge to determine. This is the primary challenge for companies
- Obtaining all the information of potential lease contracts – as many items not currently accounted for as a lease may become in scope
- Implementation options – simplified transition approach likely to be most popular, but all the options available need to be considered. On the simplified approach, comparatives do not need to be restated, though a rec between the ‘old’ lease liability and the new opening lease liability in the notes will be required. On this basis, the discount rate to be used should be the incremental borrowing rate on the date of transition (usually 01/01/19)
- US registrants are likely to have to maintain different processes, controls and accounting systems for each framework to comply with the different lessee accounting and reporting requirements as the IFRS 16 and US GAAP Topic 842 are not fully converged
Apart from the gross-up of the balance sheet, IFRS 16 has the potential to materially change the following:
– Earnings profile – Though the overall profits of an entity will be unaffected over the lease term, reported operating profits will increase, due to the bifurcation of the expense, whilst finance costs will be higher. This will result in a higher reported EBITDA, so management should be aware of the possible implications on bonuses and performance related pay (if linked to EBITDA, for example).
– Balance sheet volatility – The initial conversion will change the profile of the balance sheet and major lease additions or disposals will become much more apparent.
– Key financial ratios – Such as gearing and interest cover. Although many financial covenants include ‘frozen GAAP’ clauses, management should review their borrowing agreements to make sure the new standard does not create unexpected issues.
Some of the more important considerations for management are as follows:
– Review the inventory of leases. Is it complete and up to date? If not, how challenging will it be to obtain a comprehensive list of lease documentation and ensure it captures all the required information?
– Review lease contracts to determine their classification and accounting under IFRS 16. This could throw up some surprises and may require legal opinions to be obtained.
– Model the standard’s provisions on the balance sheet and earnings profile and check impacts on financial covenants if necessary. Consider how the impacts will be communicated to investors, analysts and banks.
– Transition options: is early adoption a consideration? If so, are plans sufficiently advanced?
– Lease data: do IT systems capture the required information? How complex is it to amend or is an off-the-shelf solution a possibility?
– Business impacts: consider terms and conditions of leases; pricing; renewal options etc. Although the IASB believes the new standard will not alter the economics of entering into a lease, the ultimate impact on the structuring of leases in the market is not yet known.
– IFRS 16 impacts not just finance – IT, procurement and legal are likely to be involved, so communication and training plans need to be considered carefully.
IFRS 16 requires entities to determine whether a sale has occurred in a sale and leaseback transaction. This is a significant change from current practice – under IAS 17 the focus is whether the leaseback is an operating or finance lease and not whether a sale of the asset has occurred. The new standard will also occupy legal departments’ minds in considering if existing or new service contracts should be considered a lease or vice versa.
HMRC is consulting on the effect of IFRS 16 on company profits, so UK tax impacts are not yet known (this is still the case as of July 2017). Similarly, regulators are reviewing the standard to assess whether regulatory requirements need to change in the light of IFRS 16. Companies will need to monitor developments carefully.
Effective date and next steps
IFRS 16 takes effect for annual reporting periods beginning on or after 1 January 2019. Early adoption is permitted if the new revenue standard IFRS 15, Revenue from Contracts with Customers, has also been applied. Early adoption in the EU is only permitted once EFRAG endorses the standard which is expected in Q4 2017. Although 2019 seems a long way off, there are many areas of impact and companies with significant lease exposures are well advised to commence their detailed planning and contractual reviews now.
In conclusion, the financial and accounting impacts of the new standard will ensure finance departments are kept busy well ahead of 2019. The usual maxims hold true – plan early, consider the broader business impacts and seek specialist advice where necessary.
IFRS 16 does not provide details of lease asset types, but it does refer to asset classes which are out of scope of the standard as well as exemptions to the recognition requirements of IFRS 16. The accounting standards dealing with assets (IAS 16, Property, Plant and Equipment and IAS 38, Intangible assets) also do not specify asset classes, though IAS 38 does provide examples of intangible assets:
- patented technology, computer software, databases and trade secrets
- trademarks, trade dress, newspaper mastheads, internet domains
- video and audiovisual material (e.g. motion pictures, television programmes)
- customer lists
- mortgage servicing rights
- licensing, royalty and standstill agreements
- import quotas
- franchise agreements
- customer and supplier relationships (including customer lists)
- marketing rights
Asset classes out of scope of IFRS 16
IFRS 16 Leases applies to all leases, including subleases, except for: [IFRS 16:3]
- leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
- leases of biological assets held by a lessee (see IAS 41 Agriculture);
- service concession arrangements (see IFRIC 12 Service Concession Arrangements);
- licences of intellectual property granted by a lessor (see IFRS 15 Revenue from Contracts with Customers); and
- rights held by a lessee under licensing agreements for items such as films, videos, plays, manuscripts, patents and copyrights within the scope of IAS 38 Intangible Assets
A lessee can elect to apply IFRS 16 to leases of intangible assets, other than those items listed above. [IFRS 16:4]
A lessee may elect to account for lease payments as an expense on a straight-line basis over the lease term or another systematic basis for the following two types of leases: [IFRS 16:5, 6 & 8]
- leases with a lease term of 12 months or less and containing no purchase options – this election is made by class of underlying asset; and
- leases where the underlying asset has a low value when new (such as personal computers or small items of office furniture) – this election can be made on a lease-by-lease basis. (Low value in this context is taken to mean assets with an initial value <$5k, meaning that cars are not low value leases.)
Possible asset classes
Given the lack of specific asset class definitions, it is difficult to be prescriptive as to lease asset classes. The following serves as a guide but it is not exhaustive or supported by any definitive guidance in the standard:
- Intangible assets
- Small assets (<$5k initial value)
- Plant and machinery
- Transportation: vehicles, ships, planes
- Office equipment
IFRS / US GAAP differences
|Item||IFRS 16||ASC 842||Comment|
|Effective date||Annual periods beginning on or after 01/01/19. Early adoption is permitted if the new revenue standard is also adopted||Annual periods beginning after 15/12/18 (public business and certain other entities) and after 15/12/19 for other entities. Early adoption is permitted||Non-public dual reporters may decide to adopt both ASC 842 and IFRS 16 on the same date|
|Transition and comparatives||Full retrospective approach, or modified retrospective approach with practical expedients available.
The modified retrospective approach is based on leases at the date of initial application and comparative information is not restated. Instead, the effect of adopting the new standard is recognized in opening retained earnings (or other equity component as appropriate) at the date of initial application.
|Modified retrospective transition is required for all leases existing at, or entered into on or after, the beginning of the earliest comparative period presented in the financial statements – i.e. comparative information is restated.
Practical expedients are available on transition, which are less extensive than those under IFRS
|Dual reporters may need to start implementing the lease standards earlier than companies that only report under IFRS to be able to present comparative information in their US GAAP reporting. They should also consider whether applying the full retrospective approach under IFRS 16 will result in greater comparability in the comparative periods presented|
|Balance sheet recognition||Lessees may elect to apply the recognition exemption for leases of ‘low-value’ assets||No low value exemption||Dual reporters will have to decide whether to use the low-value exemption or recognize leases of low-value assets to maintain consistency between US GAAP and IFRS reporting. When applying the exemption, entities will have to identify leases of low-value assets in the entire lease population to quantify the adjustment between US GAAP and IFRS|
|Lease classification||A single on-balance sheet lease accounting model for lessees||Dual classification on-balance sheet lease accounting model for lessees: finance leases and operating leases. Lease classification affects measurement of the right-of-use asset, lease expense and income statement presentation||Dual reporters will have to separately track leases that have a different classification between US GAAP and IFRS because their accounting will be different|
|Lease re-measurement||Lessees remeasure the lease liability for changes in variable lease payments based on an index or rate on the date when there is a change in the contractually required cash flows||Adjustments to an index or rate do not constitute a reassessment event||Dual reporters will have to separately track the re-measurement assessment for leases that are tied to an index or rate|
|Sale and leaseback||If the seller-lessee has a substantive option to repurchase the underlying asset, the transfer is not a sale.
The seller-lessee measures the right-of-use asset at the retained portion of the previous carrying amount of the underlying asset (i.e. at cost). Only the amount of any gain or loss related to the rights transferred to the buyer-lessor is recognized.
|If the seller-lessee has a substantive option to repurchase an underlying asset that is not real estate, the transfer may be a sale under certain circumstances.
The seller-lessee measures the right-of-use asset at the present value of the lease payments in the same way as any other lease. A gain or loss is recognized for the difference between the sale proceeds and the carrying amount of the underlying asset.
|Dual reporters will have to separately track the accounting for sale and leaseback transactions|
|Sub-leases||Unless the sub-lessor for the head lease applies the recognition and measurement exemption applicable to short-term leases, a sub-lessor classifies a sub-lease by reference to the right-of-use asset arising from the head lease||A sub-lessor classifies a sublease by reference to the underlying asset||Most subleases under ASC 842 are likely to be classified as operating leases, while most subleases under IFRS 16 are likely to be classified as finance leases by the sub-lessor|