In January 2016, the International Accounting Standards Board (‘IASB’) issued IFRS 16 replacing IAS 17. IFRS 16 has fundamentally changed accounting for operating leases.
IFRS 16 became effective as from 01 January 2019 and has a major impact on the accounting and tax treatment for lessees of property and high-value equipment.
Off-balance sheet OUT
FRS-16 brings added transparency to the balance sheet by requiring companies to bring most leases on-balance sheet, recognising new assets and liabilities.
Increased debt to equity ratio
Companies that lease major assets for use in their business will see an increase in reported assets and liabilities.
Front Loading of Expenses
Interest expenses are higher in the early years of the lease and decrease over time
Various Sectors Affected
This will affect a wide variety of sectors, from airlines that lease aircraft to retailers that lease stores.
Off Balance Sheet
The new standard requires companies to bring most leases on-balance sheet, recognising new assets and liabilities. At present, many analysts adjust financial statements to reflect lease transactions that companies hold off-balance sheet.
Current lease accounting requires financial statement users to adjust for off-balance-sheet leases. The key change will be the increase in transparency and comparability. For the first time, analysts will be able to see a company’s own assessment of its lease liabilities, calculated using a prescribed methodology that all companies reporting under IFRS will be required to follow.”
Front Loaded Expenses
The impacts are not limited to the balance sheet. There are also changes in accounting over the life of the lease. In particular, companies will now recognise a front-loaded pattern of expense for most leases, even when they pay constant annual rentals. And the new requirements introduce a stark dividing line between leases and service contracts – the former will be brought on-balance sheet, while service contracts will remain off-balance sheet.
The effect to lease expense due to “Front Loading.” the lease asset and the lease liability are measured at the present value (pv) of the lease payments. Companies generally depreciate leased assets over the term of the lease if the lease does not include a transfer of ownership or a bargain purchase option because the asset will be returned at the end of the lease.
The result of “Front Loading” treat amortization and interest on a lease as separate costs, because while amortization costs are straight-line, interest expenses are higher in the early years of the lease and decrease over time (FASB, 2013). Business have to recognize significant interest costs on the income statement when they enter into a Type A lease.
All leases will have a front-loaded profile on the income statement, comprised of interest expense and amortization expense. As contrasted against existing operating lease treatment,profitability will be more adversely affected at the beginning of a lease term and improved at theend of it.
Compliance, Commencement & Related
The new standard takes effect in January 2019. Before that, companies will need to gather significant additional data about their leases, and make new estimates and calculations that will need to be updated periodically. The new requirements are less complex and l
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ss costly to apply than the IASB’s earlier proposals. However, there will still be a compliance cost. For some companies, a key challenge will be gathering the required data. For others, more judgemental issues will dominate – for example, identifying which transactions contain leases."
The Tail Shouldn't Wag The Dog
The accounting changes do not affect cash flows directly. However, given the scale of the accounting change, companies will be keen to understand the size of the lease liabilities arising from transactions they enter into. “No one wants to see accounting drive business behaviours – the tail shouldn’t wag the dog. But if accounting consequences are in the mix when a company is considering a deal, then the mix will change. For example, this standard essentially kills sale-and-leaseback as an off-balance-sheet financing proposition.”
Some key impacts cannot yet be quantified. For example, the new accounting could prompt changes in the tax treatment of leases. And a key question for the financial sector is how the prudential regulators will treat the new assets and liabilities for regulatory capital purposes.”
The US Financial Accounting Standards Board (the FASB) will publish a new US GAAP standard on lease accounting shortly. Although the IASB and FASB worked together on lease accounting for years, their final standards feature different lessee accounting models. O’Donovan concluded: “It’s ironic that the outcome of this long-running convergence project will be divergence in accounting for common lease types. The new IFRS and US GAAP standards will introduce differences in the profile and presentation of annual lease expense where none currently exist, reducing comparability between the two major accounting frameworks.”