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Financial Reporting Brief
Our featured article for February is Lease Accounting: The New Standard with Brendan Sheridan commenting on IFRS 16: Leases which was published by the IASB during the past month.
Lease Accounting: The New Standard
Currently, listed companies around the world have around US$3.3 trillion of lease commitments, in the form of future payments. Over 85% of those commitments do not appear on company balance sheets.
On 13 January 2016, the IASB published IFRS 16 ‘Leases’, which replaces the currently extant standard, IAS 17 ‘Leases’, which was first published some thirty years ago. The biggest change introduced is that all leases, with the exception of certain short-term and low value leases, will be brought onto companies’ balance sheets. Almost half of all listed companies throughout the world using IFRS or US GAAP will be affected by the lease accounting changes.
While it is clear that bringing all leases on balance sheet will have a significant impact for a wide range of companies, those which are probably most significantly affected include those in the property and aircraft sectors.
Accounting under IFRS 16
Under IFRS 16, a lessee recognises a right-of-use asset and a lease liability. IFRS 16 defines a lease as a contract that conveys to the customer (‘lessee’) the right to use an asset for a period of time in exchange for consideration. A company assesses whether a contract contains a lease on the basis of whether the customer has the right to control the use of an identified asset for a period of time. Distinguishing between a lease and a service contract may in some cases require careful consideration, with the latter not involving any asset recognition or related accounting.
Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as lease assets (right of use assets) or together with property, plant and equipment. The lease liability is initially measured at the present value of the lease payments payable over the lease term, discounted at the rate implicit in the lease if that can be readily determined and, if not, the lease shall use the incremental borrowing costs of the lessee company.
The accounting treatment in the income statement for assets being brought on balance sheet, that were previously treated on a disclosure basis as operating leases, changes significantly. Currently, such leases have a straight line operating expense model. This will change to a model with a depreciation charge for assets, included in operating costs, and an interest expense on lease liabilities, included in finance costs and will have the effect of ‘upfronting’ the lease cost. The change aligns the lease expense treatment for all leases.
There are exemptions which companies may elect to avail of to recognise assets and liabilities for (a) short term leases i.e. leases of 12 months or less, and (b) leases of low-value assets, e.g. personal computers or small items of office equipment. The ‘low value’ exception is unusual in that it applies in absolute terms rather than by reference to the size of the reporting entity i.e. it is not based on a measure of materiality of the lessee. It is a major departure from precedent that the IASB has suggested that €5k is ‘low value’, and it remains to be seen how this applies in practice.
IFRS 16 substantially carries forward the lessor accounting requirements in IAS 17. Accordingly, a lessor continues to classify its leases as operating leases or finance leases, and to account for those two types of leases differently. Similarly to the requirements for lessee accounting, the Standard includes a disclosure objective for lessors, which is to disclose information in the notes that, together with the information provided in the primary statements, gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessor.
IFRS 16 is applicable for annual reporting periods beginning on or after 1 January 2019. Earlier application is permitted for entities that apply IFRS 15 ‘Revenue from Contracts with Customers’ at or before the date of initial application of its standard. The IASB has confirmed that a company can choose to apply IFRS 16 with a full retrospective approach or a modified retrospective approach. Applying the modified retrospective approach provides, inter alia, that on transition a company is not required to restate comparative information, instead opening equity is adjusted. Applying either transition approach, a company is not required to reassess whether existing contracts contain a lease based on the revised definition of a lease.
The IASB and the US FASB have reached the same conclusions on many areas of lease accounting, but there are some differences between their final Standards which include that the FASB has retained a dual accounting model for lessees which effects the recognition of lease-related expenses and the reporting of lease-related cash flows. The FASB is not making available a ‘low – value’ exemption.
Broader Implications than Accounting
The potential implications go beyond a mere change in accounting. The Standard will have a significant effect on financial ratios and debt covenants because of leased assets, with equivalent liabilities, that are going to be newly recognised on lessee balance sheets. Changes in income statement accounting may also affect such matters as employee compensation arrangements and dividend planning. While accounting will change, there is a firm belief that credit providers and analysts have always known about material operating lease commitments and have routinely adjusted entity financial statements. The new standard may bring improved consistency to such analysis and comparisons.
The IASB set the effective date of 1 January 2019, three years out, with the consideration of time and cost that will be involved in implementing the new standard. This time allows entities to consider the effects of IFRS 16 for example in respect of:
- Changes that may be needed to systems and processes
- Judgements required in such areas as the definition of a lease and the assessment of the lease term
- The impact of the standard in such areas as debt covenants, as above
- Additional information that entities may need to gather to make the required disclosures.
The IASB Chairman concludes a recent presentation stating ‘the new standard will provide much-needed transparency on companies’ lease assets and liabilities meaning that balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy’.
Changes in accounting are not intended to drive business behaviours – the tail shouldn’t wag the dog – but accounting consequences are inevitably a significant part of the considerations in any funding arrangement.
The new accounting for leases will change balance sheets in many cases, and may effect consideration of leasing in some cases, but the many valuable benefits which lease finance may provide should be borne in mind, including:
- The ability to pay for and use only the portion of an asset’s life the lessee requires
- Use of assets without legal ownership
- Alternative source of finance with predictable payments
- Ongoing asset refreshes as technology changes
- Complimentary services by lessors, such as maintenance or simplified asset disposals.
Many of these are particularly significant for ‘big ticket’ leases.
The long wait for the standard is over, now the focus is on preparing for implementation.
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