Factsheet: IFRS 16 Leases standard

IFRS 16 Leases establishes principles for the recognition, measurement, presentation and disclosure of leases, with the objective of ensuring that lessees and lessors provide relevant information that faithfully represents those transactions. Most companies use leases to obtain access to an asset and consequently will be affected by the adoption of this standard.

Understanding the accounting impacts of this standard.

Lessees will be required to recognize a right of use asset and a lease liability. The lease liability will be recognized at the present value of the future minimum lease payments while the right of use asset will be recognized at this amount plus any initial direct costs incurred by the lessee.

The right of use asset will subsequently be measured at cost less accumulated depreciation and accumulated impairment. Depreciation will be provided either over the term of the lease or the useful life of the asset, whichever is shorter. The lease liability will be reduced by the capital portion of the payments made in terms of the lease.

It is worth noting that two optional exemptions to these requirements exist:

• leases with a term of less than 12 months and containing no purchases options; this election is made by class of underlying asset;
• leases where the underlying asset has a low value when new; this election can be made on a case by case basis. The International Accounting Standards Board (IASB) in the Basis for Conclusions of the Standard has stated that a low value would be under US$5,000.

The overall impact on the earnings of lessees will be an increase in Earnings Before Interest, Taxation, Depreciation and Amortization (EBITDA) and an increase in Operating Profit and Finance Costs. The impact on profit before taxation is not expected to be large for companies that hold a portfolio of leases that are constantly being renewed but could increase or decrease for companies which hold few leases, depending on where in the lifecycle of each lease the company is at a given point in time.  

The accounting requirements for lessors remain largely unchanged from the requirements contained within IAS 17 Leases as well as the SOCPA (Saudi Organization for Certified Public Accountants) standard on leases. Consequently, the situation will arise where the same asset is recorded on the balance sheets of both lessors and lessees.

So these are the accounting requirements; what are the potential business impacts?

The potential business impacts for lessees are both internal and external.

• The accounting treatment described previously will result in lessees putting assets and liabilities on their balance sheet, which were previously not recorded. This may result in loan covenants with their lenders being breached without any change in the underlying fundamental aspects of the business. Lessees will need to discuss the impact of this standard with their lenders. It is however expected that lenders will adjust debt covenants in a manner which will differentiate mere accounting policy changes from true economic changes of the business.
• Staff remuneration schemes that are dependent on the level of earnings will need to be adjusted to absorb the impact of the adoption of this standard into account.
• Entities will need to compile a detailed register of all existing leases in order to extract the data relevant to comply with IFRS 16, such as lease payments and lease terms. It is expected that lessees will have at least some of this information available already given the need to disclose operating lease commitments under the accounting standards in place currently.
• Entities with large volumes of leases, for example retailers, will need to consider the need for an IT system in order to automate much of the accounting. While it is possible to use spreadsheets to perform the necessary calculations, it does increase the risk of error.
• Entities wishing to make use of the optional exemptions for low value and short-term leases will need to devise a system for identifying these and accounting for them on a straight-line basis. Entities may consider renegotiating their leases in order to make them for a period of less than 12 months.
• Entities may choose to purchase assets as opposed to leasing them in order to avoid putting debt on the balance sheet. 

There are fewer business impacts for lessors, given that the accounting requirements remain largely unchanged. These impacts are likely to be more negative than positive in that lessees may choose to either purchase assets as opposed to leasing them, or may choose to ask for shorter-term leases, which will impact the business risk of lessors in that it will jeopardize their future income stream. It should be noted that the mere adoption of this standard will not in itself increase or decrease the demand for assets but may have an impact on the overall leasing market.

The costs for lessees associated with implementing the new standard will vary according to the number of leases in existence, the extent to which the required information is readily available, the level of education required to be given to accounting staff and the existing systems currently in place. The International Accounting Standards Board expects that the costs required to apply IFRS 16 on an ongoing basis will be slightly higher than to apply the current leasing standard.

Advantages of the new leasing standard.

The IASB has identified the following advantages of the new leasing standard:

• A better presentation of the company’s financial leverage and capital employed.
• A reduced need for investors and analysts to make adjustments to reported financial information of lessees to take into account the impact of offbalance sheet leases.
• Improved comparability between those companies that lease assets and those companies that buy assets.

Conclusion

The adoption of the new leasing standard could have a significant impact on lessees, both accounting- and business related. Lessors could face an increased business risk resulting from the adoption of the leasing standard; while investors will have access to better information and thus be able to make better investment decisions.

The ability to properly compare companies that are in a similar line of business but have a different asset acquisition model will be greatly enhanced. Companies that have very few, but material leases–for example a lease of a large building–will experience greater volatility in their income statement as a result of the finance charges for the lease being disproportionately charged to the income statement in the earlier years of the lease and will therefore be resistant to this change. The IASB is to be commended for being pragmatic about the treatment of smaller and short-term leases and allowing for exemptions as discussed above.

By Steven Harmer, Director, Audit, Deloitte, Saudi Arabia