IFRS 16 Leases sets out the principles for the recognition, measurement, presentation and disclosure of leases. It replaces the requirements in IAS 17 Leases and related interpretations and is applicable for the first time for entities with an annual reporting period beginning on or after 1st of January 2019.
It is available for early adoption, as displayed in the table which you can see here. It will require companies to bring most leases on-balance sheet and the accounting treatment of leases by lessees will change fundamentally. For example, companies with operating leases will appear to be more asset-rich, but also more heavily indebted. Lessor accounting remains similar to previous accounting policies.
The standard features a variety of different transition options and practical expedients for lessees, as displayed in the table which you can see here. Many of them can be elected independently of each other. Some can even be elected on a lease-by-lease basis. The options and expedients that simplify and reduce the costs of transition tend to reduce the comparability of the financial information.
Under the new leasing standard, IFRS 16, lease definition becomes the key on-/off-balance sheet test. Therefore, assessing whether an arrangement is, or contains, a lease will be one of the biggest practical issues. In general a lease is a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. If a contract contains a lease, then it will generally be on-balance sheet for the lessee. In many cases, assessing whether a transaction is a lease will be straightforward and a transaction that is a lease today will be a lease under the new standard. A key focus will be completing and documenting the assessment. In other cases, the assessment will be more complex and there may be changes in which transactions are identified as leases – e.g. power purchase, IT outsourcing and transport agreements.
As companies prepare to adopt the new standard, a key decision will be whether to apply the practical expedient to grandfather the lease definition for existing contracts on transition.
All leases will be accounted for as being finance leases, resulting in the recognition of all lease obligations as liabilities. Furthermore, the present value of future lease payments of operating leases will be capitalised and the right to use an asset will be recognised as an asset to be depreciated in the lessee's statement of financial position (balance sheet); i.e. the company that pays the lease payments rather than the lessor, who is the legal owner. However, there are practical expedients to the above accounting treatment for leases, with a duration of less than one year and for very low-value assets for which information will continue to be provided through disclosures. The nature and extent of discount rate information required in 2019 will depend on the transition approach chosen.
Impact on Ratio
For some entities, the new standard will have a significant impact on their financial KPIs and their systems and processes. The new accounting treatment affects both the statement of financial position (balance sheet) and the statement of comprehensive income.
In the statement of financial position assets and liabilities will be increased, and mainly indicators showing the company's leverage from debt and equity will be adversely affected, where in some cases they may create a problem to the solvency of businesses towards banks and other creditors.
Regarding the statement of comprehensive income, in simple words, the costs of operating leases will be replaced with depreciation and interest. What will change to the benefit of businesses is the EBITDA ratio, which will no longer be reduced by the lease payments, as these will be recognised as depreciation and financial costs, which are excluded from the calculation of the EBITDA.
The objective of the new standard is to ensure that lessees and lessors provide relevant information, in a manner that faithfully represents those transactions. This information 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 an entity. Each new standard has positive and negative effects, however, no compliance discounts are allowed to the accounting principles when drafting the financial statements.
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