If your business leases anything (think office space, equipment, machinery, etc.) and is subject to International Financial Reporting Standards (IFRS) then lease accounting is likely top of mind. The new lease accounting standard, IFRS 16 became effective for annual reporting periods beginning on or after January 2019, which means the days of keeping leases off the balance sheet have come to an end. This also applies to companies subject to AASB 16 (Australia), PFRS 16 (Philippines), JMIS (Japan), Hong Kong FRS, or similar governing bodies. Despite the passing of the effective date, companies still have a lot of work ahead to comply with IFRS 16.
Very few businesses have resources with the time to read the standards or sift through hundreds of pages of interpretations. To save time and quickly bring you up to speed, here’s a summary of the critical components of IFRS 16.
Where Did IFRS 16 Come From?
To some, it may seem like the new leasing standards appeared out of nowhere, however it’s been a project in the works since 2006. The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) initiated a joint project on leases so balance sheets would more accurately reflect a company’s true long-term liabilities. Thirteen years later, these standards are finally beginning to take effect. Here’s the timeline you need to know:
Under the old standard (IAS 17), only capital leases were accounted for on the balance sheet, while operating leases were off-balance sheet, and were reflected only in the Profit & Loss statement. There were strict thresholds, referred to as “bright lines,” that clearly classified each lease as either operating or capital. This definitive classification allowed companies to structure lease agreements so they would qualify as operating leases when in substance, they more closely aligned to a capital lease. For example, financing the acquisition of assets through debt. In classifying these leases as operating, companies were able to keep future lease obligations off the balance sheet, masking their true liabilities, and making key ratios appear more favorable.
IFRS 16 on the other hand, now requires that virtually all leases be reflected on the balance sheet. To do so, a “lease liability” is recorded at the commencement of a lease, and a new “right of use” (ROU) asset account is introduced for all lease types. This has the biggest impact on what were previously considered operating leases. The diagram below illustrates this change:
How Does the P&L Presentation Change?
As the IASB and FASB worked together to define a new lease standard, they had differing opinions on whether or not operating or finance leases should be presented separately on the income statement. While the FASB elected to maintain two different lease types, the IASB decided to reduce complexity and eliminate the separate operating classification. The net impact on the P&L for IFRS 16 is that expenses for leases previously classified as operating will now be recorded as amortisation/depreciation and interest, as shown in the diagram below.
How Much More Accounting is Required?
Prior to IFRS 16, a fixed-payment operating lease was simple, and monthly entries were all the same (see below).
Under IFRS 16, the same lease now requires an initial entry and subsequent entries that change each month:
Initial Entry: On the date a lease is commenced a lease liability is recorded at the present value of all future lease payments. A right of use asset is also recorded at the same amount, adjusted for initial direct costs, prepayments, or incentives.
Subsequent Entries: Accounting for finance leases under IFRS 16 is similar to capital leases under IAS 17. The lease liability is accounted for using the effective interest method, where interest expense is incurred monthly and the liability is reduced as payments are made against the liability. The capitalised right of use asset is treated like a fixed asset and amortised on a straight-line basis over the lease term.
What Practical Expedients & Transition Relief was Provided?
In an attempt to make your transition to IFRS 16 a little easier, IASB is providing a few practical expedients and other relief. Here are a few worth noting.
Grandfather Contract Assessments
Companies are not required to reassess whether a contract is, or contains a lease at the date of initial application. This must be disclosed and consistently applied.
Choice Between Full Retrospective & Cumulative Catch-Up
Full retrospective requires you to prepare your financial statements as if IFRS 16 has always been applied, for all periods presented. As relief you can use a cumulative catch-up approach, where the cumulative effect of adoption is recorded against retained earnings at the date of initial application. For finance leases existing balances remain and are now classified as ROU asset and lease liability. Whichever option is selected must be disclosed and consistently applied.
Companies are not required to reconstruct the accounting based on its original assessment of lease terms, but it can make an assessment at the transition date. This can be applied on a lease by lease basis.
Right of Use Asset Measurement
At the date of initial application, the right of use asset can be recorded at the lease liability balance adjusted by the amount of any prepaid or accrued lease payments related to the lease immediately prior to the transition date. Initial direct costs can also be excluded.
Low Value & Short-Term Lease Exemption
If the fair value of the leased asset is less than US$5,000, you are not required to apply IFRS 16. If the original lease term or remaining lease term at the date of transition is under one year, no adjustments are required. This can be applied on a lease by lease basis and may trigger disclosure requirements.
Single Portfolio Discount Rates
Application of a single discount rate to a portfolio of leases is allowed if they have similar characteristics (ex: remaining lease term, economic environment, class of underlying asset). This can be applied on a lease by lease basis.
Combination of Lease & Non-Lease Components
As opposed to separating out lease and non-lease components of each lease, companies can combine all payments and reflect that in the ROU asset, lease liability, and monthly lease expenses.
What Should Companies Do Now That IFRS 16 is in Effect?
Though the effective date of IFRS 16 has passed, many businesses are not yet properly complying with the new standards or leveraging a sustainable system to account for leases in the future. If you haven’t done so already, evaluate potential software solutions that can perform the proper calculations and reduce the risk of error associated to spreadsheets. For help on selecting the right software tool, RSM’s blog post on the topic.