Sweet 16? Lease Accounting and IFRS in a Glimpse
The age of 16 almost always brings delight to any teenager. This is called the “coming-of-age” celebration where puberty really hits the pedal. Unfortunately, this article will not dwell on this exciting milestone, but on a different topic involving the same sweet number: lease accounting and IFRS 16.
In January 2016, the International Accounting Standards Board (IASB or the Board), the sole body to have both the responsibility and authority to issue international accounting standards, published the International Financial Reporting Standard (IFRS) 16, Leases.
Every professional in the business and accounting world wondered what this new standard could put into the table as the prevailing International Accounting Standards (IAS) 17, Leases, has been pretty much set in stone. The magic words are “right-of-use asset” and “lease liability.”
Under the existing rules of IAS 17, lessees account for lease transactions either as operating or as finance leases, depending on complex rules and tests which, in practice, use “bright-lines” resulting in all or nothing being recognized on the balance sheet for sometimes economically similar lease transactions.
On the other hand, IFRS 16 requires lessees to recognize nearly all leases on the balance sheet which will reflect their right to use an asset for a period of time and the associated liability for payments. Therefore, lessees will be greatly affected by the new leases standard. The lessors’ accounting largely remains unchanged. However, lessors might observe an impact on their business model and lease products due to the changes in needs and behaviors.
The Big Picture
Owing to the new lessee accounting requirements in IFRS 16, a lessee will have to recognize right-of-use assets (that will be depreciated) and lease liabilities (that will be accounted for at amortized cost) for substantially all their leases.
For lessees, there is no longer a distinction between operating and finance leases. Substantially, all leases are accounted for in the same manner: on the balance sheet. Why? Because IASB wanted there to be greater transparency in an entity’s leasing activities.
Although this accounting treatment will make entities look asset-rich, it will also make them seem heavily indebted. Moreover, it will also impact the income statement because entities will have to record the depreciation expense on the right-of-use assets and an interest expense on the lease liabilities separately. The additional assets and liabilities recognized and the change in presentation in the income statement will affect the key performance ratios such as asset ratios and debt to equity ratios which could consequently impair the ability to satisfy any debt covenants.
Choosing Your Own Destiny
The Board presented somewhat of a wiggle room as it laid down two approaches wherein entities can choose how they adapt IFRS 16. The full retrospective approach requires entities to retrospectively apply the new standard to each prior reporting period presented as required by IAS 8. Under this transition approach, entities need to adjust equity at the beginning of the earliest comparative period presented.
On the other hand, the modified retrospective approach lessee does not restate comparative information. Consequently, the date of initial application is the first day of the annual reporting period in which a lessee first applies the requirements of the new leases standard. At the date of initial application of the new leases standard, lessees recognize the cumulative effect of initial application as an adjustment to the opening balance of equity as of 1 January 2019.
Each approach has their own advantages and disadvantages which each management should carefully consider in choosing the right approach to apply to their business.
A Bit of Consolation
Most, but not all, former operating leases will be on the balance sheet, because the IASB has provided two exemptions which will give the lessee the option to not apply IFRS 16 lessee accounting to certain types of leases. These exemptions should provide some relief from the IFRS 16 requirements since it will be costly and time consuming to account for leases using the new model.
The Board included two exemptions in the new standard to reduce the costs and complexity of IFRS 16 based on feedback provided to the IASB on cost and benefits. Lessees are not required to recognize assets or liabilities for leases of low value assets such as tablets and personal computers, small items of office furniture and telephones.
The IASB has included in the Basis of Conclusions an indicative amount of less than $5,000 when new as the value of assets that would normally qualify for the exemption. Additional exemption is also granted for short-term lease, a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset regardless of the probability of whether the purchase option will be exercised.
The Clock is Ticking
Just like that, one month had already passed in 2019, which means that every entity and professional concerned with the new standard only have the remaining 11 months to completely study and assess its impact before it officially takes its reign. What we’ve discussed above is just the tip of the iceberg. Hopefully, all stakeholders from company management to financial consultants have their safety belts and life jackets ready as head-on collision is the only option.
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