IASB issues a new accounting standard IFRS 16, Leases
IASB issues a new accounting standard IFRS 16, Leases
The International Accounting Standards Board (IASB) has undertaken a project to review the over three decade old standard on leases and received extensive feedback on their proposals.
The International Accounting Standards Board (IASB) has undertaken a project to review the over three decade old standard on leases and received extensive feedback on their proposals. Since March 2014, they have re-deliberated on almost all aspects of the project.
IASB, on 13 January 2016, issued a new accounting standard, IFRS 16 Leases. At the simplest level, the accounting treatment of leases by lessees would change fundamentally. For the first time, analysts can anticipate to see a company’s own assessment of its lease liabilities, which is calculated using a prescribed methodology that all companies reporting under IFRS will be required to follow.
The new standard is effective from 1 January 2019, early application is permitted (as long as the recently issued revenue standard, IFRS 15, Revenue from Contracts with Customers is also applied).
Accompanying the Standard, IASB has also published a separate Effects Analysis, which outlines the costs and benefits of the Standard. It demonstrates the need for the Standard and outlines IASB’s analysis that the benefits of applying the new standard outweigh the costs associated with its implementation.
For the lessee
- The accounting treatment of leases by lessees would change fundamentally. Some of the significant changes brought in by IFRS 16 for the lessee accounting model are as follows:
- Most leases would be brought onto entities’ balance sheets, resulting in an increase in reported assets and liabilities. IFRS 16 does not distinguish between off-balance sheet operating leases and on-balance sheet finance leases (for the lessee - the lease customer). It introduces a single, on-balance sheet accounting model that is similar to current finance lease accounting.
- Entities would recognise a front-loaded pattern of expense for most leases, even when they pay constant annual rentals due to higher interest and depreciation expenses in the early years of the lease arrangement. While this is expected to lead to lessee entities recording lower Earning Per Share (EPS), it is expected that there would be a positive impact on Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) for such entities.
- IFRS 16 also changes the definition of a lease and increases focus on which party controls the use of an asset. As a result, several arrangements need to be re-evaluated to determine if they are leases under the new standard. Those that meet the definition would be brought on-balance sheet, while other service contracts will remain off-balance sheet.
- Short-term leases (less than 12 months) and leases of low-value assets (such as personal computers) are exempt from the requirements.
For the lessor
Lessor accounting under IFRS 16 remains similar to current practice i.e. lessors would continue to classify leases as finance and operating leases. Leases that transfer substantially all the risks and rewards incidental to ownership of the underlying asset are finance leases; all other leases are operating leases. The lease classification test is based on the criteria in IAS 17.
For the sale and leaseback
IFRS 16 essentially makes sale and leaseback transactions redundant as an off-balance sheet financing structure, i.e. all sale and leaseback transactions would be on-balance sheet for the seller-lessee. Lessees entering into such a transaction need to assess whether there has been a sale in accordance with the requirements of IFRS 15, Revenue from Contracts with Customers.
IFRS 16 offers a range of transition options, featuring many practical expedients. On the initial application of the new standard, lessors and lessees can choose to
- Apply the new lease definition to all contracts, or
- Grandfather the assessment of which existing contracts are, or contain, leases under IAS 17 and IFRIC 4, Determining Whether an Arrangement Contains a Lease, and to apply the new lease definition only to new contracts.
The new standard becomes effective in January 2019. Prior to that, entities need to gather significant additional data about their leases, and make new estimates and calculations that will have to be updated periodically. The accounting changes may not affect cash flows directly.
However, given the scale of the accounting change, it is expected that companies would be keen to understand the size of the lease liabilities arising from transactions they enter into between now and 2019.
The lease definition has changed in IFRS 16 as the new on/off balance sheet test for lessees. In many cases, transactions that are leases today will be leases in 2019. However, common transactions like power purchase agreements and transport agreements might be affected.
Putting leases on the balance sheet, the new front-loaded lease expense and different presentation of expenses and cash flows could have an impact on ratios, non-GAAP measures and covenants. It is important to think about the impacts early as it may be necessary to renegotiate and set correct expectations. In order to assess the impact, detailed modelling may be required. The right systems and processes would be prerequisite to measure lease assets and liabilities in accordance with IFRS 16.
FASB is expected to publish its new lease accounting standard shortly. While this would be converged with IFRS 16 on some aspects, there could likely be significant differences in the lessee accounting model, measurement and transition requirements.
The new requirements will affect a wide variety of sectors, from airlines to retailers. The larger the lease portfolio, the greater the impact on key reporting metrics and financial ratios. Current lease accounting requires financial statement users to adjust for off-balance sheet leases. The key change will be the increase in transparency and comparability.
IFRS 16 eliminates the current dual accounting model for lessees which distinguishes between on-balance sheet finance leases and off-balance sheet operating leases. Instead, there is a single, on-balance sheet accounting model that is similar to current finance lease accounting. However, the lessor accounting model is inconsistent with the accounting model to be applied by lessees as lessors retain a dual model. For example, in the case of an operating lease, the lessee would recognise a financial liability for its obligation to make fixed lease payments, but the lessor would not recognise a financial asset for its right to receive those lease payments.
In India, companies are currently transitioning to Indian Accounting Standard (Ind AS) 17, Leases which is based on IAS 17, Leases. However, they may find it useful to start assessing the impact of IFRS 16, both on current and prospective leasing arrangements, to ensure that they are well prepared to adopt the new standard when it becomes notified and applicable in India.
Also in India, the CBDT has not provided guidance on how to account for leases from tax perspective. We would have to watch the developments in the space of computation of taxes on application of IFRS 16.
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