IFRS 16 Leases was introduced by IASB in January 2016. IFRS 16 Leases is effective for periods beginning on or after 1 January 2019. Early adoption is allowed, but only in conjunction with IFRS 15 Revenue from Contracts with Customers because significant interactions are likely. This standard will significantly change how lessees account for leases as it removes the distinction between operating and finance leases (around 85% of lease contracts are operating leases). For lessors, IFRS 16 will only have minor effects.
IFRS 16 Leases replaces four standards and interpretations on leases, IAS 17 Leases, IFRIC 4 Determining when an Arrangement contains a Lease, SIC 15 Operating Leases – Incentives and SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.
Reasons for change – Lessee
IAS 17 was implemented in the early 1980’s because many Financial Statements of lessees charged all types of leases to expenses in the income statement as incurred (as such designated as period costs). This financial reporting principle is called the expense recognition principle which is a core element of the accrual basis of accounting. The lease commitments were disclosed off-balance sheet, resulting in significant differences in important balance sheet ratios compared to actual owners of assets. Actual owners of assets include the owned assets and related liabilities in the statement of financial position.
Improvements were made to IAS 17 resulting in the introduction of the difference between operational lease contracts and financial lease contracts, as follows:
- a finance lease contract represents a lease contract that transfers substantially all the risks and rewards to ownership (lessee). Under IAS 17, at inception of the lease, the finance lease is recognised as assets and liabilities in the statement of financial position at amounts equal to the fair value of the leased asset, or if lower, the present value of the minimum lease payments,
- an operating lease contract represents a lease contract that does not transfer substantially all the risks and rewards to ownership (lessee). Under IAS 17 operational leases are, in general, recognised as an expense on a straight-line basis over the period of the lease term. If the time pattern of the user’s benefit is not best represented by the straight-line basis, an other systematic basis better representing this time pattern is applied.
The risks relate to possible impairments, technological obsolescence and deviations in the rate of return on investment in an asset due to changes in economical decisions. Rewards relate to potential value increases or a book profit at the disposal of the asset.
The improvement is obvious, finance lease contracts are treated the same as actual owners of assets. Assets and liabilities are included in the statement of financial position. Operating leases are still recorded off-balance sheet. Keeping in mind that the largest part of lease contracts are operating leases (around 85%) the improvement is all of a sudden not that much of an improvement anymore.
IFRS 16 Leases – Lessee
Following IFRS 16 almost all leases are recognised in the statement of financial position as assets and liabilities. These assets are a new category: Right-of-use asset.
Leases of assets of low value and short-term leases, based on narrowly defined descriptions, are allowed to be recognised as expenses in the income statement as incurred. This exemption can be applied on a lease by lease basis. However IFRS 16 does not allow a lessee to break an asset down into many underlying assets of low value unless:
- the lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee, and
- the underlying asset is not highly dependent on, or highly interrelated with, other assets.
In addition, if a lessee sub-leases an asset, or expects to sub-lease an asset, the head lease cannot qualify as a lease of an asset of low value.
Based on the type of asset, it is subsequently recognised based on IAS 16 Property, Plant and Equipment (applying the cost model or revaluation model) or IAS 40 Investment Property.
The lease liability is recorded as long-term and short-term liabilities over the term of the lease. The monthly lease payment is separated in an interest expense (recognised as expenses as incurred) and a repayment of the liability.
Earnings Before Interest Taxes Depreciation and Amortisation (EBITDA) will improve if a reporting entity would choose to not apply the recognition exemption in IFRS 16 to some or all assets of low value. The recognition of a Right-of-Use Asset will increase EBITDA because depreciation is recognised when assets of low value and the corresponding lease liability are included in the statement of financial position. This depreciation would otherwise be included in EBITDA as lease expenses.
IFRS 16 Leases What is it about?
IFRS 16 Leases What is it about?
IFRS 16 Leases What is it about? IFRS 16 Leases What is it about? IFRS 16 Leases What is it about? IFRS 16 Leases What is it about? IFRS 16 Leases What is it about?