Reading time: minutes
IFRS 16, the new lease accounting standard, was published in January 2016, and will be applicable for periods beginning on or after 1 January 2019. For lessors there are virtually no changes in comparison with the current leasing standard, IAS 17. There is, however, a new accounting model for lessees.
Today all leases are recognised either as finance leases, and recorded on the balance sheet, or as operating leases. Under IFRS 16 this distinction no longer applies to lessees. Under the new provisions, all leases are comparable to the current finance lease, and therefore have to be recognised on the balance sheet in the form of a right-of-use asset and a lease liability. This expands the balance sheet. Lessees that currently hold only operating leases will in future have to recognise the rights of use for leased assets such as property, aircraft, vehicles, moving equipment and IT (see Figure 1).
Under IFRS 16 lessors, unlike lessees, must continue to distinguish between finance and operating leases. The standard-setters opted not to create completely new rules for lessor accounting, but preferred to carry forward the rules set down in IAS 17.
The only change for lessors under IFRS 16 is the enhancement of disclosures. For example, a lessor should disclose its risk management strategy for the rights it retains in underlying assets. The fact that lessors and lessees are treated differently could pose new challenges for existing financial reporting systems, especially when it comes to intragroup leasing arrangements.
As lessor accounting remains substantially the same, and IFRS 16 will have hardly any impact on a lessor’s accounting model, for the remainder of the article we will focus our discussion on the impact for lessees.
Under the terms of IFRS 16, a contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for a consideration.
In the future a lessee will recognise a right-of-use asset and a lease liability. This figure is derived from the present value of the lessee’s minimum lease payments. To calculate this the lessee must first determine the lease term. The present value of the lease payments is discounted at the interest rate charged by the lessor to the lessee. If the lessee does not know the interest rate, it uses its incremental borrowing rate.
The right-of-use asset is initially measured at the amount of the lease liability, plus any initial direct costs incurred by the lessee in connection with the lease and payments made at or prior to commencement. The estimated costs to be due from restoration obligations to which the lessee may be subject also have to be taken into account. Under IAS 37 a provision for the costs of restoration is recognised in the balance sheet separate from the lease liability (see Figure 2).
The lease liability is subsequently measured at amortised cost using the effective interest rate method. The right-of-use asset is depreciated on a straight-line basis over the lease term. Interest on the lease liability and depreciation on the right-of-use asset will thus be recognised in the income statement. This results in a decreasing ‘total lease expense’ throughout the lease term. This effect is sometimes referred to as ‘frontloading’. Straight-line rental expenses under the IAS 17 operating lease model, will no longer exist.
Under IFRS 16, the expected term of the lease is critical to the initial measurement of the right-of-use asset. Options are taken into account if the lessee is reasonably certain to exercise these options. Whether extension, termination or purchase options are exercised will therefore affect the lease term and thereby the amount of lease payments included in the lease liability.
Variable lease payments are part of the lease payments if they depend on an index or a rate; variable lease payments that depend on another variable are not included. Hence, payments linked to a specified percentage of sales, sometimes known as landlords’ commissions, are recognised in the income statement in the period in which the sales occur.
Contracts that contain lease and non-lease/service components will have to be carefully analysed in the future. This could apply, for example, when leasing a property with a cleaning service or a vehicle with insurance. Lessees can account for these elements separately or elect to account for all components as a lease, and not separate lease and service components. However, because non-lease components are also recognised on the balance sheet, this results in the recognition of a higher right-of-use asset.
The standard contains two recognition and measurement exemptions. Both exemptions are optional and they only apply to lessees:
If one of these exemptions is applied, the leases are accounted for in a way that is similar to current operating lease accounting (that is, payments are recognised on a straight-line basis). Before electing for one of these options, the entity should make sure this really will result in a simplification.
Let us take the example of a five-year lease for business premises. The rent is fixed at CHF 100,000 a year. The interest rate agreed in the contract is 5% per annum. Initial direct costs of CHF 10,000 are incurred. On this basis, the present value of the lease payments for the lease liability comes to CHF 432,948. The right-of-use asset has to be increased by the amount of the initial direct costs, and thus comes to CHF 442,948 (see Figure 3).
|Balance sheet||Year 1||Year 2||Year 3||Year 4||Year 5|
|Right to use asset||442’948||354’358||265’769||177’179||88’590||0|
|Income statement||Year 1||Year 2||Year 3||Year 4||Year 5|
|Annual cash payment||500’000||100’000||100’000||100’000||100’000||100’000|
|Total lease expense||510’000||110’237||106’319||102’206||97’887||93’351|
Now that the lessee recognises an interest element of what were previously operating leases as financing activities, the distribution of expense for these leases over the lease term is no longer even but degressive. This is because the interest expense at the commencement of a lease is greater than towards the end. As a result the lease expense in the first year for our example comes to CHF 110,237, considerably more than the lease instalment of CHF 100,000, while the lease expense in the last year of the lease is lower than the instalment, at CHF 93,351. This front-loading effect is even more pronounced for long-term leases.
The new standard will have far-reaching consequences across most organisations. Alongside the financial statement the main areas affected include key financial performance indicators and business decisions (such as lease or buy).
The front-loading effect and the fact that what were previously operating leases are now recognised on the balance sheet may in individual cases have a considerable impact on a lessee’s balance sheet figures. This is because rental expense is replaced by interest expense and depreciation, leading to an increase in EBITDA (earnings before interest, taxes, depreciation and amortisation). An expanded balance sheet results in changes in equity ratios and leverage. This in turn can influence loan covenants, credit ratings, internal budgeting processes and compensation systems. The new standard will also affect other areas of the business, including investor relations, IT, controlling and legal.
PwC has conducted a global lease capitalisation study to assess the impact of the new leases standard on reported debt, leverage, solvency, and EBITDA for a sample of 3,199 listed entities reporting under IFRS across a range of industries. The research identifies the minimum impact of capitalising existing off-balance sheet operating leases based on commitments disclosures in entities’ published financial statements in 2014. The median increase in debt and EBITDA for some of the most impacted industries can be summarised as follows below. According to the study, financial liabilities for retailers with their extensive rented retail space will almost double.
Given that virtually all leases will now have to be recognised on the balance sheet, an entity must first make an inventory of the relevant contracts, and thoroughly adapt internal processes and systems on a regular basis.
First it should make an inventory of existing leases, capturing all the important data such as lease term, lease instalments and extension or purchase options. The entity should ensure consideration of the new standard when entering into any new contracts.
Other functions such as tax, IT, investor relations and treasury should also be informed about the new requirements. Entities also have to review their strategy and the terms of contracts to meet the operational and financial goals of the company.
Lessees will soon see major changes in the way they account for leases. To avoid surprises, companies should already be assessing the potential implications of the new standard, formulating measures to make sure the relevant contracts are recognised properly, and identifying points of overlap with other projects. Under certain circumstances this may involve new systems that will take time to acquire, implement and test. Before the changes to the accounting take effect, companies should be making sure they capture all the relevant information on existing and new leases.
Experience with the first projects in this area is showing that implementing IFRS 16 can turn out to be very complex, especially for entities with a large number of leases. Identifying and making inventories of these leases across the organisation is essential to implementing the standard, but also very time-consuming. For example, even working out everything that is defined as a lease under IFRS can be difficult.
IFRS 16 will be applicable for periods ending on or after 1 January 2019. Early implementation is possible in principle if IFRS 15 Revenue from Contracts with Customers has already been implemented early.