Lease Accounting

What is IFRS 16?

Overview

The International Accounting Standards Board (IASB) published the new lease accounting standard, IFRS 16, on January 13, 2016. It will replace the current IASB lease accounting standard, IAS 17. It applies to all countries who report under International Financial Reporting Standards. Public companies must implement the standard for the first fiscal year beginning on or after January 1, 2019. Private companies follow a year later on January 1, 2020.

IFRS 16 is the result of a collaboration between the IASB and the US Financial Accounting Standards Board (FASB). The purpose of the new standard is to close a major accounting loophole in IAS 17: off-balance sheet operating leases.

Major Changes from IAS 17

Under IAS 17, corporations can report operating leases in the footnotes of financial statements, rather than on the statement of financial position as assets and liabilities. However, this method could potentially hurt smaller investors that do not have the resources to dig through financial statements. They face a lack of transparency into a corporation’s true liabilities.

In response, after a decade of work writing and reviewing exposure drafts, the IASB released IFRS 16. IFRS 16 closes the IAS 17 loophole by requiring that all operating leases now be accounted for as finance leases.

Lease Definition

The definition of a lease is slightly different from IAS 17. Under IFRS 16, “A contract, or part of a contract, that conveys a right to use the asset (the underlying asset) for a period of time in exchange for consideration.”

To qualify as right-of-use, the contract must meet the following criteria:

  1. There is an identified asset: An asset can only be identified if it is physically distinct or if the lessee receives substantially all of the capacity of the asset. In addition, the lessor cannot have substantive rights to substitute the asset.
  2. The lessee receives substantially all of the economic benefit: First, the parties must define the economic benefits of the asset. Then, they must determine the allocation of economic benefits.
  3. The lessee has the right to direct the use of the asset:The lessee has the right to direct the use of the asset. In a case where how the asset is used is predetermined, the lessee must have the right to operate the asset or had designed it in a way that predetermines how it will be used.

Certain leases do not have to be reported on the statement of financial position. Those are short-term leases (less than or equal to 12 months) and low-value leases (less than or equal to $5000).

Impacts to Financial Statements

Upon transition to the new standard, almost all current operating leases will be reported as finance leases. This move will likely have significant impacts for two financial statements.

  • Statement of Financial Position: For every operating lease, the right-of-use assets and lease liabilities will be capitalized on the statement of financial position. This will affect financial metrics like current ratio, leverage ratio, and return on assets.
  • Statement of Profit and Loss: Instead of recognizing a straight-line expense for operating leases like under IAS 17, companies will recognize a front-loaded interest expense and depreciation expense on separate line items. This will likely affect metrics including EBITDA, earnings per share, and interest cover.