Understanding the New Lease Accounting Standard for International Financial Reporting
Overview of IFRS 16
IFRS 16 is a new lease accounting standard published by the International Accounting Standards Board (IASB) in January 2016. IFRS 16 changes the way that companies account for leases in their financial disclosures, especially their balance sheets and income statements. It replaces an earlier international lease accounting standard – IAS 17. The purpose of IFRS 16 is to close a major accounting loophole from IAS 17: off-balance sheet operating leases. IFRS 16 will be effective for reporting periods beginning on or after 1 January 2019 for entities reporting under international financial reporting standards.
Major Changes from IAS 17
The major change IFRS 16 makes from IAS 17 is that it removes the operating lease classification for leases, eliminating the ability of corporations to report operating leases in the footnotes of financial statements. The reasoning for the change was that by reporting operating leases in the footnotes, companies were hurting smaller investors that do not have the resources to dig through their financial statements. 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.
IFRS 16 Lease Definition
The definition of a lease has changed slightly. 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 3 criteria:
There must be 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.
The lessee must receive substantially all of the economic benefit. To determine what qualifies as “substantially all,” the parties must define the economic benefits of the asset and then determine the allocation of economic benefits.
Direct the Use of Asset
The lessee must have the right to direct the use of the asset. If how the asset will be used was predetermined, the lessee must have the right to operate the asset or they must have designed the asset in a way that predetermines how it will be used.
Leases that are considered short-term (having a term less than or equal to 12 months in length) or low-value (the underlying asset’s value is less than or equal to $5000) do not need to be reported on the balance sheet.
IFRS 16 Calculator
Volkswagen Financial Services Fleet launched an IFRS 16 Calculator to calculate the lease liability, right-of-use asset, interest, and depreciation expense.
IFRS 16 Impacts to Financial Statements
Impact to the Balance Sheet
With IFRS 16, almost all leases will be reported on corporate balance sheets. A new right-of-use (ROU) asset will be presented separately on the balance sheet, as will a separate lease liability. Under the current standard, IAS 17, only certain lease arrangements – called finance leases – were listed on the statement of financial position while operating leases were only reported in the footnotes. Under IFRS 16, all leases will now be considered finance leases unless they meet certain exceptions. Key financial metrics such as Return on Assets will be influenced through the addition of these new assets and liabilities to the balance sheet.
Impact to the Income Statement
Companies must report a depreciation charge for leased assets within the operating costs section of the profit and loss statement. An interest expense must be reported for lease liabilities within the finance costs section of the profit and loss statement. Under the old standard, IAS 17, companies reported a straight-line lease expense that was typically the same in each period of the lease. With IFRS 16, the expenses for leases will be front-loaded as the amount of interest is reduced over the term of the contract.