What is IFRS 16

Understanding the New Lease Accounting Standard

Overview of IFRS 16

The International Accounting Standards Board (IASB) published the new lease accounting standard, IFRS 16, on 13 January 2016. It will replace the current IASB lease accounting standard, IAS 17. It applies to all countries who report under International Financial Reporting Standards for fiscal years beginning on or after 1 January 2019. The purpose of the new standard is to close a major accounting loophole in IAS 17: off-balance sheet operating leases.

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:

Identified Asset

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.

Economic Benefit

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.

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. 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.

Impacts to Financial Statements

The transition to IFRS 16 will likely have significant impacts on corporate financial statements.

Balance Sheet

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.

Income Statement

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.