IFRS 16 – LEASES:
EVOLUTION OR REVOLUTION?
IFRS 16 in a nutshell
The genesis of IFRS 16 dates back to 2005 when the US Security and Exchange Commission expressed concerns over their estimation (2005: $1.25 trillion1) of “off balance sheet” amounts of unreported leases. As a result, the FASB (US GAAP) and the IASB (IFRS) came together and agreed that “a lessee leasing an asset should recognize assets and liabilities arising from those leases.”
IAS 17 focused on the distinction whether a lease “was economically similar to purchasing an underlying asset”, in which case the lease was classified as a Finance lease and reported on the company’s balance sheet, as opposed to Operating leases which were accounted for with a rental expense being recognized in the income statement instead. The picture was therefore incomplete and did not reflect the companies’ real financial position.
"Complying with the new paradigm will require yet another significant effort. The IASB expects however an increased transparency about companies’ financial leverage and capital employed."
Major normative consequences
IFRS 16 treats all leases as Finance leases and requires the lessees to “capitalize” those on their balance sheet. The change will not affect the lessors who will continue to use the same accounting treatment as the one described in IAS 17. The lessee is now required to “recognize 1) assets & liabilities for all leases with a term that goes beyond a 12-month period (unless the value of the lease is of insignificant value) and 2) depreciation of lease assets separately from interests on lease liabilities in the income statement.”
A study over 14,000 listed companies has shown “off balance sheet” lease amounts in excess of $3 trillion2 (in 2014) urging the IASB to conclude that eliminating the Finance vs. Operating lease classification would increase transparency and uniformity. Effective January 1st 2019, companies will be required to capitalize all their leases on their balance sheet.
In doing so, the present value of the lease payments will need to be recognized either directly as a lease asset or together with property, plant and equipment. Similarly, on the liabilities side of the balance sheet, the companies will record a financial liability that represents their obligation to make future lease payments (whenever lease payments are made over time). The major consequence will be a significant increase of companies’ assets and liabilities.
On the income statement the former straight-line operating expense (from the Operating leases) will be replaced by a depreciation charge for the lease asset and by an interest expense on the lease liability, making the lease expense treatment uniform. As a result, although the cash effect will be neutral, there will however be a decrease in operating cash outflows with a corresponding increase in financing cash outflows.