IFRS 16 is effective for annual reporting periods beginning on or after 1 January 2019, with earlier application permitted (as long as IFRS 15 is also applied).
What is IFRS 16
The objective of IFRS 16 is to faithfully represent lease-based transactions and support users assessment of cash flows arising from leases. The standard requires the lessee to recognise assets and liabilities for all leases with more than 12 months tenor unless the underlying asset is of low value. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.
A lessee measures right-of-use assets similarly to other non-financial assets (such as property, plant and equipment) and lease liabilities similar to other financial liabilities. Therefore, a lessee should charge depreciation (usually straight-line method) of the right-of-use asset and interest on the lease liability. In the statement of cash flows, a lessee cash payment should split into principal ( financing activities) and interest (either operating or financing activities) in accordance with IAS 7.
Assets and liabilities arising from a lease are initially measured on a present value basis. The measurement should include non-cancellable lease payments, inflation-linked payments, and payments to be made in optional periods if the lessee is reasonably certain to exercise an option to extend the lease, or not to exercise an option to terminate the lease.
The lease asset is the right to use the underlying asset and is presented in the statement of financial position either as part of property, plant and equipment or as its own line item.
As in IAS17, lessors can continue to classify its leases as operating leases or finance leases and to account for them differently.
Sectors Impacted by IFRS 16
For most companies, the need to comply with the new standard starts in 2019. Most leases were previously reported in the footnote disclosures of financial statements. However, effective 2019, many leases will on the balance sheet as right-of-use assets and lease liabilities. These changes on the balance sheet will impact many financial metrics such as the Gearing ratios, EBITDA and return on assets. IFRS 16 will have a significant impact on companies such as airlines, transport, telecommunication sector, as they rely on operating leases as off-balance-sheet financing.
Impact of IFRS 16 on Lessee’s financial statements
The most significant effect of IFRS 16 requirements will be an increase in lease assets and financial liabilities. Accordingly, for companies with material off-balance sheet leases, there will be a change to key financial metrics derived from the company’s reported assets and liabilities
IFRS16 will impact both side of balance as lessee recognises a new group of assets for the right-of-use asset and the related lease liabilities. Therefore, companies that used show operating lease as the off-balance-sheet will now have to increase their assets and liabilities.
The carrying amount of the leased assets will typically reduce more quickly compared to the carrying amount of the related lease liabilities. This effect will result in a reduction in reported equity compared to IAS 17 for companies with material off-balance sheet leases. – IASB Effect Analysis of IFRS 16
Profit and loss statement
Under IAS 17, lease expenses were accounted as operating expenses. However, IFRS 16 will recognize them as the depreciation of the right-of-use assets as well as an interest expense. Therefore, under IFRS 16, deprecation will be higher, operating expenses will be lower and interest expense will be higher. Although the depreciation charge on the leased asset is typically even, the interest expense will reduce over the life of the lease as lease payments are made to the lessor. This results in reducing total expense as an individual lease matures.
Under IAS 17, operating leases were reported under operating expenses, however, with IFRS16 such expenses will be between deprecation and interest expenses. This effect will give higher EBITDA and EBIT. Therefore, valuation experts and analyst should watch out for an increase in valuations when EBIT or EBITDA multiples are used.
Changes in accounting requirements do not cause a difference in the amount of cash transferred between the parties to a lease. IFRS 16 is only expected to impact the cash flows classifications through operating and financing activities.
IFRS 16 is expected to reduce operating cash outflows, with a corresponding increase in financing cash outflows, when compared to the amounts reported applying the IAS 17. This is because, under IAS 17, companies presented cash outflows of off-balance-sheet leases as operating activities. However, under IFRS 16, principal repayments on all lease liabilities are included within financing activities. Interest expenses can also be included within financing activities applying IFRS 17.
In conclusion, IFRS 17 reduces the need for analysts to adjust the amounts reported on a lessee’s balance sheet and income statement and improve comparability between companies that lease assets and companies that borrow to buy assets. However, it will impact all elements of financial statements and financial ratios.