Leases are no longer off-balance sheet items

By Syed Md Enamul Kabir

The new accounting standard for leases, IFRS 16 Leases, is effective for accounting periods beginning on or after 1 January 2019. IFRS 16 is going to replace IAS 17 Leases and brings in changes in the accounting for leases, particularly for lessees, that is quite different from the accounting for leases we have known and practiced for ages. It has multifaceted implications and, hence, require attention even from the board level. Here is a short summary on IFRS 16 intended to create awareness among the preparers, auditors and regulators of financial statements.

New lease accounting model

• Accounting treatment of a lease contract under IFRS 16 is based on ‘control of an underlying asset’, which is a shift from ‘transfer of risks and rewards’ model used in IAS 17.  
• Lessees will initially recognize right-of-use assets and lease liabilities for all leases except for short-term leases (leases with lease term of one year or less than one year) and leases of low-value items (e.g. items costing US$5000). The distinction between operating leases and finance leases is eliminated for lessees in IFRS 16.
• Lessees will no longer recognize lease rents for lease contracts recognized in balance sheets. Instead, lessees will recognize depreciation of right-of-use assets and interest cost arising from winding up of lease liabilities.
• Lessors will continue to follow almost the same accounting model as was in IAS 17. Hence, lessor accounting is no longer a mirror image of lessee accounting.

Financial implications for lessees

• Leases are no longer off-balance sheet items for lessees. Almost all leases will be on the balance sheets of lessees.
• Impact of leases on profit or loss will not be the same each period over the lease term, which was the case under IAS 17. Under IFRS 16, lease expenses (depreciation plus interest cost) are expected to be higher in initial periods of the lease term compared to those in later periods of the lease term.
• Transition from IAS 17 to IFRS 16 might have impact on commonly used financial metrics (e.g. gearing ratio, EBITDA, EPS and operating cash flows), bonuses and remuneration, tax payment, debt covenants and periodic profitability. Debts, interest expenses, EBITDA and operating cash flows are expected to increase.
• Industries (e.g. airlines, retails, telecommunications) that typically rely heavily on leases will experience significant financial impact. According to a PWC study (1), companies will see between 21% and 98% increase in debt and between 8% and 41% increase in EBITDA.

Implementation

• The higher the number of lease contracts and the greater the variety in lease terms and conditions the more complex the transition will be.
• Companies having large number of lease contracts will need IT system to manage lease contract information and to calculate the related financial figures (e.g. right-of-use assets and lease liabilities).  
• Lessees should be proactive in making the stakeholders (e.g. shareholders, board, financial institutions, tax authority) aware of the implications of IFRS 16.  
• A cross-functional team involving people from accounting, tax, procurement, IT, treasury and investor relations departments is a must for smooth transition.

References

(1) PWC. 2016. IFRS 16: The leases standard is changing -Are you ready?https://www.pwc.com/gx/en/services/audit-assurance/assets/ifrs-16-new-leases.pdf.

About the author

Syed Md Enamul Kabir, MBA, FCA is the Managing Partner of ESS & Partners.

This is a very high-level summary and cannot be relied on as guidelines for specific situations. ESS & Partners will be happy to advise readers on how to apply principles of IFRS 16 to their specific circumstances.