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Impact on Businesses of the New IFRS 16 “Leases “
Posted By yelli On 26 October, 2016 @ 12:38 pm In Accounting,Edición 58 | No Comments
By: Norma Leticia Leal Pimentel,
ITAM
Introduction
In many countries, leasing has been one of the most important financing options that companies frequently use. The explanation is that in this way companies have a factory and equipment without incurring cash flows that might affect them; they do not have to carry out bureaucratic procedures for authorizing purchases that delay the acquisition of assets; and they can renovate assets that are subject to rapid technological changes and obsolescence more quickly and efficiently, in order to have state-of-the-art technology. In addition to these operational incentives, the current International Accounting Standard (IAS) 17 “Leases” model has meant that in many cases lease contracts are not reflected in the assets and liabilities on the lessee’s statement of financial position, i.e., they are “off balance.” This has a positive effect on key financial ratios to assess the risk of the company, such as debt, leverage and performance on total assets, which can be very important when the company has a contractual commitment to maintain certain financial ratios.
With this background and for greater clarity and transparency, the International Accounting Standards Board (IASB)1 issued on January 13, 2016, the new IFRS 16 “Leases,” which will replace, beginning 2019, the IAS 17 standard used for almost 40 years.
This article briefly discusses the antecedents of the change from the current IAS 17 to the new IFRS 16. It explains what the new model of the IFRS 16 consists of and indicates the main changes and effects for lessees and lessors.
Antecedents
Although the need for reform in lease accounting has been discussed for some time, the detonator to launch it occurred in 2005, when the Securities and Exchange Commission (SEC)2 reported that public companies in the United States would have approximately 1.25 billion dollars in payment commitments for off-balance sheet leases, which were not reflected in the assets and liabilities of these companies (IASB, 2016 (b)).
These off-balance sheet leases are accounted for in a manner similar to an income expense, so that investors and analysts cannot compare the financial information of companies that borrowed to buy assets with that of companies that lease them, and to make them comparable they have to make adjustments and estimates (according to common practices of investors).
Because of this lack of transparency, the IASB and the Financial Accounting Standards Board (FASB)3 launched a joint project to improve lease accounting and concluded that, despite the fact that with the signing of a lease, an asset (right to use of the good) and a liability (for the obligation of future payments) are generated automatically in the majority of the contracts, this asset and this liability were not reflected in the statement of the financial position, even though they were disclosed in the notes. This conclusion was the guide for developing the new accounting model for leases, under which the lessees must handle the accounting in the same way as almost all their lease contracts, with the goal that the leases that fall off balance are the exception (Morales, 2016).
The IASB report found that according to the annual reports of 2014, out of a sample of 30,000 public companies that used IFRS or US GAAP, more than 14,000 revealed 2.9 billion dollars in payment commitments for leases that were not reflected in the statements of financial position (IASB, 2016 (c)). This figure shows the growth of the off-balance sheet leases with respect to the figures published by the SEC in 2005.
Although the new IFRS 16 emerged from a collaborative project between the IASB and the FASB, the FASB standard has its differences with the IFRS 16 (which fall outside the scope of this article).
The new IFRS 16 “Leases” will be effective for annual periods beginning on or after January 1, 2019. Earlier application is permitted only if the company also applies in advance the IFRS 15 “Income from Contracts with Clients.”
New Model of IFRS 16
With IFRS 16, the “right of use” model emerges, which replaces the “risks and rewards” model of IAS 17 (PWC, 2016).
With IAS 17, leases should be classified into one of two categories: finance or operating leases. Finance leases are those in which the lessor has transferred substantially all the risks and rewards of ownership (of the asset) to the lessee, which in essence is assimilated to a financed purchase. All other leases are classified as operating leases and the lessor remains the economic owner of the property. Only those classified as finance leases are accounted for and are reflected in the assets and liabilities of the statement of financial position. In contrast, in the new IFRS 16 there are no finance or operating lease classifications and all (with some exceptions, such as short-term leases or “low value” property)4 must appear in the statement of financial position, and not only those with IAS 17 are considered finance leases.
A key point of IFRS 16 is the identification of a lease in order to register it accountable as such. For a contract to be considered as a lease it is now based on a right of use model. The standard defines a lease as a contract, or part of a contract, which gives the client the right to control the use of an identifiable5 asset during the period of use, which is the total time that an asset is used to fulfill a contract with the client, including any non-consecutive period. It is understood that the client controls the use of an identified asset, if throughout the period of use he/she has the right to the following: 1) obtain substantially all of the economic benefits from the use of the identified asset, and 2) direct the use of the identified asset (how and for what purposes it is used). All contracts that meet this definition are considered leases and shall be registered in accordance with the new IFRS 16. Although in the majority of cases it is easy to establish whether a contract contains a lease or not, there are complex situations in which it is necessary to exercise value judgments; for example when both the client and the supplier (the entity that provides goods or services covered by a contract) make decisions with regard to the use of an identified asset or when the supplier has the substantive right to replace the asset during the period of use.6
Lessees must initially register a right of use of the asset and a liability for lease, based on the present value of the future payments of the lease and the term of the lease estimated in accordance with the new standard. IFRS 16 defines the term “lease” as “the non-cancellable period for which the lessee has the right to use the asset in question, including optional periods, when the entity is reasonably certain to exercise the option to extend (or not terminate) the lease.” To do this, “the lessor must consider all relevant information and circumstances that may create economic incentives to exercise the option” (PWC, 2016).
IFRS 16 does not apply to contracts for services, so there is no need to settle them in the statement of financial position. If a contract includes leasing and services, they must be separated; but if it is decided to leave them together for practical reasons, everything is capitalized, i.e., it is recorded in its entirety as a lease contract.
Main Changes and Effects for Lessees and Lessors
Lessee
Lessors
Conclusion
The statement by IASB president Hans Hoogervorst, that “the new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligations” (IASB, 2016 (a)), expresses the essence of the change.
Although the new IFRS 16 will not be effective until January 1, 2019, the sooner the investors and managers understand and assimilate the impact that this standard will have on their company and its business model, the more prepared they will be to deal with the change and lower the cost of implementation.
It is expected that the fact that now the lessees will have to present virtually all leases in the statement of financial position translates into benefits for creditors and investors by having greater clarity and disclosure of the lease commitments of the organization and a better assessment of the risk. However, the implementation of the new standard will not be easy, and the entire business community must be educated and become aware of the reasons for the change and its main effects.
FOOTNOTES
1 Issuing body of the International Financial Reporting Standards (IFRS)
2 Regulatory body for the securities markets in the United States
3 Issuing body of financial regulations in the United States
4 Short term means 12 months or less. Assets are set as “low value” assets with a máximum value of $5,000 dollars or less when new (IASB, 2016 (b)). The concept of low value does not depend on the volume of assets; for example, tablets, personal computers, small pieces of furniture, office equipment, telephones and others.
5 An identifiable asset can be a specific part of a larger asset; for example, a floor or a comercial establishment of a building.
6 As a general rule, in accordance with the IFRS 16, if the client cannot easily determine whether the supplier has a replacement of substantive rights, it must be assumed that he/she does not have it. (IASB, 2016 (b)).
7Earnings before interest, taxes and depreciation.
REFERENCES
EY, 2016, “IFRS Developments Issue 117 (January 2016) IASB issues new leases standard,” consulted on June 15, 2016 at
IASB, 2016 (a), “IASB shines light on leases by bringing them onto the balance sheet,” consulted on June 15, 2016, at
IASB, 2016 (b), “IFRS 16 Leases. Effects analysis,” consulted on June 15, 2016, at
IASB, 2016 (c). “IFRS 16 Leases. Project summary and feedback statement,” consulted on June 15, 2016, at
Morales Díaz, José (2016). “La nueva revolución en la contabilidad de los arrendamientos. Efectos contables y económicos,” consulted on June 10, 2016, at
PwC, 2016, “IFRS 16: The leases standard is changing. Are you ready?” consulted on June 10, 2016, at
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