How does IFRS 16 affect you?
What is IFRS 16?
IFRS 16 (International Financial Reporting Standard) is a new standard for lease accounting which will come into force in January 2019. It will replace the existing IAS 17 lease accounting standard. It’s been put together by the International Accounting Standards Board (IASB).
At first glance, it’s a complicated piece of accounting legislation which could potentially be a nightmare to navigate. On closer examination, however, it’s fairly straightforward to understand, but could be less so to implement.
Here we try to make it easier for you to wade through the pros, cons and implications for your business accounting and even come up with a suggestion or two to make it simpler still.
What’s changed under IFRS 16?
Basically, the changes apply to the way accounting is done for lease agreements that companies take out on property, plant and equipment (PPE).
The biggest IFRS 16 change is that now most leased items have to be included as an asset in the company books, following the new ‘right of use’ model which says:
‘A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration’ (IFRS16, par.9)’
In addition, the payments you make on the lease agreement have to be reported as a liability on your balance sheet.
Also, accounting can be further complicated by the new standard as costs for maintenance, cleaning etc have to be separated from the main lease payments, if they’re included in them, and reported separately.
Added to these, the depreciation of the asset and interest on the lease liability have to be shown on your profit and loss accounts.
One ‘pro’ for IFRS 16 is that, if your company carries a number of lease agreements, it can be possible to combine them into a portfolio, instead of having to individually report them. This can only be done if you can show that there is no financial advantage for you in doing this.
Exceptions to the rule
There are two specific types of lease which don’t come under IFRS 16 and which don’t have to be entered on the balance sheet as an asset:
- A lease with a shorter than 12-month term and which does not have an option to buy the leased item at the end of the lease.
So for example, if you were to use a scheme where the lease period on each vehicle is less than 12 months and you don’t have the option to buy the cars at the end of the contract, then you don’t have to list them as assets on your balance sheet.
That’s a definite advantage when you consider that any maintenance, breakdown cover or anything else which is included as part of the car leasing agreement won’t need to be calculated and reported separately, as has to be done with a long-term lease agreement. Also, there won’t be any impact on your apparent asset holdings.
If that sounds like a good option for your business, find out how CLM’s Mini-lease can give you a cost-effective way to both lease your fleet and save yourself some accounting headaches.
- A lease where the value of the item when new is low value, currently defined as less than US$5000.
Why the changes?
The object of the changes is to make sure that companies all return information for leased items as assets in the same way, making their existence more transparent financially. Previously, businesses could hold large financial liabilities on their operating leases but keep them off the balance sheets, giving a skewed view of their overall financial status.
The IASB chairman Hans Hoogervorst says of the new requirements:
“(They) bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.”
How does IFRS 16 apply to my business?
Initially, at least, these changes will only apply if you own a PLC or a company that already reports to IFRS. The majority of SME’s report to the UK’s generally accepted accounting principles (UK GAAP) and this is unlikely to change until around 2022/23.
If IFRS 16 does apply to your company, then you need to first determine whether your rental contracts are actually considered to be leases under the new IFRS 16 rule or are some other kind of contractual or service agreement.
A simple example would be renting long-term storage space.
If you rent a specific unit – a self-contained building or storage container or similar – where you have sole access, you have the keys and you have exclusive use of the space during the life of the contract, then you have right of use. This would need to appear on your balance sheet as an asset and any included maintenance costs etc would have to be pulled out and separately reported in your accounts.
Alternatively, imagine you rent some space in a large warehouse where you don’t have sole use of the facility and the landlord simply rents you some square meterage. If the area you occupy is chosen by him and can be changed by him down the line depending on the space available, then that’s not considered to give you right of use and isn’t technically a lease under IFRS 16. The payments would just be included in your profit and loss statement and the storage facility not added to your balance sheet as an asset.
Major IFRS 16 Cons
The new rules could have some significant and possibly detrimental effects on the way the company finances appear on its balance sheet.
- Businesses leasing assets will appear from their balance sheets to be more asset-rich, but they will also appear to carry a bigger debt burden. The bigger your company’s number of lease agreements, the bigger the impact on its balance sheet.
- If your company has a large lease portfolio, you’ll find that the changes will affect your key accounting and financial ratios. This may decrease the firm’s potential attractiveness to investors and its ability to raise finance.
- You may also have problems if you already have banking covenants in place which stipulate, for example, that a specific level of profitability must be maintained for existing bank agreements to continue. You’d be wise to check with your bank to make sure the new rules won’t affect your funding.
In a nutshell…
Okay, so here’s a quick summary of the major changes to your financial reporting needed to comply with IFRS 16:
- You’ll need to identify and show on your balance sheet your right to use an item as an asset and your obligation to make payments for it as a liability.
- You’ll need to collate all the information on the leases – term, rental payable, end-of-term options etc. and then extract and show separately any part of the payments which are not applicable to IFRS 16.
If you need more help with any aspect of IFRS 16, have a chat with your accountant and they should be able to help you.
Also, have a look at the first half of this video, put together by IFRSbox. It might help to clarify things a little more –