The Simple Guide to IFRS 16: What You Need to Know
IFRS 16 is a new International Financial Reporting Standard for lease accounting which came into force on 1 January 2019. It replaced the existing IAS 17 accounting standard and was introduced by the International Accounting Standards Board (IASB).
At first glance, it’s a complicated piece of accounting legislation which could potentially be difficult 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 understand the pros, cons, and implications of IFRS 16 for your business accounting and even come up with a suggestion or two to make it simpler still.
What is IFRS 16?
IFRS 16 is the most significant change to lease accounting in over 30 years. Since its introduction on 1 January 2019, this new standard will affect most companies reporting under IFRS and will have a major impact on the financial statements of lessees of property and high-value equipment.
IFRS 16 takes a totally new approach to accounting for leases, called the ‘right-of-use’ model. This means that if a company has control over, or right to use, an asset they are renting, it is classified as a lease for accounting purposes and, under the new rules, must be recognised on the company’s balance sheet.
This no longer allows for significant financial liabilities to be held off-balance sheet, as permitted for certain types of leases (operating leases) under the previous rules. The objective is to ensure that companies report information for all of their leased assets in a standardised way and bring transparency on companies’ lease assets and liabilities.
As with other changes to accounting standards, companies will also need to produce a set of comparative accounts for the prior year.
What’s changed under IFRS 16?
Basically, the changes apply to the accounting treatment for lease agreements. Previously, these were split into finance leases and operating leases. Generally, operating leases were not included on balance sheets but were simply accounted for via profit and loss accounts.
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’ (IFRS 16, par.9)’
In addition, the lease payments you make on the agreement have to be reported as a lease liability on your balance sheet.
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.
It’s worth noting that lessor accounting is basically unaffected by the introduction of IFRS 16.
Exceptions to the rule
There are two specific types of lease which don’t come under IFRS 16 leases and which don’t have to be recorded as an asset:
A lease where the value of the item when new is low value, currently indicated as less than US$5000.
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 a vehicle is less than 12 months and you don’t have the option to buy the cars at the end of the contract, then these would not be included under IFRS 16.
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.
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.
What is IFRS 16 replacing?
IFRS 16 replaces IAS 17 accounting standard.
Why the change?
The objective of the change is to make sure that companies all return information for leased items 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.
Who does IFRS 16 apply to?
Initially, at least, these changes will only apply to organisations that already report using IFRS, typically international companies or PLCs. The majority of SMEs 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 organisation then you need to first determine whether your rental contracts are actually considered to be IFRS 16 leases under the new standard, 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 the right to 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 be a right-of-use asset and isn’t technically a lease under IFRS 16. The payments would just be included in your profit and loss statement and you would not account in your financial statements under IFRS 16.
What does this mean for financial reporting?
For companies affected by the changes, this will work in a similar way to the reporting of other non-financial assets (such as property, plant and equipment) and financial liabilities:
Balance sheets – lessees will need to show their right-of-use asset as an asset and their obligation to make lease payments as a liability.
P&L accounts – lessees will show depreciation of the asset as well as interest on the lease liability. The depreciation would usually be on a straight-line basis.
As interest charges are higher in the early years of the lease, the total impact on the P&L account is front-loaded even though rentals remain constant throughout the term of the lease.
Rather than having to account for all asset leases individually, there is scope to combine these into a portfolio. This can only be applied if the company can demonstrate that there would be no financial advantage to them taking this approach.
Affected companies will broadly have to go through three stages to be able to complete their IFRS 16 financial reporting:
Identification of all their assets which will be defined as leases under the new regulations (property, equipment, vehicles, etc).
Collecting all the information on these leases – term, options at end of lease, rentals payable, interest rate of the lease (if available; for operating leases this will not usually be available) so the lessee will need to think about their incremental borrowing cost (this could be the rate they internally borrow at).
The accounting for their leases to recognise assets and liabilities – once all the information is assembled the calculation is actually relatively easy – it’s just finding the inputs that could be challenging.
It is expected that step 2 will be the most difficult, and potentially time-consuming, for organisations with a large number of assets.
Efficient lessors should be able to assist companies with this stage by anticipating needs and communicating proactively.
Downsides of IFRS 16
The new rules could have some significant and possibly detrimental effects on the way the company finances appear on its balance sheet.
Businesses leasing equipment will appear from their balance sheets to be more asset-rich, but they will also appear to carry a bigger debt burden. The larger 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.
What is included and excluded under the IFRS 16 definition of a lease?
Many leasing contracts contain elements other than the actual rental of the underlying asset (e.g. services such as maintenance). Under IFRS 16 these don’t constitute part of the lease and will need to be split out as a separate charge by the supplier.
For example, a company leases a building and rental payments include fees for maintenance, cleaning or other ancillary services. These should be separated, as only the lease of the asset itself needs to be reported on the balance sheet.
Where a supplier has the right to substitute an asset being used by the customer for an alternative asset, and they have an opportunity to gain a financial benefit from doing this, the contract is not regarded as a lease and does not need to be reported.
Payments regarded as ‘contingent to the use’ of the supplied asset (such as charges for wear and tear during the term of the lease) do not need to be included in financial reporting.
If a company has a formal option within its contract to extend the term of the lease and it takes this option, then it will need to calculate the value of the use of the asset and include this within its reporting. However, informal extensions of leases, for example where a new asset is on order, do not need to be reported.
IFRS16 also has two specific exemptions where leases do not need to be reported on balance sheets:
Leases with a term of 12 months or less with no purchase option (such as a car Mini-lease)
Leases where the asset has a low value when new (indicative definition of low value is < US$5000).
Vehicle leasing specifics
The general rules and exemptions described above have some specific implications for vehicle leasing:
IFRS 16 effectively removes the distinction between Operational Leasing (of which contract hire is the most common type) and Finance Leasing. The ‘lease’ element of both forms of finance will now appear on-balance sheet.
Charges for ancillary vehicle services, such as maintenance, accident management, breakdown cover, etc. will need to be broken out of the overall lease payments for reporting purposes.
As with all assets, providing the contract is for less than 12 months, short and medium-term hire vehicles do not need to be reported as assets.
Informal vehicle extensions at the end of their initial contract do not need to be reported.
While no specific guidance has been given on items related to the usage of the vehicle (such as excess mileage or damage charges), costs that are regarded as ‘contingent payments’ based on the use of the asset do not need to be reported.
Where a supplier has the right to substitute a vehicle for another during the term of the contract, this is not regarded as a lease and does not need to be reported. In practical terms, this could look like pooling of cars that multiple companies can access.
The ability to combine assets at a portfolio level provides fleet operators with the opportunity to simplify their financial reporting.
What are the impacts of IFRS 16 leases?
While the IFRS reporting changes do fundamentally change the treatment of assets acquired through operational leasing, companies are likely to want to continue to lease assets as the majority of the benefits remain:
Spreading a fixed cost over the lease term of the right-of-use asset rather than outlaying capital upfront.
Providing 50% VAT recovery on the financing of certain assets (e.g. company cars).
Offering protection against fluctuations in residual values and providing the opportunity to outsource operations and services
A very quick summary of the major changes to your financial reporting needed to comply with IFRS 16 from 1 January 2019:
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, lease payments, end-of-term options, etc. and then extract and show separately any part of the payments which are not applicable to IFRS 16.
You might also find this video, from IFRSbox, useful. It covers an overview of IFRS 16 and the accounting treatment.
If you need more help with any aspect of IFRS 16, contact an accountant who should be able to assist with the technicalities or advice in specific circumstances.
Important: The Maxxia Group of companies does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.