Ifrs 16 leases

What Is IFRS 16 Leases?

IFRS 16 Leases is an International Financial Reporting Standard (IFRS) that specifies how companies should recognize, measure, present, and disclose leases in their Financial Reporting. Part of a broader category of Financial Accounting Standards, IFRS 16 fundamentally changed how lessees (the parties leasing an asset) account for most lease agreements by requiring them to bring nearly all leases onto their Balance Sheet as both Assets and Liabilities. This standard aims to provide a more accurate representation of an entity's financial position, addressing previous criticisms that many lease obligations remained hidden as off-balance sheet items.

History and Origin

The journey to IFRS 16 Leases began with a recognition that the previous leasing standard, IAS 17 Leases, allowed for significant off-balance sheet financing, particularly for operating leases. Under IAS 17, many companies could expense lease payments through the Income Statement without recognizing the associated assets and liabilities on their balance sheets. This practice was criticized for obscuring the true extent of a company's obligations and its financial leverage⁷⁶, ⁷⁷, ⁷⁸.

The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) collaborated on developing a new standard to address these shortcomings, aiming for greater transparency and comparability across financial statements⁷⁴, ⁷⁵. After extensive deliberation and several exposure drafts over a decade, the IASB issued IFRS 16 Leases in January 2016. The standard became effective for annual reporting periods beginning on or after January 1, 2019, replacing IAS 17 Leases and related interpretations⁷⁰, ⁷¹, ⁷², ⁷³. According to the IFRS Foundation, the objective of IFRS 16 is to provide information that faithfully represents lease transactions and allows users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases.⁶⁹

Key Takeaways

• IFRS 16 Leases introduces a single lessee accounting model, requiring most leases to be recognized on the balance sheet.⁶⁷, ⁶⁸
• Lessees must now recognize a "right-of-use" (ROU) Right-of-Use Asset and a corresponding Lease Liability for nearly all lease agreements.⁶⁴, ⁶⁵, ⁶⁶
• The standard largely eliminates the distinction between finance leases and operating leases for lessees, which was central to the previous IAS 17.⁶², ⁶³
• Lessor accounting remains substantially unchanged from IAS 17, retaining the classification of leases as either finance or operating for lessors.⁵⁸, ⁵⁹, ⁶⁰, ⁶¹
• Exceptions exist for short-term leases (12 months or less) and leases of low-value assets, which can still be expensed.⁵⁵, ⁵⁶, ⁵⁷

Formula and Calculation

Under IFRS 16, a lessee initially measures the Lease Liability at the Present Value of the lease payments that are not paid at the commencement date of the lease. The lease payments are discounted using the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee's incremental borrowing rate is used as the Discount Rate.⁵³, ⁵⁴

The formula for calculating the lease liability is:

Where:

• (\text{LP}_t) = Lease payment in period (t)
• (r) = Discount rate (interest rate implicit in the lease or the lessee's incremental borrowing rate)
• (n) = Lease term in periods

Simultaneously, a Right-of-Use Asset is recognized. This asset is initially measured at the amount of the lease liability, adjusted for any lease payments made at or before the commencement date, initial direct costs, estimated costs of dismantling and removing the underlying asset, and any lease incentives received.⁵²

Interpreting the IFRS 16 Leases

The implementation of IFRS 16 Leases significantly alters how a company's financial position and performance are presented in its Financial Reporting. By bringing lease liabilities onto the balance sheet, the standard provides a more comprehensive view of an entity's contractual obligations. This increases total assets and total liabilities, which in turn impacts key Financial Ratios.⁴⁹, ⁵⁰, ⁵¹

For instance, the recognition of lease liabilities typically increases a company's reported debt, potentially affecting leverage ratios such as debt-to-equity. While this does not change the underlying economic reality of a company's leases, it provides greater transparency to investors and analysts. Additionally, the income statement presentation changes; what was previously a single operating lease expense is now split into Depreciation of the right-of-use asset and Interest Expense on the lease liability. This reclassification generally leads to an increase in Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), while net income may see little change or a different expense pattern over the lease term.⁴⁵, ⁴⁶, ⁴⁷, ⁴⁸

Hypothetical Example

Consider Company A, which enters into a 5-year lease agreement for office equipment with annual payments of $10,000, payable at the end of each year. The interest rate implicit in the lease cannot be readily determined, so Company A uses its incremental borrowing rate of 5%.

Step 1: Calculate the Lease Liability
The lease liability is the present value of the 5 annual payments of $10,000 discounted at 5%.

Using present value tables or a financial calculator:

• PV of an ordinary annuity for 5 periods at 5% = 4.32948
• Lease Liability = $10,000 * 4.32948 = $43,295

Step 2: Recognize the Right-of-Use Asset
At the commencement date, Company A recognizes a Right-of-Use Asset and a corresponding Lease Liability:

• Debit Right-of-Use Asset: $43,295
• Credit Lease Liability: $43,295

Step 3: Subsequent Accounting (Year 1)
In subsequent periods, Company A will recognize Depreciation on the right-of-use asset and Interest Expense on the lease liability.

• Depreciation: Assuming straight-line depreciation over the 5-year lease term:
  • Annual Depreciation = $43,295 / 5 = $8,659
• Interest Expense:
  • Beginning Lease Liability: $43,295
  • Interest Expense (Year 1) = $43,295 * 5% = $2,165
  • Cash Payment: $10,000
  • Principal Repayment = $10,000 - $2,165 = $7,835
  • Ending Lease Liability = $43,295 - $7,835 = $35,460

Journal Entries for Year 1:

• Debit Depreciation Expense: $8,659

• Credit Accumulated Depreciation: $8,659

• Debit Interest Expense: $2,165

• Debit Lease Liability: $7,835

• Credit Cash: $10,000

This example illustrates how IFRS 16 shifts the accounting from a simple rental expense to a more complex asset and liability recognition, with both depreciation and interest impacting the income statement over the lease term.

Practical Applications

IFRS 16 Leases has broad practical applications across various sectors and for financial analysis. For companies that heavily rely on leasing, such as airlines, retailers, and transportation firms, the standard fundamentally changes their Financial Reporting.⁴⁴

One significant application is its impact on a company's reported Capital Expenditures versus operating expenses. Under IAS 17, operating leases allowed companies to keep significant asset financing off their balance sheets, presenting lease payments as operating expenses. IFRS 16 now requires the capitalization of most leases, effectively moving them from operating expenses to a combination of depreciation and interest, which are more akin to financing a purchased asset.⁴², ⁴³ This change can influence "lease versus buy" decisions, as the accounting treatment for leases now more closely resembles that of purchased assets.⁴⁰, ⁴¹

For investors and analysts, IFRS 16 enhances the comparability of financial statements between companies that lease assets and those that purchase them. It provides a clearer picture of a company's total financial leverage and the resources it controls through leasing, allowing for more informed investment decisions.³⁸, ³⁹ A detailed analysis of these implications is available from various sources, including accounting advisory firms.³⁷

Limitations and Criticisms

Despite its goal of increased transparency, IFRS 16 Leases has faced some limitations and criticisms. A primary challenge for companies implementing the standard has been its complexity and the extensive data collection required. Identifying all lease contracts, extracting relevant terms, and making necessary estimates (such as the lease term and the appropriate discount rate) can be time-consuming and resource-intensive, particularly for decentralized organizations or those with numerous lease agreements.³³, ³⁴, ³⁵, ³⁶

Another area of concern is the significant impact IFRS 16 has on key Financial Ratios. The recognition of substantial lease liabilities increases reported debt, which can negatively affect a company's debt-to-equity ratio and other leverage metrics.²⁸, ²⁹, ³⁰, ³¹, ³² This shift may even lead to potential breaches of existing loan covenants that were based on pre-IFRS 16 financial structures.²⁷ While these changes reflect a more accurate financial reality, they can initially be perceived negatively by credit rating agencies and lenders. Research into the effects of IFRS 16 highlights how the standard has led to an increase in reported assets and liabilities for companies, impacting their financial performance metrics.²⁶ Furthermore, while the new standard aims for a single accounting model for lessees, the reliance on various estimates can introduce a degree of subjectivity.²⁵

IFRS 16 Leases vs. IAS 17 Leases

The fundamental difference between IFRS 16 Leases and its predecessor, IAS 17 Leases, lies in the lessee's accounting treatment. Under IAS 17, leases were classified into two categories: Finance Lease and Operating Lease. Finance leases were recognized on the balance sheet, with both an asset and a liability. In contrast, operating leases were treated as off-balance sheet arrangements, with lease payments expensed directly to the income statement as rent. This allowed companies to keep significant lease obligations hidden from the balance sheet.²², ²³, ²⁴

IFRS 16 largely abolishes this dual classification for lessees. It introduces a single, on-balance sheet accounting model, requiring lessees to recognize a Right-of-Use Asset and a corresponding Lease Liability for nearly all leases, regardless of whether they would have been classified as finance or operating leases under IAS 17.²⁰, ²¹ The accounting for lessors, however, remains largely unchanged between the two standards, with lessors continuing to classify leases as either finance or operating leases.¹⁶, ¹⁷, ¹⁸, ¹⁹ This distinction between lessor and lessee accounting, where the former retains the old classification while the latter adopts a single model, represents a key divergence from the initial goal of full convergence between global accounting standards.

FAQs

What types of leases are exempt from IFRS 16's on-balance sheet recognition?

IFRS 16 provides two main exemptions that allow lessees to avoid recognizing a Right-of-Use Asset and a Lease Liability on the balance sheet: short-term leases and leases of low-value assets. Short-term leases are those with a lease term of 12 months or less at the commencement date, provided they do not contain a purchase option. Leases of low-value assets refer to underlying assets that have a low value when new, such as personal computers or office furniture. For these exempt leases, companies can recognize lease payments as an expense in the Income Statement on a straight-line basis over the lease term.¹², ¹³, ¹⁴, ¹⁵

How does IFRS 16 affect a company's financial statements?

IFRS 16 Leases has a significant impact on a company's Financial Statements, primarily the balance sheet, income statement, and statement of cash flows. On the Balance Sheet, both Assets (as Right-of-Use assets) and Liabilities (as Lease liabilities) generally increase, leading to a larger balance sheet size. This often results in changes to Financial Ratios such as the debt-to-equity ratio and return on assets. On the income statement, what was previously a single operating lease expense is replaced by Depreciation on the right-of-use asset and Interest Expense on the lease liability. This typically increases EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) but can also alter the pattern of total expense recognition over the lease term. In the statement of cash flows, principal repayments of the lease liability are classified as financing activities, while interest payments can be presented as either operating or financing activities.⁶, ⁷, ⁸, ⁹, ¹⁰, ¹¹

Is lessor accounting different under IFRS 16 compared to IAS 17?

No, the accounting treatment for lessors under IFRS 16 Leases is substantially unchanged from its predecessor, IAS 17 Leases. Lessors continue to classify leases as either a Finance Lease or an Operating Lease and account for them differently based on whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset.¹, ², ³, ⁴, ⁵ The primary focus of the IFRS 16 changes was on lessee accounting to bring more transparency to lease obligations on the balance sheet.