New IFRS Operating Lease Rules to Have Major Balance Sheet Impact

New lease accounting changes to bring US GAAP and IFRS accounting regulations for leases into line could wreak havoc on balance sheets.

The chief issue is the removal of the distinction between financial and operating leases.  The new standards present a fundamental shift in the recognition of all assets and liabilities arising from leases.

According to the IFRS, in 2005, the US Securities and Exchange Commission (SEC) estimated that US public companies may have approximately US$1.25 trillion of off balance sheet leases.   This is a substantial figure and one that typically gets footnoted on balance sheets.  Responding to a lack of transparency, both FASB and IASB agreed that a customer (lessee) leasing assets should recognise assets and liabilities arising from those leases.  Essentially their argument is that at the start of a lease a lessee obtains the right to use an asset for a period of time and, if payments are made over time, incurs a liability to make lease payments.

Why this is Important

Banks and other lenders, investors and analysts use common financial metrics (including leverage ratios, current ratios, asset turnover, interest cover, EBITDA, operating profit, net income, ROE and operating cash flows) to compare companies. As IFRS stated,

"For many companies, the effect of a lease on reported assets and financial leverage was substantial. The absence of information about leases on the balance sheet meant that investors and analysts were not able to properly compare companies that borrow to buy assets with those that lease assets, without making adjustments."

What changes on a company’s balance sheet?

IFRS 16 eliminates the classification of leases as either operating leases or finance leases for a lessee. Instead all leases are treated in a similar way to finance leases applying IAS 17. Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as lease assets (right-of-use assets) or together with property, plant and equipment.

What does IFRS 16 mean for a company’s income statement?

For companies with material off balance sheet leases, IFRS 16 changes the nature of expenses related to those leases. IFRS 16 replaces the straight-line operating lease expense for those leases applying IAS 17 with a depreciation charge for the lease asset (included within operating costs) and an interest expense on the lease liability (included within finance costs).

Figure: IFRS 16 Impact on Income Statement

Lease1

Are there any exemptions?

Yes. IFRS 16 does not require a lessee to recognise assets and liabilities for (a) short-term leases (ie leases of 12 months or less) and (b) leases of low-value assets (for example, a lease of a personal computer).

Companies must comply when the new standards come into force on 1st January 2019 or 15th December 2018 for US GAAP.

Source: IFRS.org

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