What is IFRS 16?
IFRS 16 is a new International Financial Reporting Standard (IFRS) that came into force on 1 January 2019. It provides a lease accounting model that specified the guidelines for recognising, measuring, presenting and disclosing leases.
It was introduced by the International Accounting Standards Board (IASB) and has replaced the existing International Accounting Standard 17 accounting standard.
IFRS 16 requires lessees to recognise all the assets and liabilities for all leases unless they have a term of not more than 12 months or the underlying asset has a low value.
Earlier the lease agreements were divided into two parts:
- Finance leases
- Operating leases
Usually operating leases were not considered as a part of the balance sheet. Rather they were simply included in the profit and loss accounts on accrual basis.
But now IFRS 16 has eliminated the distinction that was earlier there between the operating leases and the finance leases. It has led to the use of the “right-of-use” model approach for accounting for leases.
Under this model, a rented asset is classified as a lease for accounting purposes and is shown in the company balance sheet if a company has control over it or has the right to use it.
Moreover, the lease payments that a company will make on the agreement will be recognised as a lease liability in the balance sheet of the company.
Apart from this, the profit and loss accounts of a company will also include the interest that the company pay on the lease liability along with the depreciation of the asset.
Key elements of the ‘right-to-use’ model:-
Experlu sharing some of the key elements of this new model and its effects on the financial statements of the companies are as follows:
- The ‘risk and reward’ model that was earlier followed by the companies has now been replaced by the ‘right-of-use’ model. Due to this, the lessees now must recognise an asset and liability during the establishment of a lease.
- All the lease liabilities will be calculated with respect to an estimation of the lease term.
- Variable lease payments or contingent rentals that depend on an index or a rate have to be included when leased assets and liabilities are measured.
- The lease term should be reassessed by the lessees only when there is an occurrence of a noteworthy event or a noteworthy change in the circumstances that are in the hand of the lessee.
Benefits of IFRS 16:
- This model will ensure that the leased assets and liabilities of the companies are transparent and that all the companies will report the information related to their leased assets using a standardised approach.
- Instead of individually reporting all the lease agreements that a company carries, the company can combine them into a single portfolio as per the standards provided by IFRS 16.
- This will allow the users of the financial statements to analyse the timings, amount, and uncertainty of the cash flows that will arise from these leases.
- The new requirements under IFRS 16 redefine the meaning of the financial metrics that are commonly used (For example- EBITDA and gearing ratio). This will lead to an increase in the comparability of the companies.
- The new standards under IFRS 16 can lead to the acceleration of the existing market developments in leasing. One such example is the increased focus of the market on services instead of physical assets.
How does IFRS 16 impact the industries?
Leasing is a commonly used financing solution that allows the company to acquire and use property and equipment without the fear of experiencing large cash outflows at the start only. This can help the companies to flexibly use a physical asset that may not be available for purchase.
Different industries have different terms and structures of the lease agreements; thus, due to IFRS 16, there may be different implications for each industry.
- Retailers
Retailers indulge in the heavy use of real estate leases for their stores. Due to IFRS 16, they will need to split service charges from the lease elements. They will need to use systems to estimate and reassess the variable payments that depend on an index or rate.
- Telecommunication
Telecommunication industry businesses lease numerous big-ticket items like cell towers, network equipment and fibre optic cable. Due to the new model, they must distinguish the lease and non-lease elements. They can adopt the new lease standard s by combining them with the new revenue recognition standards, which may help them become cost-efficient.
- Real estate and equipment lessors
While IFRS 16 may not profoundly impact the industries in this sector, it may lead to requests for more variable lease payments and shorter lease terms. This can not only increase the risk for the lessor but also put constraints on the pricing.
- Transport and logistics
The industries in this sector commonly lease big-ticket items like trains, aircraft, real-estate and other vehicles. Leases play a significant role in their revenue-generating activities.
Under the new model, it can be difficult for these industries to distinguish between an operating lease or a service. Moreover, the lessees will also need to separate lease and non-lease elements by unbundling the lease information. This is done so that accounting for lease separate from service elements can be made possible.
