What is IFRS16?

Before IFRS16 came into effect, lease agreements were split into finance leases and operating leases for accounting purposes, with operating leases excluded from balance sheets and instead accounted for via profit and loss accounts.

Following IFRS16, the majority of leased items now have to be included as an asset on the company books, with all leases being treated in a similar way to finance leases:

• Balance sheet – you will need to show your right-of-use assets as an asset, and your obligation to make lease payments as a liability
• Profit and loss accounts – you will need to show the depreciation of the asset as well as the interest on the lease.

IFRS16 applies a control model for the identification of leases, distinguishing between leases and service contracts in terms of whether there is an identified asset controlled by the lessee.

There are two types of lease that don’t come under IFRS16:

• Leases where the value of the item when new is classed as low value (currently less than 5000USD
• Leases with a term shorter than 12 months, without the option to buy the leased item at the end of the lease.

IFRS16 replaced the IAS17 accounting standard in a bid to make leasing more financially transparent. Under IAS17, businesses could have significant financial liabilities in the form of operating leases, but they weren’t reflected on their balance sheets. This meant it was difficult to get a clear and accurate picture of their financial status.

IFRS16 has had a significant impact on the way companies account for their lease assets, particularly those who had previously kept a substantial proportion of their financing off the balance sheet, in the form of operating leases.

When completing IFRS16 reporting, companies must now:

• Identify is assets are defined as leases under the regulations
• Collect all the necessary information on these leases, including terms, options at end of the lease, rentals payable, interest rate, etc
• Account for the leases to recognise assets and liabilities.

How each individual business’ financial statements are impacted will depend on the lease agreements they have in place. However, for many, it has meant an increase in recognised assets and liabilities, with more lease expenses recognised in the early periods of a lease, and less in the later periods.

Many businesses have had to change their systems and processes in order to accommodate the changes.

For the majority of businesses, however, leasing still remains a beneficial option, allowing them to spread capital spending over the term of the lease.

So for example, let’s take a business leasing a building over 5 years, making payments of £20,000 per year, with an interest rate of 9%.

The present value for year 1 would be £77,793 – the initial cost of the asset plus the lease liability.

In future years, the liability will be adjusted to show interest recognition and the lease liability payment, as illustrated below.

IFRS16 offers a number of advantages.

It increases the visibility of lease commitments and ensures their financial position is more accurately reflected in their accounts. This will also make it easier to compare the financial position of businesses that lease their assets with those that fund their assets through borrowing, creating a fairer and more accurate playing field.

As mentioned above, under IFRS16, all other advantages of leasing also remain.

IFRS16 may also have some disadvantages for some companies, and the more lease agreements they have, the larger the impact will be.

When leased assets are included on the balance sheet, they may appear to be more asset-rich, however, they will also appear to have an increased burden of debt. For businesses with a large lease portfolio, this could impact the ability to access finance, as well as decrease the appeal to potential investors.

It may also impact existing funding. For example, if a company has banking covenants in place that state a certain level of profitability must be maintained, their funding may be affected.

In summary, the introduction of IFRS16 means that businesses now need to show on their balance sheet their right to use an item as an asset, and their obligation to make payments for it as a liability.

This new approach was implemented to improve transparency and comparability. Those leasing assets can still enjoy the many benefits that leasing offers.

To find out more about the benefits of leasing, or leasing under IFRS16, get in touch.