What is IFRS 16?

A little about me: I come from the world of finance so i have decided to add my professional writings in my blog as well.

IFRS 16 (International Financial Reporting Standard) is:

  • a new standard for lease accounting which came into effect in January 2019
  • Replacing the existing IAS 17 lease accounting standard
  • It’s been put together by the International Accounting Standards Board (IASB).

Initially it seems slightly complicated – the part which could have been a nightmare, but when I took a closer look it is fairly straightforward to understand, but could be less so to implement.

So My colleague made it so easy for me and here I will try to make it easier for you to walk through the pros, cons and implications for your business accounting and who knows maybe even come up with a suggestion or two to make it simpler still.

What’s different under IFRS 16?

The changes apply to the way accounting is done for lease agreements that companies take out on property, plant and equipment (PPE).

Earlier this was divided into:

  • finance leases and
  • operating leases.

You see operating leases were not included in balance sheets as assets but were simply added to profit and loss accounts.

The prime IFRS 16 change is:

  •  Most leased items should 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’ (IFRS16, par.9)’

  • The payments you make on the lease agreement have to be reported as a liability on your balance sheet.
  • The accounting can be further complicated :
    • as costs for maintenance,
    • cleaning etc

have to be separated from the main lease payments, if they’re included in them, and reported separately.

  • The depreciation of the asset and interest on the lease liability have to be shown on your profit and loss accounts.
  • Asset shall be recognized under recognition criteria of IAS 16 Property i.e. depreciation or revaluation as consistent with its class of assets. The lease liability would be paid off over time using the actuarial method. Lease payments would reduce the lease liability when paid.

One pluses 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.

Now the Exceptions to the rule

There are two specific types of lease which don’t come under IFRS 16 and which don’t have to be entered on the balance sheet as an asset:

  1. 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.
  2. Underlying assets has a low value currently defined as less than US$5000.

Why the changes?

The change objective is so the companies all record the leased items as assets in the same way, making their existence more transparent financially.

In the past, some businesses could or would hold large liabilities on their operating leases but keep them off the balance sheets, giving a twisted view of their overall financial status.

How does IFRS 16 apply to my business?

The changes will only apply to:

  • a PLC or a company that already reports to IFRS

IFRS 16 disadvantages

  • Businesses leasing assets will appear from their balance sheets to be more asset-rich, but they will also appear to carry a bigger debt burden
  • Will affect your key accounting and financial ratios. This may decrease the firm’s potential attractiveness to investors and its ability to raise finance.
  • It might also lead to problems if you already have banking pledges in place which specify, that a exact level of profitability must be maintained for existing bank agreements to continue – it could affect funding

A simplified summary

The major changes to your financial reporting needed to comply with IFRS 16:

  • The requirement to identify and show on your balance sheet the right to use an item as an asset and your commitment to make payments for it as a liability.
  • The need to collect all the information on the leases
    •  term,
    • rental payable,
    • end-of-term options etc.

and then remove and show separately the payments which are not applicable to IFRS 16.