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IFRS 16 – Leases: Do We Welcome the Changes it Brings?

 
October 27, 2016

IFRS 16 replaces IAS 17 Leases, effective January 1, 2019. While the new standard wont affect a lessors financial statement to a great extent, it will most certainly affect a lessees financial statement. The impact can be significant for companies with material off balance sheet leases. Now there will be no difference from an accounting point of view between an operating lease and a finance lease for a lessee. Instead, all leases will be treated in a similar manneras finance leases. Leases will be capitalized by recognizing 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. As a second effect, a company will also show a financial liability on their balance sheets representing its payment obligation.

There are two exemptions where a lessee can treat the lease as an operating one: (a) short-term leases (12 months or lesser) and (b) leases of low-value assets.

Impact on the lessees income statement

For companies with material off balance sheet leases, IFRS 16 will change the nature of expenses related to those leases, replacing the straight-line operating expense (under IAS 17) with a depreciation charge for the lease asset and an interest expense. Although the depreciation charge is typically even, the interest expense reduces over the life of the lease. This will reduce the total expense as the individual lease matures.

For these companies, IFRS 16 is expected to result in higher profit before interest (for example, operating profit) compared to the accounting figures arrived at by applying IAS 17. This is because, while applying IFRS 16, a company presents the interest component in lease payments as part of finance costs, instead of operating cost.

Impact on the lessees balance sheet

For companies that have material off balance sheet leases, IFRS 16 is expected to result in an increase inlease assets and financial liabilities. The newly recognized lease asset (the right-of-use asset) is a non-current non-financial asset, and the lease liability is part of current and non-current financial liabilities, depending on the timing of lease payments. Accordingly, the key financial ratios derived from a companys reported assets and liabilities will change. For example, asset turnover, financial leverage or gearing, (due to higher assets and liabilities) will all change.

Will the new standard affect the lessees cash flow statement as well?

Yes, IFRS 16 is expected to reduce the operating cash outflows, with a corresponding increase in financing cash outflows. This is because, while applying IAS 17, companies present cash outflows on off balance sheet leases as operating activities. In contrast, while applying IFRS 16, principal repayments on all lease liabilities will be included within financing activities.

Overall Impact of IFRS 16 Leases on Industries

Companies possessing material off balance sheet leases will be impacted significantly. Organizations in airlines, retail, travel and leisure, transport, telecommunications, energy, media, distribution, information technology, and healthcare sectors that possess large amounts of off balance sheet leases that spend considerably on operating lease rentals will be affected. Their financial statements are going to look different now.

Companies requiring heavy plant equipment or a fleet of vehicles will have to make a strategic decision: buy or lease? The financial statements of two companies doing the same business, with the same margin and volume, will be analyzed differently if one has bought assets and the other has acquired them on lease. One company will have a heavier balance sheet and lower profits in the initial years, while the other will have a lighter balance sheet with higher profits. The financial statements may suggest that the company that has decided to lease, outperforms the one that went in for the buy decision. The comparison of profitability and balance sheet ratios in such a scenario may be misleading. Analysts and researchers have to adjust these financial statements to make them comparable before analyzing them. The business forecasts for these two companies will yield different results too.

Thus, IFRS 16 Leases will help decisively compare the financial statements of different companies on common grounds. The new way of accounting, along with strengthened disclosure requirements shall improve comparability, and the overall quality of financial statements. In our view, this is a welcome change.

Salil Godambe is a Domain Consultant with the Finance and Reporting Practice within the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). He is a chartered accountant with over 20 years of experience in the areas of accounting, financial reporting, auditing, and business process outsourcing. Godambe has a Bachelors degree in Commerce.