Everything You Need to Know about IFRS 16

January 8, 2023
Manaswini
Lease Management

IFRS 16 seems to be an overly complex and potentially challenging component of accounting legislation. A closer look reveals that while it's easy to grasp, putting it into practice may be trickier.

So this guide covering all crucial aspects of IFRS 16 is an attempt to break down this lease accounting component and help weigh the benefits, drawbacks, and overall impact it will have on the company's books.

Let's get started.

IFRS 16 – Transitioning to the New Leases Standard - Digital Finance  Transformation at NTT DATA

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What is IFRS 16?

IFRS 16 represents one of the most significant reforms in more than three decades in lease accounting. It went into effect on January 1, 2019.

This revised standard has had a prominent influence on the financial accounts of high-value equipment and property lessees and governs most corporations accounting under IFRS.

With IFRS 16, a new accounting model for leases gets adopted. This method is known as the "right-of-use" model.

In other words, under the new standards, a lease must get recognized on a company's balance sheet if it has authority over or the right to use the rented asset.

The previous laws allowed some types of leases (primarily operating leases) to be retained off-balance sheets. But this new rule does not allow such huge financial liabilities to be hidden from investors.

The goal is to provide transparency on lease assets and liabilities by mandating consistent reporting practices across all leased assets owned by a company.

Companies need to create a set of annual accounts that compares to those from the previous year, just as they do whenever there is a revision to accounting standards.

Prominent Changes Under IFRS 16

Key features of the IFRS 16 accounting standard and its impact on financial statements include:

  • The 'risks and rewards' framework has been replaced with the 'right-of-use' framework. When a lease commences, the lessee must acknowledge the existence of both an asset and a liability.
  • If a business gets assurance to exercise an opportunity to extend or not terminate a lease, then that option period should be included in the calculation of the lease liability.
  • The evaluation of lease assets and liabilities must include contingent rentals/variable lease payments if those payments are based on certain indices or rates or when they are, in essence, fixed payments.
  • When reassessing the lease liability for other reasons, such as a reevaluation of the lease term, and when there is a variation in the cash flows due to an alteration in the benchmark indices or rates, the lessee should reevaluate the variable lease payments relying on the index or rate. 
  • Lessees should only reevaluate the lease term when a material event or development in situations within the lessee's discretion has occurred.

Top Exceptions to the IFRS 16 Rule

Unlike most leases, which must get reported as an asset under IFRS 16, the following two forms of leases are exempt from this rule:

  • A lease in which the worth of the equipment or asset when it was new is quite low, typically less than $5000.
  • A lease with a term less than 12 months long and does not include an option to purchase the leased item at the conclusion of the lease.

This means if someone were to use a scheme in which the lease term on a vehicle is much less than twelve months, and they do not have the choice to purchase the vehicle at the expiration of the contract, then these won't get classified under IFRS 16.

So, when compared to the requirements of a long-term lease agreement, the costs of any servicing, breakdown protection, or other services incorporated into the car leasing agreement won't need to be estimated and reported separately. It is a significant benefit.

Some other critical lease exemptions under IFRS 16 include:

  • Leases of a lessee's biological assets
  • Exploration or utilization leases for oils, minerals, natural gas, and comparable non-regenerative resources
  • Deals involving concessions for the provision of services
  • Authorization licenses to use a lessor's intellectual property
  • Any patents, copyrights, or other rights the lessee may have under the terms of the lease.

What has IFRS 16 Replaced, and Why the Need for the Change?

In the past, companies could conceal significant financial obligations on operating leases from their balance sheets, giving an inaccurate picture of their true financial health.

So to ensure that critical financial information is provided by lessees and lessors that properly reflect such transactions, IFRS 16 sets forth criteria for the recognition, assessment, representation, and reporting of leases.

This new standard replaces the following standards and regulations:

  • IAS 17 Leases
  • SIC-15 Operating Leases - Incentives
  • IFRIC 4 - Checking for a Lease in an Arrangement
  • SIC-27 - Assessing the Content of Transactions Regarding a Lease's Legal Structure.
Impact of New Lease Accounting Under IFRS 16

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Which Organizations Need to Comply With IRFS 16?

The IFRS 16 lease accounting standard concerns lessees who use the International Financial Reporting Standards. More than 160 nations around the world are required to enforce this standard.

Since IFRS 16's inception, businesses across industries have modified their lease management practices to conform with the new standard.

Implications of IFRS 16 for Financial Reporting

The reporting of such lease accounting changes functions in a manner comparable to accounting for other non-financial assets (such as equipment, plants, and property) and financial liabilities for enterprises impacted by the changes. 

  • Lessees are required to reflect their right-of-use asset on their balance sheets as an asset and their obligation to provide lease payments as a liability. 
  • Lessees' profit and loss statements should include both depreciation of the leased asset and interest expense on the leased liabilities. In most cases, the depreciation gets calculated on a straight-line basis.

Although rental payments do not change over the course of the lease's duration, the overall impact on the profit and loss account is front-loaded because interest charges are often higher in the first few years of the contract.

Further, there is the potential to consolidate all the asset leases into a portfolio, which eliminates the need to account for each one separately.

This should only be implemented if the corporation can provide convincing evidence that following this course of action will not result in any financial benefits for the company.

For concerned businesses to be able to formalize their IFRS 16 financial reporting, they are generally needed to proceed through the following three stages:

Stage 1 - Recognition of all their assets (including equipment, vehicles, or property), which according to the new regulations, are considered leases.

Stage 2 - Gathering every information that pertains to these leases, including:

  • The term
  • The options at the termination of the lease
  • Rentals that are payable
  • The rate of interest associated with the lease (if obtainable) so that the lessee can consider their incremental cost of borrowing (the rate at which they borrow internally).

Stage 3 - Once all the data and information are available, the assessment for the accounting for their leases to recognize assets and liabilities is simple. The difficulty rather lies in identifying the inputs.

It is anticipated that the second process poses a significant challenge, especially for businesses having a significant number of assets; it may also be the stage that takes the longest.

However, effective lessors should be capable of assisting businesses with this phase by helping anticipate the company's needs and proactively communicate with them.

What are the Drawbacks Associated with IFRS 16?

The new regulations may have some substantial consequences, some of which may be adverse, based on the approach the company's balance sheet presents the company's financial information. 

  • Firstly, the balance statements of companies that lease equipment give the impression that they have a huge number of assets, but it also makes it appear that they have a substantial amount of debt. 
  • The implications on the company's balance sheet will be greater proportionately to the volume of lease agreements that the business maintains. The borrowing costs for the lessees might significantly increase as a consequence.
  • Second, if a company currently has banking covenants in effect, for instance, that stipulate a minimum level of revenue and profitability figure must be maintained for the continuation of existing banking arrangements, then the company may face further difficulties. 
  • In this case, it becomes prudent to verify with the financial institution to ensure that the newly implemented regulations will not have an impact on the funding.
  • Third, the adjustments in lease accounting due to IFRS 16 affect the essential accounting and financial metrics of the organization if it has a significant leasing portfolio.
  • Due to this, the potential appeal of the company to potential investors and the company's capability to raise capital may both suffer.
  • Lastly, many believe that these rules make reporting more costlier and complicated, particularly when it comes to leases corresponding to enormous quantities of small assets. 
  • Additionally, advanced lenders already assess the impact of off-balance sheet lease agreements on leverage when they lend, so it is argued that there isn't a requirement to introduce these to the balance sheet.

Key Inclusions and Exclusions Under the IFRS 16 Definition of a Lease

IFRS 16 revises the lease definition and offers recommendations for its implementation.

Under IFRS 16, a lease is defined as a contract or a component of a contract that provides the 'right-to-use' of the underlying asset for a specified time in return for compensation.

Only when the underlying asset gets 'identified' can a contract become a lease or include a lease. 

IFRS 16 - Definition of a lease l Grant Thornton Insights

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One who has the authority to manage a recognized asset also has the right to direct how that asset is used and to reap all financial rewards that result from that usage.

These privileges must be maintained for a certain time frame, with the duration of utilizing the asset predecided based on the usage level.

  • In addition to the rent of the underlying asset, many leasing arrangements include components like services like repair and maintenance. According to IFRS 16, these do not belong to the lease and must be itemized by the provider.
  • For instance, when a business leases space, it may also be responsible for paying for services like cleaning and upkeep. Only the asset lease directly requires to be recorded as an asset on the balance sheet. Hence, these attributes need to be kept separate.
  • Contracts that do not require reporting as leases include those in which the provider has the right to replace an asset being utilized by the client with an alternative asset and derive financial profits from doing so.
  • It is not required to include in financial reporting any payments regarded as being "contingent to the use" of the asset supplied (for example, costs for use and deterioration incurred over the time of the lease).
  • If an organization with the legal authority to extend the lease term within its contract chooses to exercise this option, then the firm will be required to assess the worth of the utilization of the asset and disclose this information while reporting.
  • On the other hand, unofficial extensions of leases do not have to be notified, such as when a new asset is ordered.
  • Other specific exemptions, such as the 12-month term and low asset value reporting, are already discussed.  

Final Thoughts

The domain of lease accounting is undergoing transformation on both a domestic and international scale.

Despite the fact that IFRS 16 adds additional complexity levels and leaves the possibility for errors in computations, it does promise better transparency to stakeholders.

Both the process of putting them into practice and the continuous accounting management are likely to be affected comparably by such lease requirements. Rarely, significant shifts of this kind take place in the world more frequently than once per few decades.

These alterations can be made much simpler with the availability of lease accounting software solutions.

Such tech solutions make it possible for businesses to streamline and collaborate throughout the entire lease lifecycle, which would enable them to have a better understanding of their cash flows and leasing arrangements.

As a consequence, teams can lessen their exposure to risks, improve the effectiveness of their procedures, and accomplish complete openness regarding their accounting decisions and responsibilities.

LeasO is a cloud-based lease management software where you can track, manage, and centralize all your lease data in ONE place. With LeasO, you can take care of all the compliances and complex IFRS 16 tax calculations right inside it to avoid any manual accounting error. Book a demo to know more.

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