Dr. Antony Michail
Nov 6, 2018

IFRS 16, the new leases standard, and its expected effect on lessee financial reporting

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First Published: https://ifrsboutique.com/articles/current-issues

Date: October 2017 By: Chris Ragkavas, BA, MA, FCCA, CGMA StudySmart management consultant, senior finance & accounting tutor, IFRS technical

expert.

 

 

IASB and FASB have been considering for quite some time the lack of complete information with regards to long-term, in-substance unavoidable liabilities that most entities are committed to. Specifically, liabilities related to properties they lease.

 

The new accounting standard IFRS 16 Leases, which is applicable for financial reporting periods beginning on, or after 1/1/2019, sets the record straight in that respect, as it obliges entities to recognize these liabilities, as opposed to the existing standard IAS 17 Leases, where a mere reference to operating lease liabilities was required, in the notes to the financial statements.

 

The application of the standard will result into a material increase in long-term liabilities for almost all entities.

 

The driver for introducing the new standard is very simple. Entities leasing properties as part of their operating activities, (i.e. without the motive to purchase the property at some stage during or at the end of the lease term), do so for a long period. Think of banks, all sort of apparel retailers  (Burberry’s, Benetton, Zara, H&M), or consumer electronics retailers as Curry’s, Dixons, Media Markt. Would they enter into a lease agreement, with the aim of vacating the property soon? They strategically select a location that suits their exposure to their clientele, and they would prematurely vacate that property either due to discontinuing operations, or due to expansion and a move to a larger property, both of which are not expected to occur, say, every 3 years.

 

The standard introduces a single lessee model, which is the subject of this article, so there is no distinction between finance and operating lease, anymore.

As long as the lease agreement relates to:

  • A specified asset; and

  • The use of this asset is determined at will by the lessee or the lease agreement does not allow the lessor to alter the terms of the use;

… the lease agreement contains a lease and IFRS 16 is applicable.

IFRS 16 allows entities not to apply the treatment described below, for

  • Lease of low-value assets, an indication of which is a maximum of $5,000.

  • Short-term leases, i.e. less than 12 months.

These leases are simply expensed as currently under IAS 17.

 

Lease liability So the lease agreement, irrespective of the legal or financial jargon, results into an in-substance long-term liability. Under IAS 17, all “operating leases” are simply disclosed and not recognized as a long-term liability. IFRS 16 on the contrary, obliges entities to recognize the present value of these liabilities, at the inception of the lease.  This liability will be amortized during the lease period, and finance cost will be recognized based on the actuarial method.

 

The rate to be used will be the rate implicit in the lease the definition of which, is the same as IAS 17’s. However, I believe that it is more likely that entities will use the provided alternative, which is the rate of interest that “a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment” (Appendix A).

 

In other words, the same rate that the lessee would incur as finance cost if they would borrow a similar amount that would be repaid as the lease payments.

 

Right-of-use asset Naturally, this non-current liability is entered into, with the aim of securing economic benefits for the entities, through cash flows that will arise in the future from their primary operating activities, as selling of inventory, rendering of services.  Therefore, entities will also recognize for the same amount as the non-current liability, a non-current asset, a right-of-use asset. This asset will also include initial direct costs incurred by the lessee.

The asset is subject to amortization, impairment, as any other non-current asset. The standard provides entities with alternative options, outside the scope of this article.

The asset is presented in the statement of financial position either as such (a right-of-use asset), or in the same line as that within which, the corresponding assets would be presented if they were owned, e.g. property, plant and equipment.

 

Effect on lessee financial reporting

Gearing The recognition of liabilities that according to IAS 17 are treated as off-balance sheet will have an effect on gearing. The materiality of the effect depends on the volume and magnitude of lease contracts classified under IAS 17 as operating leases. Considerable increase in gearing may have a material effect on some or all of the areas mentioned below.

 

Covenants of existing debt Covenants of existing debt stipulating a maximum acceptable level of gearing, may be affected. Increase in gearing may trigger cash payments of part of existing loans. It may also trigger increase on variable rates, to compensate debt providers for the increased risk.

As a safeguard, many entities anticipating a change in a financial reporting standard that might adversely affect their credit standing due to its effects on financial reporting, include in their debt contracts, ‘frozen GAAP’, carve-out clauses.

 

These clauses protect entities from the effects of a worsening position due to financial reporting requirements. The credit standing of the entity is judged based on pronouncements of financial reporting standards on the date the loan agreements were entered into.

 

These clauses can be non negotiable, or effective for a period after the application of new financial reporting standards, after which the entity and the loan provider will amend the original agreement in good faith and adjust the covenants to retain the agreement’s original intend. The same can be said for the cost of borrowing of existing loans.

 

Cost of new loans Raising of new loans may be more expensive, to compensate for the increased risk. If however, credit officers have already been considering the effect of off-balance sheet operating leases while an entity has been applying IAS 17, the effect of transition can be negligible.

 

Queries, comments, are welcome at cragkavas@ifrsboutique.com

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