On 13 January 2016 the International Accounting Standard Board issued IFRS 16 Leases, the new accounting standard on leasing. The new standard eliminates the distinction between finance and operating leases for lessees and requires recognition of lease liabilities for all leasing arrangements.
This contrasts with the existing accounting model for leases which requires lessees to classify their leases as either finance leases or operating leases and account for those leases differently. As a result lessees in an operating lease is not required to present important information about significant assets and liabilities arising from such leases.
IFRS 16 is effective for annual period beginning on or after 1 January 2019. A company can choose to apply IFRS 16 before that date but only if it also applies IFRS 15 Revenue from Contracts with Customers.
Under US GAAP, ASC 842, Leases, was added by ASU 2016-02 on February 25, 2016. It is effective for public business entities for annual periods beginning after December 15, 2018 (i.e., calendar periods beginning on January 1, 2019), and interim periods therein. For all other entities, ASC 842 will be effective for annual periods beginning after December 15, 2019. Like IFRS 16 this standard also requires lessees to recognise lease liabilities for all leasing arrangements.
Lessee accounting model
Under the new model the underlying principle reflects that, at the start of a lease, the lessee obtains the right to use an asset for a period of time and has an obligation to pay for that right. Consequently the new standard requires lessees to recognise assets and liabilities arising from all leases on the balance sheet, subject to certain exemptions for short term (leases with a lease term of 12 months or less) and small asset leases (where the underlying asset has a low value when acquired).
As the new standard considers all leases as financing arrangements, a lessee would always recognize and present in the income statement amortisation of lease assets separately from interest on lease liabilities.
Impact on the balance sheet
For companies that currently have significant operating leases, the new lease standard is likely to result in increase in lease assets and corresponding lease liabilities and may have significant impact on key financial ratios derived from recognition of lease assets and liabilities (for example, leverage and performance ratios).
Impact on the income statement
The impact on income statement of the new model will depend on the significance of leasing to the lessee and the length of its leases. EBITDA is likely to increase compared to the amounts reported today because, a lessee will present the implicit interest component operating lease payments as part of finance costs whereas, today, the entire lease expense is included within operating costs.
The net profit, however, is likely to decrease because interest expense is typically front loaded as the combined effect of amortization of lease asset and interest on lease liability is higher in the earlier years of a lease than in the later years and vice-versa. Over the lease term, the total amount of expense recognised remains the same.
Impact on the cash flow statement
Consistent with the balance sheet, the new model reduces operating cash outflows, with a corresponding increase in financing cash outflows for principal repayments, compared to the amounts reported today to reflect the economics of a financing arrangement
Lessor accounting model
The lessor’s accounting will not change as the difference between finance and an operating lease has been retained. However, it requires a lessor to provide some additional disclosures to enable users of financial statements to better evaluate the uncertainty of cash flows associated with the lessor’s leasing activities. The enhanced lessor disclosure requirements are as listed below:
- Table of lease income- requires a lessor to disclose the components of lease income recognised in the reporting period.
- Information about exposure to residual asset risk- requires a lessor to disclose information about how it manages its risk associated with any rights that it retains in leased assets.
- Information about assets subject to operating leases- IFRS 16 requires a lessor to provide the disclosures required by IAS 16 Property, Plant and Equipment separately for assets subject to operating leases-further distinguished by significant classes of underlying assets from owned assets that are held and used by the lessor for other purposes.
Key differences between IASB and FASB lease accounting model
While both IASB and FASB requires a lessee to recognise lease assets and liabilities on the balance sheet giving an exemption related to short term leases, the IASB model provides an additional exemption for small asset leases (i.e. asset whose underlying value is low at inception) from recognition as assets and liabilities.
Although both Boards require recognition of lease liabilities for all leasing arrangements on the balance sheet, the Boards have diverged on the recognition of leases in the lessee’s income statement. While the IASB’s model requires all leases to be presented in a manner similar to today’s finance leases, the ASC 842 has a dual model that requires finance leases to be accounted in a manner similar to financed purchases (i.e. right-of-use asset is amortized to amortization expense and interest expense is recorded in connection with the lease liability) and operating lease expense is recorded in a single financial statement line item on a straight-line basis over the lease term. This is achieved by measuring the amortisation of the lease asset each period as a balancing amount (i.e., accounting plug), calculated as the periodic straight-line lease expense (calculated in a manner similar to current operating leases) minus interest on the lease liability for the period. Therefore, for the operating leases the amortisation of leases asset will be inverse of interest on lease liability i.e. it will lower in earlier years and will increase in later years so that the charge on income statements reflect straight-line pattern.