The new accounting principle IFRS 16 will come into effect on 1st January 2019 and will regulate accounting procedures for lease contracts. IFRS 16 will lead to a substantial alignment of finance and operating leases and will affect the way leases are reported in the balance sheet, with a strong impact especially on companies that have numerous lease contracts in their portfolio.
In this blog series, we will focus on the major new features that will be introduced by IFRS 16 and provide some suggestions on how to tackle the effects on accounting systems, according to the current state of your business.
What is a Lease?
A lease is a contract (or part of a contract) by which an owner (the lessor) of a specific asset grants a second party (the lessee) the right to its exclusive use for a specific period of time, in return for periodic lease payments. By acquiring the right to control the use of the identified asset, the lessee obtains the resulting economic benefits.
Operating leases, similarly to rental agreements, consist of a producer providing the right of use of the asset directly to the user, whereas finance leases consist of a financial holding company buying an asset on behalf of a third company and conferring to it to the right of make use of the asset under restrictive conditions. This contract type establishes a triple relationship (lessor, financier and end-user) and the presence of a financial intermediary.
The new accounting principle IFRS 16
IAS 17, the current accounting principle in place, distinguishes between operating and finance leases. It requires that companies highlight operating leases in the notes to the financial statements. On the contrary, finance leases must be reported within the financial statements.
IFRS 16 abolishes this difference and requires to include debts from operating leases in the financial statements. This modification will not introduce any substantial change for the lessor, but will produce evident accounting effects on the lessee's financial statements.
IFRS 16 application is always a must, except for the two following cases, in which the lessor has the right to choose to apply it or not:
- if the lease contract lasts less than 12 months;
- if the contract's amount is not significant, meaning that it does not exceed the established material threshold of $5,000.
Accounting effects: what will change in your financial statements
As of 1st January 2019, the lessee will need to draw up lease contracts as defined in IFRS 16. Here are the main accounting effects:
- At the start date of the lease contract ("commencement date") the right of use (RoU) of the asset is recorded on the asset side of the balance sheet, while the debt incurred for the use of the asset is recorded on the liabilities side. The RoU corresponds to the present value of future payments due throughout the duration of the lease contract, plus any potential direct cost chargeable to the lessee. The rate applied for the determination of the present value corresponds to the implicit interest rate related to the lease contract in case it is directly determinable or otherwise to the lessee's incremental borrowing rate.
- Registration, during the clearance of accounts procedure, has the following effects:
- Interests and related leasing debt increase are recorded in the income statement;
- RoU depreciation charge and related redemption fund increase are recorded in the income statement;
- Leasing debt reduction for the amount of payments incurred up to the date considered.
IFRS 16: analyze impacts to minimize risks
IFRS 16 entails important consequences that may affect considerably all companies making use of lease contracts. In the paragraphs above, we have discussed the consequences of IFRS 16 from a purely accounting point of view.
However, this is not enough to be prepared - it is crucial to make accurate and prompt analyses of the impacts IFRS 16 will bring to your financial statements overall, in order to have a complete view of the effects on business performance. This will allow you to properly manage IFRS 16 entry, minimizing the risks.