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Of 166 jurisdictions, nearly all have made a public commitment to IFRS as the single set of accounting standards across the globe. IFRS
Introduced to replace IAS 17 ‘Leases’ and IFRIC 4, SIC 15 and SIC 27, the purpose of IFRS 16 is to bring previously unrecognised operating leases onto the balance sheet of lessee companies, where they are recognised as lease liabilities and right-of-use assets. Depreciation of these assets and interest expense on lease liabilities must now replace operating lease expenses in the income statement. So what does all this mean in practical terms? Professor Thorsten Sellhorn at the European Accounting Association (EAA) explains. “The IASB is the standard setter behind IFRS and its decade-old motivation is for firms’ balance sheets and income statements to fairly represent the assets and obligations, income and expenses related to leases,” he says. “One famous quip by a former IASB chairman was that he’d love to fly in an aeroplane that is actually on the airline’s balance sheet.” The airline sector does, indeed, provide a perfect example of a business heavily reliant on operating leases – and one that has had to closely examine the impact of so many leases being brought onto the balance sheet.
“Before IFRS 16, most aeroplanes were not on the balance sheet, as they were held under operating leases, and hence off-balance-sheet,” Sellhorn continues. “The idea is that any lease is fundamentally a contract in which one party allows another to use an asset for an agreed time period in exchange for periodic payments. Based on this premise, lessees should present on their balance sheet the right to use the asset and their obligation to pay, as well as the amortisation of the right-of-use asset and interest expense on the liability. So, to the IASB, leases typically have a financing component.”
“The idea is that any lease is fundamentally a contract in which one party allows another to use an asset for an agreed time period in exchange for periodic payments.”
A transition to transparency In other words, the overriding impetus for the introduction of IFRS 16 was to ensure that investors have an accurate view of companies’ exposures – vital for any would-be backer.
“IFRS 16 was a response to concerns expressed by investors, and others, about the lack of clear information about leasing transactions when companies applied previous accounting requirements,” a spokesperson for the IFRS tells Finance Director Europe. “Leasing is a common form of finance for many businesses, especially in sectors like the airline industry, retail, and shipping.
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However, under the previous requirements, the majority of leases were labelled as ‘operating leases’ and not recorded on the balance sheet, despite leases creating real liabilities.” Previously, investors would try many different techniques to effectively add these operating leases to the balance sheet to factor in the leased asset and the resulting liability. However, these methods would often amount to little more than rough calculations that did not always provide an accurate view of the liability’s size.
“Bringing leases onto the balance sheet gives visibility and accurate information about lease assets and lease liabilities, better reflecting the economic reality,” explains the IFRS. “It also improves comparability between companies. For example, it enables an investor to compare companies that borrow money to buy their premises with companies that lease their premises.” The IFRS has made clear that the change only applies to operating leases. There is no significant change to the key financial metrics derived from a company’s financial statements for what were once known as finance leases. Furthermore, there are some exceptions in the application of IFRS to operating leases. In particular, low-value leases, which do not represent core assets, are exempt from the new regulations. Office space and aeroplanes must be added to the balance sheet, in other words, but a printer leased for use in the office probably does not have to be.
As the IFRS puts it: “There are many benefits to leasing that will continue to exist – reporting the leases on the balance sheet does not take that value away or change the business benefits of leasing.” There will, of course, be some impact on key financial metrics that companies use to monitor performance. While the impact on profit before tax impact may be limited, IFRS 16 can have a significant impact on levels of operating profit and finance expenses. Indeed, as Sellhorn explains, the effect of the new rules on commonly-used financial ratios and performance metrics will be significant for many companies. “These impacts can be profound, in particular for firms used to leasing most of their asset base, such as airlines leasing aircraft, retailers leasing stores, or logistics firms leasing trucks and warehouses,” he says. “The most affected ratios are measures of financial leverage such as debt-to-assets, and asset structure, such as current versus noncurrent assets, but there is also an impact on earnings before interest, taxes, depreciation, and amortisation (EBITDA) and earnings before interest and taxes (EBIT).” The key question is whether these consequences, outlined by the IFRS back in 2016 when it laid out plans for the new standard, is changing how companies view the benefits of leasing compared to purchasing assets. Some felt it would encourage
Finance Director Europe /
www.ns-businesshub.com
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