IFRS 16 Lease Standard: Essay On Requirements And Financial Effects.

IFRS 16 Lease was issued recently and applies to annual reporting periods beginning on or after 1 January 2019.

Discuss the existing and new requirements of the new lease standard for both lessee and lessor. Also, critically appraise the financial effects of IFRS 16 on a company listed on Singapore Exchange of your choice. 

Changes In Accounting Requirements

Amendments have been in accounting standards by governing authorities for better presentation of financial information. By considering this aspect, significant changes has been announced in provisions of IFRS 16 which will be applicable from the financial year 2019 (Kraft & Landsman, 2014). The present study is focused on the description of changes proposed in provisions of IFRS 16. The report will include the impact of changes on the financial statement as per perspective of lessor as well as lessee. Further, the impact of these changes will be evaluated by considering annual report of ACMA Ltd.

The new leasing standard, IFRS 16 eliminates the difference between finance and operating leases for the lessees. It is because; all of the leases will be recorded on the balance sheet as liabilities, at their current value of the upcoming lease payments, besides with an asset considering the accurate way to use the asset of the lease term (Pettersson & Brolin, 2014). At present, under IFRS and UK GAAP, treatment of lessees are done in two ways, relying on proper balancing of risk and payment ownership of the principal asset under the lease agreement. As per existing system, there are two types of leases:

Accounting of finance lease is done in case where all the risk and reward is transferred to the lessees. In this type of lease; current worth of lease payments is determined as a debt on the balance sheet with an equivalent asset (Kvaal & Nobes, 2016).

In accordance with the current practice, operating leases are categorised as non-specialized property leases which carry no liability on the occupier’s balance sheet, particularly “in-year” lease costs such as rent and service charges are identified in the income statement. Accounting for operating lease is done when the considerable risk and reward remains with the lessor then the lessee identifies the operating expenses in the profit and loss account as it falls owed, it creates no impact on the balance sheet.

As per the new leasing standard released by IASB, rent expenses will be displaced with depreciation and interest operating cost (Borg, 2016). Further, at the time of calculating EBITDA, neither depreciation nor interests are assumed into accounts. As per this aspect, it will have a significant impact on banking contracts and also effect on items such as bonuses, which are linked to these procedures of profitability.

Two exemptions have been offered for leases with an utmost time period of twelve months or less and leases with low value. If these exemptions are implied, then the current service contract type accounting may persist.

The lease liability considers initial adjusted income payment or rate (such as interest) related payments and acquire account of renewal options and break clauses, excluding dependent rents. Assets and liabilities are remeasured while changing index modifies the payments if an individual has portfolios of related leases (New leases standard – Introducing IFRS 16, 2016). The requirement of a considerable amount of judgment and calculation of liabilities on a lease-by-lease basis is necessary as per provisions of new IFRS 16. The new leasing standard outcomes in an income statement expense which is far greater than the straight-line rent expense that is classically identified below the current standards. This will result in declining to a lesser cost halfway through the lease as well as in the interest cost. During execution, offered leases must be handled in a related manner, as it will result in the growth of assets and liabilities of lessees and also have an impact on reported earnings.

Effects On Financial Statements

As per the new standard of IRFS 16, companies will be able to identify new assets and liabilities, as it will bring more transparency to the balance sheet. Nowadays, lease transactions are demonstrated by making adjustments in financial statements by analysts. Under new provisions of IFRS 16, all companies will be required to follow an approved methodology which is calculated to observe company’s own consideration of its lease liabilities (Öztürk & Serçemeli, 2016). As per this methodology, bigger the lease portfolio, higher the effect on the standard of measurement. There is a fundamental change in the accounting treatment of leases by lessees. As per IRFS 16, current double accounting replica for lessees is excluded as it differentiates between –balance sheet finance leases and off-balance sheet operating leases (Marton, 2017). Rather, there is a particular on-balance sheet accounting replica that is related to present finance lease accounting. Accounting of lesser is related to the present practice such as lessors maintain to sort leases as finance and operating leases.  

In the context of the lessees, the lease will turn into an on-balance sheet liability, from which stakeholders interest will also be affected because of the new assets which are on the another side of the balance sheet (Xu, Davidson & Cheong, 2017). Further, the assets become richer because of the lessees, but it also becomes heavily indebted.

The impact for the balance sheet is not limited. According to the provisions of new standards, there is a change in accounting practices regarding the life of leased asset. Particularly, from now the companies will identify many of the leases expenses by the front-loaded pattern despite fact of constant payments of the annual rentals (Yong, Lim & Tan, 2016).

Addressing the wider business application, all the companies will have to evaluate the impact of the standards, and they will expect analyses for taking a close interest. Areas which they have to focus will include:

• Effects of the standard on the financial result.
• Implementations of cost; and
• Future changes in the business practices.

According to this standard, the commercial and retail property will include leases, equipment and vehicles. Accordingly, affected corporate will see:

Primarily, in the balance sheet the assets and liability are increased, with impact on potential material in the calculations of covenant;

Income statement’s cost summary will change, with twisted costs for the beginning years of the lease and there will be greater unpredictability because of the occurrence of the recalculation (New leases standard – Introducing IFRS 16, 2016).

In the income statement, the character of costs will change, among the positive impact on EBITDA, but with the greater weight of depreciation and finance cost

The negative impact will be on the accounting benefits of sale and leaseback of the transactions.

It will be challenging for ‘OpCo/PropCo’ structure to gain the benefits of financial reports.

Figure 1: Impact on lessees of changes in provisions of IFRS 16

(Source: Leases: A summary of IFRS 16 and its effects, 2016)

Accounting for lessors will be similar to the current practices as they will continue the classification of the lease in the category of finance and operating. In the context of operating leases, lessors will continue to recognise the primary asset concerned with it (New leases standard – Introducing IFRS 16, 2016). Further, in the case of finance leases, lessors will derecognise the concerned asset and recognise a net investment in the lease comparable to the requirements at present. In case if there is profit or loss on selling then it must be recognised at the commencement of the lease.

Impact on lessees

Figure 2: Impact on lessors of changes in provisions of IFRS 16

(Source: Leases: A summary of IFRS 16 and its effects, 2016)

IFRS 16 does not provide different accounting treatment for operating and finance lease but all the leases are treated in same manner as the accounting treatment is done in case of finance lease. Therefore the same accounting is adopted by Acma Ltd. As in present case Acma Ltd which has followed IFRS 116 for recognizing the transaction involved in legal form of Lease relating to recognition, measurement, presentation and disclosure of lease. The rental income has been provided on straight line basis over the lease tem and related cost has been reduced from the same which was previously accounted on straight line basis (Pettersson & Brolin, 2014). A major change has been observed in finance lease payable i.e. increase from .03m $ to .8m $ and the same is due to inclusion of Xenon group in finance lease payable. As IFRS 16 has amended the manner of recognizing expenses relating to lease and replace straight –line operating lease with depreciation charge interest for the lease asset and an interest expense on financial liability rather than including the same as one operating expense. Acma ltd has appropriately provided both the expenses differently.

As per the provision available in IFRS 16 an increase in assets and financial liabilities will be observed as the material off balance sheet lease will be changed to key financial metrics obtained from company reported assets. Thus, a main change in figures of financial lease payable (current and non-current liabilities) have been observed in comparison to previous year figures as now all the off balance sheet items have been recognised in balance sheet in appropriate manner. As per the requirement of IFRS 116 initial recognition of lease liabilities are recorded at present value of lease payments and those which have not been paid are valued at future value of lease payments (Che Azmi & English, 2016). The same comprises amount of initial measurement of liabilities relating to lease and other related cost which is to be incurred by lessees. The lease assets have been depreciated in same manner as owned assets and no assurance exists that at the end of contracted period the ownership relating to assets will be obtained or not. The liability regarding lease has been recorded as finance lease obligation. A major change has been observed in the account as off balance sheet liability has no appropriately recognised in the books of accounts at fair value (Kraft & Landsman, 2014). The increase in financial liabilities will change the leverage ratio i.e. gearing ratio; thus the users of financial statements will be able to recognize the liability which was previously unrecognised. Increase in asset will have impact on other ratios such as asset turnover and hence user will be able to take much appropriate decision relating to company. Through above specified changes a significant impact has been assessed in gearing ratio and the same will be considered by the investor while taking decision relating to company.

Figure 3: Impact on Financial liabilities

 (Source: Annual report of ACMA Ltd, 2016)

In accordance with provision of IFRS 16 before interest is increased in company i.e. EBITDA as the implicit interest relating to finance which is part of off balance sheet item is not recognised in part as finance cost. The change in provisions can be observed in the books of accounts of Acma Ltd. as the loss of previous year $(377, 79,000) to profit of present year $ 2111,000. The reason behind the same is that depreciation and finance expenses relating to lease have been recognised after EBIDTA (Mellado & Parte, 2016). As all other effect which were previously present in application of IAS 17 for lease will occur in IFRS 16 and the same can be observed by assessing the net profit of Acma Ltd; in which no major change is present in comparison to operating profit. Increase in finance cost can also be assessed in the income expenses i.e. $188,000 to $345,000 due to application of provisions of IFRS 16 (Annual report of ACMA Ltd, 2016). An increase in cash outflow relating to operating activities relating to Acma Ltd with simultaneously decrease in cash outflow relating to financial activities can be observed in books of accounts.

Figure 4: Impact on operating profit

 (Source: Annual report of ACMA Ltd, 2016)

Conclusion

In accordance with the present study, the conclusion can be drawn that proposed changes made under IFRS 16  leases has a significant  impact on financial statements of companies listed on Singapore exchanges. Due to this aspect, companies are required to consider the altered provisions to incorporate the same in their accounting policies.

References

Annual report of ACMA Ltd. (2016). [PDF]. Available through < https://info.acmaltd.com/AR2016AuditedResultsVA.pdf>. [Accessed on 01^st June 2017].

Borg, C. (2016). Proposed changes in lease accounting: implications for Maltese banks (Master's thesis, University of Malta).

Che Azmi, A., & English, L. M. (2016). IFRS Disclosure Compliance in Malaysia: Insights from a Small?sample Analytical Study. Australian Accounting Review.

Kraft, P., & Landsman, W. R. (2014). Effect of mandatory IFRS adoption on accounting-based prediction models for CDS spreads.

Kvaal, E., & Nobes, C. (2012). IFRS policy changes and the continuation of national patterns of IFRS practice. European accounting review, 21(2), 343-371.

Leases: A summary of IFRS 16 and its effects. (2016). [PDF]. Available through < https://www.ey.com/Publication/vwLUAssets/ey-leases-a-summary-of-ifrs-16-and-its-effects-may-2016/$FILE/ey-leases-a-summary-of-ifrs-16-and-its-effects-may-2016.pdf >. [Accessed on 01^st June 2017].

Marton, J. (2017). The role and current status of IFRS in the completion of national accounting rules–Evidence from Sweden. Accounting in Europe, 1-10.

Mellado, L., & Parte, L. (2016). Determinants of corporate lobbying intensity in the lease standard-setting process. Revista de Contabilidad.

New leases standard – Introducing IFRS 16. (2016). [Online]. Available through < https://home.kpmg.com/xx/en/home/insights/2016/01/leases-new-standard-balance-sheet-transparency-slideshare-first-impressions-ifrs16-130116.html>. [Accessed on 01^st June 2017].

Öztürk, M., & Serçemeli, M. (2016). Impact of New Standard" IFRS 16 Leases" on Statement of Financial Position and Key Ratios. Business and Economics Research Journal, 7(4), 143.