Business, Planning Analytics

IFRS 16: The biggest rethink in Lease Accounting in 40 years

International Financial Reporting Standards (IFRS) issued IFRS 16 in January 2016, which kicks in from the start of 2019. IFRS 16 comes in response to the US Securities and Exchange Commission’s (SEC) estimation that US public companies may have approximately US$1.25 trillion of off-balance sheet leases. Ten years in the making, it marks one of the most significant changes to lease accounting standards in 4 decades. IFRS 16 is mandatory for all Australian companies from the start of their financial year after 1 January 2019.

 

What is IFRS 16?

Under IFRS 16, lessees must record leased assets (representing the right to use the leased item for the lease term) on the balance sheet as well as liabilities (the present value of future obligations for lease payments on those leased assets). Further, in the Income Statement, lessees now will record both the depreciation and interest expense on lease assets, rather than the rental.


So what’s new? Basically, a “right-of-use” (ROU) model to determine who should book an asset. This replaces the typical “risks and rewards” model. On the other side of the balance sheet, all lease liabilities will need to be measured with reference to the present value of the lease liability.

 

Implications of IFRS 16

Investors in companies that rely on leased assets to run their operations will now have more information than ever to make decisions. IFRS 16 aims to bring more “transparency, accountability, and efficiency” to companies by forcing companies to disclose the value of the asset at within their businesses and the financial obligations to pay for those assets.


Saying that, there are huge practical challenges as businesses adapt to the new standards. And while decisions involving leases will be scrutinised by many parts of an organisation, it’ll be the finance and accounting departments who will face biggest workload.

 

Exceptions to IFRS 16

These are all the exceptions to IFRS 16:

  • Short-term leases under 12 months.
  • Low-value leases, typically less than US$5000 when new, and likely applied to individual assets rather than the total value of the assets under the lease.
  • Leases to explore for or use materials, oil, natural gas and similar non-regenerative resources.
  • Leases of biological assets in scope of IAS 41 Agriculture held by a lessee
  • Service concession arrangements in scope of IFRIC 12 Service Concession Arrangements.
  • Licences of intellectual property granted by a lessor in scope of IFRS 15 Revenue from Contracts with Customers.
  • Rights held under licensing agreements in scope of IAS 38 Intangible Assets for items such as motion picture films, video recordings, plays, manuscripts, patent and copyrights (for leases of other types of intangible asset IFRS 16 is optional).

Note that Real Estate leases are not exempt from IFRS 16.

 

Balance Sheet and Bottom Line

Depreciation is still likely to be expensed on a straight-line basis. However, since interest is higher in the initial years of a lease term, this will have the effect of front-loading expenses in the profit or loss statement, which will reduce over the life of the lease as lease payments are made.


Let’s say Starbucks has a several 24 month lease agreements for its various locations around Australia. Prior to IFRS 16, the operating leases on the spaces would have been depreciated on a straight line basis, spreading the cost of the assets evenly over multiple years. With the new standard, the straight-line operating lease expenses are replaced with depreciation charges for the lease assets (included within operating costs)
and interest expenses on the lease liability (included within finance costs). At the start of the lease agreements, the profit or loss statement will be hit with higher expenses, but over the 24 months of each agreement as monthly lease payments are made, the interest expenses will reduce month on month. Can you see how this might make things complicated if lease agreements begin at different times, with different terms, different interest rates, in different markets and with different durations


Leases on the balance sheet will impact how investors and other stakeholders view a company’s financial strength. With IFRS 16 in effect, companies with operating leases will appear to be more asset-rich but also more indebted. This has implications on the decision making companies make about whether to lease or purchase and the durations of lease agreements. It will also have a major impact on how companies present their financial results and then potentially on how they are assessed by investors and lenders.


Just look at the banking industry. With the The Australian Prudential Regulation Authority (APRA) requiring locally incorporated banks to hold total capital of at least 10.5% of their risk-weight assets, all Australian banks will have to review decisions involving any lease that is over 12 months or not of low value (both of which are exempt from IFRS 16) as there may be in impact on their capital adequacy.

 

Financial Statement Impact of IFRS16

Let’s go back to Starbucks and look at one of their hypothetical multi year lease agreements.


Assume that our Starbucks store has a lease agreement with 10 years to run. The annual rent on that property is $24,000 and there is no indexation of the lease (yes, I know that is unrealistic!). The retailer’s incremental borrowing rate on that rental agreement is 5%. The present value at the beginning of 2019 of the lease payments is $188.6k. When applying IFRS16 for the first time in 2019, the retailer records a right of use and a lease liability of the same amount: $188.6k. Then during 2019, they depreciate the asset straight line over the remainder of the lease at $18.9k per annum. They also need to expense the interest, $9.1k,  implicit in the lease, but do not need to expense the $24k they previously paid for the rental under AAS/IAS 17.


In the financial statements the impact of this is as follows:

 

Balance Sheet as at 31 December 2019

Under AAS17 Under IFRS16
Owned property 100,000 100,000
Leased Assets 169,706
Cash 10,000 10,000
Total Assets 110,000 279,706
Equity 80,000 76,054
Borrowings 20,000 20,000
Lease Liabilities 173,652
Other Liabilities 10,000 10,000
Total Debt & Equity 110,000 279,706
Net Debt 10,000 183,652
Gearing Ratio 12.50% 241.48%

 

Using IFRS16, there is a very large increase in total assets and liabilities at the end of the year from the inclusion of the right to use assets and lease liabilities and the gearing ratio (Net Debt / Total Equity) massively changes.

 

Income Statement for Year Ended 31 December 2019

Under AAS17 IFRS16 Impact Under IFRS16
Revenue 200,000 200,000
Cost of Sales 120,000 120,000
Gross Profit 80,000 0 80,000
Rent 24,000 -24,000 0
Other Operating Expenses 10,000 10,000
Total Operating Expenses 34,000 -24,000 10,000
EBITDA 46,000 24,000 70,000
Depreciation 10,000 18,856 28,856
Interest Expenses 5,000 9,090 14,090
Profit before Tax 31,000 -3,946 27,054

 

When looking at the Income Statement, you can see that EBITDA improves because lease related expenses are presented as depreciation and interest, rather than as operating expenses. There is also a decrease in Net Profit in the initial years of a lease.

 

Highly Complex Calculations

If we had added indexing the lease payments into the example above, the calculations would have got significantly more complex. Add in changing lease terms, foreign currencies, a large number of leases and things get very complex, very quickly.


If you have a small volume of leases and a simple environment, then you
might be able to get away with just using an Excel spreadsheet. If not, compliance will require more sophisticated solutions to manage multiple leases with varying terms and durations.


Infocube, as accountants that specialise in business analytics and IBM Planning Analytics experts, understand IFRS16 and how to use TM1 to either create a custom solution for managing your IFRS16 obligations or where we can implement and modify as required IBM’s pre-packaged Planning Analytics Solution Accelerator for IFRS 16.


With either a bespoke Infocube solution or through implementing IBM’s pre-packaged model, you will  be able to speed up and simplify a lot of the work that finance and accounting departments will have to manage IFRS16. If you have a large set of leases, in multiple currencies, at multiple cost centres and a need for both actual and forecast calculations, then using a solution like the pre-packaged IBM Planning Analytics Solution Accelerator for IFRS 16 is a good way of managing your IFRS 16 obligations.


IFRS 16 will significantly impact businesses in retail, aviation, professional services, health care, telecommunications, transport and logistics, entertainment and real estate among others. If there are lease agreements more than 12 months in duration or of high value, expect change!

Further Reading

https://public.dhe.ibm.com/common/ssi/ecm/68/en/68017068usen/hybrid-cloud-analytics-solutions-solution-brief-68017068usen-20180612.pdf

https://www.pwc.com/id/en/publications/assets/IFRS%20NewsFlash%20-%20IFRS%2016%20Leases.pdf

https://www.iasplus.com/en/publications/global/surveys/ifrs-16-and-asc-842-readiness-survey

https://www.pwc.com.au/assurance/ifrs/assets/ifrs-spotlight-an-industry-focus-on-the-impact-of-ifrs16-retail-and-consumer.pdf

https://home.kpmg.com/ch/en/home/insights/2018/03/ifrs-16-leases-impact-on-financial-institutions.html

https://www.ey.com/Publication/vwLUAssets/ey-RHC-Leases-May2016-new/$FILE/ey-RHC-Leases-May2016.pdf

Image Credit: Gideon (https://www.flickr.com/photos/malias/201985751)

 

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