This blog outlines what is IFRS 16, what its effects are, and how firms comply with it.
IFRS 16 is an accounting standard that makes lease accounting simpler and clearer. It ensures most leases are shown on the balance sheet, making financial statements more transparent.Â
What is IFRS 16 and Why Was It Introduced?
IFRS 16 is an International Financial Reporting Standard whose provisions relate to organisations’ accounting for leases. It replaced a previous standard named IAS 17 with a view of improving clarity and consistency of leases’ accounting.
- Published by the International Accounting Standards Board (IASB) in January 2016.
- Came into force on January 1, 2019
- Aims at reducing off-balance-sheet financing by bringing leases onto the balance sheet.
- Enables a clearer picture of a company’s financial responsibilities.
IFRS 16 was published with a view of having globally consistent and unambiguous lease accounting.
How Does IFRS 16 Define a Lease?
IFRS 16 defines a lease as an arrangement conveying the right to use identified assets for a period of time in exchange for an amount of consideration.
- The lease shall designate an asset.
- The lessee has a right to obtain substantially all economic benefits of an asset.
- The lessee may direct how the asset is utilised within the term of the lease.
- Leases transferring control of an asset are leases under IFRS 16.
Understanding this definition is critical to applying the lease accounting rules accurately.
What Are the Major Changes Brought by IFRS 16?
IFRS 16 incorporates considerable changes, especially for lessees, while lessors witness minimal changes.
For Lessees
- Single Model Approach: Balance Sheet Recognition
- Lessees must recognise almost all leases on the balance sheet as a right-of-use asset and a lease liability.
- This removes the traditional finance versus operating leases distinction from lessees.
- Elimination of Operating vs. Finance Lease Distinction
- All leases are accounted for equally on the balance sheet.
- This improves comparability and transparency.
For Lessors
- Retains Classification: Operating and Finance Leases
- Lessees continue to classify leases as finance or operating leases.
- Accounting treatment remains similar as under IAS 17.
Lessees see a maximum revamp with IFRS 16, improving disclosure on the balance sheet.
How Are Leases Recognised in the Financial Statements?
IFRS 16 requires specific accounting processes for leases at financial reporting.
Initial and Subsequent Measurement
- Initial Measurement:
- Right-of-use asset at present value of lease payments and initial direct costs.
- Lease liability is the same as the present value of payments on leases.
- Subsequent Measurement:
- Right-of-use assets depreciated within the lease period.
- Lease liability reduction by lease payments, with adjustments for interest expense.
Depreciation and Interest Expense
- Depreciation charged on the right-of-use asset.
- Interest expense recognised on the lease liability.
- These are shown separately in the profit and loss account.
Impact on EBITDA, Assets, and Liabilities
- EBITDA will typically increase with the replacement of leases with depreciation and interest.
- Both assets and liabilities on the balance sheet increase due to recognition of right-of-use assets and lease liabilities.
They impact key ratios of a firm and provide a more precise indication of a firm’s financial health.
When Did IFRS 16 Become Effective and Who Must Comply?
- IFRS 16 became effective on January 1, 2019.
- It is applicable to all entities reporting under IFRS.
- Those with significant leasing activities must comply.
- Early adoption was permitted for entities desiring to replace IAS 17 previously.
It is a requirement of all IFRS reporters and weighs heavily on businesses like retailing, airlines, and property.
What Are the Exemptions Under IFRS 16?
IFRS 16 makes exemptions to simplify lease accounting for certain leases.
- Short-term leases (12 months or less) can be exempted.
- Low-value assets (e.g., laptops, office furniture) are also exempt.
- Lessees can choose not to account for right-of-use assets and liabilities for such leases.
Exemptions reduce compliance burden without significantly impacting financial transparency.
How Does IFRS 16 Impact Financial Ratios and Decision Making?
IFRS 16 has effects on various financial variables of relevance for business decision-making and creditworthiness.
- Leverage Ratios: Also increase as lease liabilities contribute toward total debt.
- Return on Assets (ROA): May decrease due to a rise in asset base.
- EBITDA: Usually improves, affecting profit margins.
- Cash Flow Statements: Operating cash flows rise because lease payments are accounted for as financing cash flows.
Companies must modify financial analysis and decision-making functions following IFRS 16 adoption.
IFRS 16 vs IAS 17: What Are the Key Differences?
| Aspect | IFRS 16 | IAS 17 |
| Lessee Accounting | Single lease accounting model (right-of-use asset and liability) | Dual model: operating and finance leases |
| Balance Sheet Impact | All leases recognised on balance sheet | Operating leases off-balance sheet |
| Profit & Loss Impact | Depreciation and interest expense separately | Operating lease expense recognised in P&L |
| Lessor Accounting | Similar to IAS 17 | Classification of operating and finance leases |
| Transparency | Increased transparency and comparability | Less transparency, potential off-balance financing |
IFRS 16 is a paradigm shift from IAS 17 as regards lessee lease accounting.
Practical Examples: How Does IFRS 16 Work in Real Life?
Assume a company leases an office building for 5 years at $10,000 per year.
- Under IFRS 16, a right-of-use asset and a lease liability with a present value of $50,000 are recognised.
- Depreciates the right-of-use asset over 5 years.
- Reports interest expense on the lease liability.
- Shows increased assets and liabilities on the balance sheet.
The next example would consist of a store leasing equipment under a short-term agreement of 6 months.
- This lease can be exempted under IFRS 16.
- Lease charges are levied directly, rather than capitalised.
Real-world examples indicate how IFRS 16 principles can be implemented effectively.
Curious About IFRS 16?
Conclusion
IFRS 16 has transformed lease accounting fundamentally, especially for lessees. By requiring nearly all leases on a company’s balance sheet, it has increased financial clarity and comparability. Although it has implications such as changes in financial ratios and calls for the newest accounting systems, it provides a clearer picture of an entity’s lease burden. Organizations must understand and implement IFRS 16 with meticulous attention so as to conform to regulations and make informed decisions.
It is crucial for organisations and finance professionals to remain up-to-date with IFRS 16, and an IFRS course will enable you to develop a better understanding of this key standard.
FAQs on IFRS 16
What is IFRS 16 in simple terms?
IFRS 16 is an accounting standard that requires entities to recognise most leases on their balance sheet, showing an entity’s right to use an asset and a corresponding lease liability.
Who is required to follow IFRS 16?
All IFRS-reporting entities, including all listed entities and large corporations, must comply with IFRS 16.
What is the difference between IAS 17 and IFRS 16?
IAS 17 allowed operating leases to remain off-balance sheet, while IFRS 16 brought most leases onto the balance sheet with enhanced disclosure.
Are all leases included under IFRS 16?
Most leases will be covered, excluding short leases and low-value assets.
