IFRS16 is set to bring about significant changes in accounting for leases. This is the first article in a four-part series, which examines the new standard and its impact on business. Readers should not act on the contents of the articles in isolation, but should read all 4 articles together.
For many years it has been acknowledged that the international standard of accounting for leases has created the potential for structuring opportunities where small changes in agreements could result in significantly different accounting treatment. Traditionally, accounting for leases distinguished between two methods, namely finance leases and operating leases. Finance leases, such as those typically offered by banks, and economically similar to purchasing the underlying asset, have been reported on the balance sheet of a lessee; while operating leases have been financed off balance sheet and only disclosed in the notes to the lessee company’s annual financial statements.
‘While both types of leases are ultimately disclosed in the financials in one form or another,’ says Fouché, Chief Financial Officer of RentWorks, ‘it has been a challenge for funders, investors and other stakeholders to obtain an accurate estimate of a company’s lease assets and liabilities. This is especially the case since there has been no clear direction to those reading the statements on how operating lease liabilities are to be calculated (as there is no definition for an operating lease liability in the current accounting standard). A company may have significant, long-term operating lease commitments, but a deceptively lean balance sheet. Interested parties could be missing some information regarding future commitments and therefore unable to accurately determine its EBITDA forecast.’
In fact, the International Financial Reporting Standards (‘IFRS’) organisation has found that listed companies using IFRS Standards or US GAAP are estimated to have around US$3.3 trillion of lease commitments; with more than 85% that do not appear on the balance sheets. The same tendency is evident in reporting by South African companies.
‘This is becoming an increasing concern,’ says Fouché, ‘especially in light of the requirements of the draft King IV Report on Corporate Governance for South Africa 2016 (‘King IV’), which is set to be finalised later this year.’ Principle 2.2 of the draft states that:
‘The governing body [of a company] should ensure that reports and other disclosures enable stakeholders to make an informed assessment of the performance of the organisation and its ability to create value in a sustainable manner.’
In January 2016, the International Accounting Standards Board (‘IASB’) issued IFRS 16: Leases which supersedes the IAS 17 standard, including the requirements to differentiate between finance and operating leases. The requirements will no longer be considered relevant or useful. IFRS 16 requires all leases to be reported on a company’s balance sheet as assets and corresponding liabilities. Note that IFRS 16 will only be applicable to companies reporting under IFRS. Companies reporting under IFRS for SMEs will not be impacted by this change, therefore the current requirements will still be applicable.
‘In other words,’ says Fouché, ‘all leases will now be treated in a similar way to IAS 17 finance leases. Leases will be “capitalised” by recognising the present value of the lease payments and showing them either as lease assets (right-of-use assets) or together with property, plant and equipment. If lease payments are made over time, a company will also recognise a financial liability representing its obligation to make future lease payments.’
The new standard is the result of extensive public consultation, as well as close collaboration between the IASB and the US Financial Accounting Standards Board, which both agree that all leases should be reflected on the balance sheet, and that they should be defined and measured in a certain way.
‘IFRS 16 will only come into effect on 1 January 2019,’ says Fouché, ‘but companies are advised to start understanding its nature and implications now, as they plan and implement business strategies and systems over the next two years.’
Further articles in this series will examine:
- The impact IFRS 16 will have on businesses, from an accounting and operational perspective;
- The exceptions to the application of IFRS 16; and
- Whether, in light of IFRS 16, there are still benefits in leasing, as opposed to buying assets.