Skattenytt nr 3 2018 s. 108
IFRS 16 – The new IFRS rules for lessees and their impacts on financial statement analysis and financial statement policy
IFRS 16 changes fundamentally the accounting for leases, especially for lessees. Despite of some exceptions due to materiality reasons all lease contracts are recognized according to a single lessee accounting model. This model implies that for each leased asset a right-of-use asset and lease liabilities are recognized on the balance sheet. In comparison to IAS 17, under which lease liabilities have to be recognized only for finance leases, some financial ratios, like the equity to total assets ratio or the gearing ratio will be reduced by this change of accounting rules. Regarding the effect on the ratios of return the picture is different. Especially ratios of return based on the operating profit might increase as only the depreciation charge and possible impairments for the right-of-use assets reduce the operating profit, whereas the finance component of the lease payments is recognized in the interest expenses. All together the financial information to interested parties will be affected and at the same time, the motives for off-balance sheet leases will still exist. Thus, there is a risk that companies will try to influence the balance sheet structure by cautious assessments of the options included in the lease contracts or by subdividing lease arrangements in order to use the exceptions of the single lessee accounting model.
On 2016, Jan., 13 the IASB published IFRS 16 “Leases” effective on or after 1 January 2019.1 Like in the preceding Exposure Drafts (ED/2010/9 and ED/2013/6) the core element of IFRS 16 is the substitution of the former risks and rewards approach in the previous IAS 17 by the right-of-use approach2 which is in line with the definition of assets in the Conceptual Framework3. Due to this approach not the physical asset which underlies a lease contract is subject of accounting but the right to use the asset that underlies the lease. In the contrary to the preceding ED/2013/6 which distinguished two types of lease contracts (type A and B leases)4, the IASB decided to implement only one set of rules for lease accounting in the financial statements of the lessees (single lessee accounting model). Furthermore, in the opposite to the ED/2013/65, as the final IFRS 16 does only prescribe the right-of-use approach for the lessee accounting, this article focuses on the changes in lessee accounting. The application of the right-of-use approach causes in the lessee’s accounting an abolishment of the former off-balance-sheet accounting in most cases when leases were classified as operating leases according to IAS 17. In addition to the presentation of the single lessee accounting model the article shows the effects on the financial ratio analysis and the probable impacts on the financial statement policy of the lessees.
See IFRS 16. Appendix C 1.
Compare for details of the history of this model Hartmann-Wendels/Schmidt, Die Wirtschaftsprüfung 2010, p. 278.
Compare especially the control criterion of the definition criteria of assets in Conceptual Framework. 4.4 a).
See Kirsch/Olsson, Re-Exposure Draft on leases and its potential impacts on the financial and taxation accounting in Sweden, Skattenytt 2014, pp. 571–586, here pp. 571–578.
See Kirsch/Olsson, Re-Exposure Draft on leases and its potential impacts on the financial and taxation accounting in Sweden, Skattenytt 2014, pp. 571–586, here pp. 578–581.
2 LEASE ACCOUNTING FOR LESSEES
IFRS 16.9 sent. 2 defines a lease as a contract, or contains, if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. In order to satisfy the characteristic of being an “identified asset” (i.e. the first criterion), the asset must latest be identified at the time that the asset is made available for use by the customer.6 Moreover in order to classify an agreement of transfer of possession as a lease contract, the supplier of the asset does not have any substantive right to substitute the asset during the period of use7 (e.g. transfer of the possession of a space in the airport which fulfills specified criteria, like a maximum distance to specified boarding areas8). Also an identified asset does not exist if a contract conveys the right to use a specified amount or a specified share of capacity of an asset (e.g. 30 %-share of the capacity of an oil pipeline during a specified period), that is not physically distinct (e.g. a floor of a building).9
The second criterion of classifying an agreement of transfer of possession as a lease contract is that the customer has the right to control the use of the identified asset. Therefore the customer must have throughout the period of use the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset.10 With regard to the last mentioned aspect protective rights in the favour of the supplier do not preclude a lease contract (e.g. a contract may restrict the use of the asset for safety reasons).11
If a contract transfers the use of a good but does not satisfy both of the criteria for a lease contract, the contract is a service contract in the scope of IFRS 15 (revenues from contracts with customers). IFRS 16 is applied to all leases according to IFRS 16.9, including leases of right-of-use assets in a sublease, except for:
leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources (scope of IFRS 6),
leases of biological assets within the scope of IAS 41 (agriculture) held by a lessee,
service concession arrangements within the scope of IFRIC 12,
licences of intellectual property granted by a lessor within the scope of IFRS 15, and
rights held by a lessee under licensing agreements within the scope of IAS 38 (intangible assets) for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.12 According to IFRS 16.4, a lessee is allowed to apply IFRS 16 also to leases of all other intangible assets.
In the next step, for a contract that contains a lease, that is in the scope of IFRS 16, an entity has to account for each lease component within the contract as a lease separately from non-lease components of the contract (e.g. maintenance or cleaning services), unless the entity applies the practical expedient in IFRS 16.15.13 According to the last mentioned exception, a lessee may elect, by class of underlying asset, not to separate non-lease components from lease components, and instead account for each lease component and any associated non-lease components as a single lease component. The allocation of the consideration in the contract to each lease and non-lease component is based on the relative stand-alone prices of the components included in the contract.14
See IFRS 16. Appendix B 13.
See IFRS 16. Appendix B 14–19.
See IFRS 16. Illustrative Examples. IE 2, Example 2 (Concession Space).
See IFRS 16. Appendix B 20.
See IFRS 16. Appendix B 9.
See IFRS 16. Appendix B 30.
See IFRS 16.3.
See IFRS 16.12.
See IFRS 16.13 and 16.14 in combination with IFRS 15.76.
2.1 Initial recognition
At the commencement date, a lessee recognises in its statement of financial position a right-of-use asset (in the following RoU asset) and a lease liability.15 At this date, the lease liability amounts to the present value of the fixed or in-substance fixed lease payments not paid at that date.16 According to IFRS 16.18, the lease term is defined as the non-cancellable period of a lease including periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option and including periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option. The fixed and in-substance fixed lease payments contain not only lease payments which are constant over the whole lease term but also such variable lease payments that depend only on an index or a rate, initially measured using the index or rate at the commencement date (e.g. inflation adjustments), amounts expected to be payable by the lessee under residual value guarantees, payments for exercising a purchase option if the lessee is reasonably certain to exercise that option, and payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.17
Although the present value of the lease payments includes also lease payments that depend on an index, e.g. an inflation index, the calculation of the present value is based only on the current lease payments and not on predicted lease payments in dependence of the forecasted development of the index. Due to simplification and comparability reasons a reassessment of those variable lease payments that are determined by reference to an index or a rate takes place only when there is a change in the cash flows resulting from a change in the reference index or rate.18 Unchanged to the preceding IAS 17, the lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. Otherwise the lessee shall use its incremental borrowing rate for discounting the lease payments.19
At the commencement date, the right-of-use asset is measured at cost.20 The cost are derived from the initial measurement of the lease liability including any lease payments made at or before the commencement date, plus any initial direct costs incurred by the lessee (e.g. provisions) and any costs to be incurred by the lessee for dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, less any lease incentives received.21 The definition of the cost of the RoU asset follows the definition of the cost of an item of property, plant and equipment in IAS 16.16.
The RoU assets have either to be presented separately in the statement of financial position or they could be included within that line item within which the corresponding underlying assets would be presented if they were owned. In the last mentioned case the entity has to disclose in the notes which line items in the statement of financial position include those RoU assets.22 Furthermore, lessees have to disclose the carrying amount of RoU assets at the end of the reporting period by class of underlying asset according to IFRS 16.53 j). Just as RoU assets, lease liabilities are either shown separately on the face of the statement of financial position or in the notes the liability items are disclosed which include those liabilities.23 If lease liabilities are not presented separately in the statement of financial position, the amount of lease liabilities need not to be disclosed in the notes. Nevertheless the (sum of the) undiscounted lease liabilities are disclosed within the maturity analysis of lease liabilities.24
See IFRS 16.22.
See IFRS 16.26.
See IFRS 16.27.
See IFRS 16. BC 190 and chapter 2.2.2 example 1.
See IFRS 16. 26 sent. 2 and 3.
See IFRS 16.23.
See IFRS 16.24.
See IFRS 16.47 a) (ii).
See IFRS 16.47 b).
See IFRS 16.58 (compare schedule 5).
2.2 Measurement after recognition
After the commencement date, a lessee shall measure the lease liability by
increasing the carrying amount to reflect interest (constant effective interest rate during the lease term) on the lease liability,
reducing the carrying amount to reflect the lease payments made, and
remeasuring the carrying amount to reflect any reassessment or lease modifications specified in IFRS 16.39–46 (e.g. reassessment of options included in the lease with a corresponding adjustment of the lease term and the lease payments during the lease term or inflation adjustments of lease payments that depend on an inflation index25), or to reflect revised in-substance fixed lease payments.26
The subsequent measurement of the RoU assets depends on the accounting model the entity applies for similar assets which underlie the RoU assets if those assets were owned. If the lessee applies the fair value model in IAS 40.33 f. to its investment property, the lessee shall also apply that fair value model to the RoU assets that meet the definition of the investment property.27 If the RoU assets relate to a class of property, plant and equipment to which the lessee applies the revaluation model according to IAS 16.31 f., the lessee may elect to apply that revaluation model to all of the RoU assets that relate to that class of property, plant and equipment.28 The other RoU assets are measured at amortised cost, i.e. cost less any accumulated depreciation and any accumulated losses according to IAS 36. In addition the amortised cost are adjusted for any remeasurement of the lease liability.29 The RoU assets are depreciated over the useful life of the underlying asset if the transfer of ownership of the underlying asset to the lessee is reasonably certain (e.g. by exercising a purchase option in the contract). Otherwise, the lessee shall depreciate the RoU assets from the commencement date to the earlier of the end of the useful life of the RoU asset or the end of the lease term.30
A lessee enters into a lease of a machine with an useful life of 8 years. The annual lease payments amount to 500.000 SEK, all payable at the end of each year. The contract specifies that the amount of the lease payments will increase with the beginning of the fourth year of use on the basis of the increase in the General Price index for the preceding 3 years. The General Price index at the commencement date is 100 and it increases until the end of year 3 of the use of the machine to 110. The non-cancellable period of the lease is 5 years. The contract contains two options: The lessee is entitled to extend the lease for an additional year for the same conditions as in the preceding year; this option must be exercised at the end of the fourth year of use. If the lessee extends the lease for an additional year, the lessee has at the end of the additional lease period (end of year 6 of use) the option to purchase the machine for a price of 800.000 SEK. At the commencement date, the lessee assesses that it is reasonably certain to extend the lease for an additional year, but that it is not reasonably certain to exercise the purchase option. According to IFRS 16.18, the lease term is 6 years. As the interest rate implicit in the lease can not be readily determined, the lessee uses its incremental borrowing rate for a comparable loan over the lease term of 6 years which amounts to 5 % p.a.
At the commencement date (01.01.01), the lessee recognises the RoU asset and the lease liability at the present value of the lease payments during the lease term, discounted with its incremental borrowing rate (5 % p.a.). At this date, the lease payments of the years 4–6 are not adjusted for the expected development of the General Price index. At the commencement date, the present value of lease payments amounts to:
The RoU asset is depreciated over the lease term of 6 years. The lease payments are subdivided in an interest portion (component of interest expenses in the p/l-statement31) and a repayment portion of the lease liability. Schedule 1 shows the development of the carrying amounts of the RoU asset and the lease liability and the effects on the p/l-statement (preliminary amounts for year 03):
p/l-effect (in total)
Schedule 1: Development of the carrying amounts of the RoU asset and the lease liability and its corresponding effects on the p/l-statement
At the end of the third year of use the General Price index amounts to 110 and has increased by 10 % since the commencement date. Therefore the lessee remeasures its lease liability at the present value of the three outstanding payments of 550.000 SEK discounted at an unchanged discount rate of 5 % p.a.32 The present value amounts to 1.497.786 SEK. According to IFRS 16.39, the carrying amounts of the lease liability and the RoU asset are increased by the difference between the present value based on the adjusted lease payments and the preliminary present value of the lease liability (i.e. 136.162 SEK = 1.497.786 SEK – 1.361.624 SEK); this adjustment does not affect the p/l-statement. Schedule 2 shows the further development of the carrying amounts of the RoU asset and the lease liability and the effects on the p/l-statement until the end of the fourth year of use if the lessee exercises the option to extend the lease included in the determination of the lease term:
p/l-effect (in total)
Schedule 2: Development of the carrying amounts of the RoU asset and the lease liability and its corresponding effects on the p/l-statement after adjustment of the lease payments
In the opposite to IAS 17, a main emphasis of IFRS 16 is on the depiction of lease modifications in the financial statements. A lease modification has to be accounted as a separate lease, if the modification increases the scope of the lease by adding the right to use one or more underlying assets, and the consideration for the lease increases by an amount based on the stand-alone price for this increase in scope of the lease.33 If one or both of these conditions are missing, than the lease modification is not accounted as a separate lease. In this case, at the effective date of the lease modification the lessee has to allocate the consideration in the modified contract to the lease and non-lease components according to IFRS 16.13–16.16, to determine the lease term of the modified lease according to IFRS 16.18–16.19 and to remeasure the lease liability by discounting the revised lease payments using either the interest rate implicit in the lease (if readily determinable) or the lessee’s incremental borrowing rate at the effective date of the modification for the remainder of the lease term.34 If the lease modification contains a partial or full termination of the lease, the carrying amount of the RoU asset has to be adjusted to reflect that decrease in the scope of the lease. Any resulting gain or loss relating to the reduction of the RoU asset and the corresponding lease liability has to be recognised in the p/l-statement.35 Other lease modifications, especially for an extension of the scope of the lease, are reflected by making a corresponding adjustment to the RoU asset and the lease liability.36
In supplementing example 1, the lessee decides at the end of the fourth year of use
not to extend the lease for an additional year, or
due to the lessee’s decision to produce goods with the leased machine for four more years to extend the lease for an additional year and to exercise the purchase option at the end of the sixth year of use.
At the end of the fourth year of use, the lessee’s incremental borrowing rate for comparable loans with a repayment period of one year amounts to 3 % p.a. and its incremental borrowing rate for comparable loans with a repayment period of four years amounts to 4 % p.a.
Compare chapter 2.2.1.
See IFRS 16.36.
See IFRS 16.34.
See IFRS 16.35.
See IFRS 16.30 in combination with IFRS 16.36 c).
See IFRS 16.32.
See IFRS 16.49.
See IFRS 16.42 b) in combination with IFRS 16.43.
See IFRS 16.44 a) and b).
See IFRS 16.45 a) – c).
See IFRS 16.46 a).
See IFRS 16.46 b).
As the lessee does not exercise the option to extend the lease previously included in the determination of the lease term at the end of the fourth year of use, the lease term has to be revised.37 The revised lease term amounts to 5 years. According to IFRS 16.40 a), this implies a remeasurement of the lease liability. At the end of the fourth year of use, the discounted present value of the future lease payments amounts to 533.981 SEK (= 550.000 SEK/1,03). Therefore the lease liability is reduced by 488.694 SEK (= 1.022.675 SEK (see schedule 2!) – 533.981 SEK). Due to the 50 % reduction of the remaining lease term the carrying amount of the RoU asset shown under schedule 2 is also reduced by 50 %. Any resulting gain or loss is recognised in the p/l-statement. The booking entry is as follows:
other (operating) gains
In the following year the remaining carrying amount of the RoU asset is fully depreciated (468.362 SEK) and the lease payment at the end of the fifth year is subdivided in the interest portion (i.e. interest expenses) by using the lessee’s incremental borrowing rate over the remaining lease term (3 % p.a.), which amounts to 16.019 SEK (= 3 % * 533.981 SEK), and the residual repayment portion of the lease payment (533.981 SEK = 550.000 SEK – 16.019 SEK).
p/l-effect (in total)
Schedule 3: Development of the carrying amounts of the RoU asset and the lease liability and its corresponding effects on the p/l-statement in the case of non-exercising the option to extend the lease (previously included in the determination of the lease term)
See IFRS 16.21 b).
The decision to produce goods with the leased machine for four more years is a business decision directly relevant for the reassessment of exercising the purchase option included in the contract.38 This induces a reassessment of the lease term which is now identical to the useful life of the machine (8 years)39. From this follows that the lease payments comprise also the payment for the extension period (550.000 SEK) and in addition the exercise price of the purchase option (800.000 SEK). Due to the lease modification the discount rate has also to be revised. It equals the lessee’s incremental borrowing rate for the remaining lease term of four years (4 % p.a.).40 At the end of the fourth year of use, the present value of the lease payments is as follows:
According to IFRS 16.46 b), the carrying amount of the RoU asset has to be adjusted by the same amount as the lease liability is increased (754.322 SEK = 1.776.997 SEK – 1.022.675 SEK; see schedule 2!). Schedule 4 shows the further development of the RoU asset and the lease liability and effects on the p/l-statement until the end of the useful life of the machine:
p/l-effect (in total)
*) in the case of cash payment of the exercise price of the purchase option
Schedule 4: Development of the carrying amounts of the RoU asset and the lease liability and its corresponding effects on the p/l-statement in the case of exercising the purchase option
See IFRS 16.20 in combination with IFRS 16. Appendix B 41.
See IFRS 16.32 sent. 1.
See IFRS 16.40 b) in combination with IFRS 16.41.
2.3 Exceptions of the single lessee accounting model
IFRS 16 contains two exceptions of applying the single lessee accounting model due to materiality reasons:
A lease that, at the commencement date, has a lease term of 12 months or less and does not contain any purchase option is defined as a short-term lease contract.41 As the general definition of the lease term according to IFRS 16.18 applies42, the effective lease term of a short-term lease could also be more than 12 months (e.g. by executing options to extend the lease if this was at the commencement date not reasonably certain). IFRS 16.5 a) contains the accounting option to apply the single lessee accounting model to the short-term leases or to recognize the lease payments associated with those leases as an expense on either a straight-line basis over the lease term or another systematic basis that is more representative of the pattern of the lessee’s benefit.43 If the entity chooses the last mentioned option neither a RoU asset nor a lease obligation is recognized in the statement of financial position. The accounting option of IFRS 16.5 a) in combination with IFRS 16.6 shall be elected by class of underlying asset to which the right of use relates.44 According to IFRS 16.53 c), in the notes to the financial statements the expense relating to short-term leases accounted by applying this accounting option has to be disclosed.
See IFRS 16. Appendix A.
See IFRS 16. BC 93 and compare chapter 2.2.1.
See IFRS 16.6.
See IFRS 16.8 sent. 1.
(2) Leases for which the underlying asset is of low value
In addition, for leases for which the underlying asset is of low value the application of the single lessee accounting model according to IFRS 16.22–49 is not compulsory. In this context “low value” means the value of the underlying asset based on the value of the asset when it is new.45 According to IFRS 16. BC 100, the IASB had in mind underlying assets with a value, when new, in the order of a magnitude of 5.000 US-$ or less. For example, leases of tablets, personal computers, small items of office furniture or telephones qualify for this exception. In order to avoid a subdivision of assets in their components the underlying asset of the lease must be such an asset of which the lessee can benefit from the use of the underlying asset on its own or together with other resources that are readily available to the lessee and the underlying asset is not highly dependent on, or highly interrelated with, other assets.46 Just as the accounting option for short-term leases the lessee has the accounting option to account for leases for which the underlying asset is of low value according to the single lessee accounting model or to recognize the expenses for such leases on a straight-line basis over the lease term or another systematic basis.47 As a peculiarity, these accounting option can be elected on a lease-by-lease basis.48 If the lessee uses the accounting option according to IFRS 16.5 b) in combination with IFRS 16.6, the expense relating to leases of low-value assets excluding the expense relating to short-term leases reported according to IFRS 16.53 c) must be disclosed in the notes to the financial statements.49
Furthermore IFRS 1. Appendix B 1 allows as a practical expedient, that an entity may apply the accounting rules for leases to a portfolio of leases with similar characteristics if the effects on the financial statements would not differ materially from applying the accounting rules to the individual leases within that portfolio.50
See IFRS 16. Appendix B 3.
See IFRS 16. Appendix B 5 a) and b).
See IFRS 16.5 b) in combination with IFRS 16.6.
See IFRS 16.8 sent. 3.
See IFRS 16.53 d).
See for details Freiberg, Betriebs-Berater 2015, p. 2543.
2.4 Sale and leaseback transactions
In a sale and leaseback transaction an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) and leases that asset back from the buyer-lessor.51 In dependence on the classification of the transfer of the asset these transactions are treated in a different way. If the transfer of the asset satisfies the requirements of a sale according to IFRS 15, the transfer shall be accounted as a sale.52 Therefore the buyer-lessor must obtain the control of that asset from the seller-lessee. In this context especially agreements to repurchase the asset have to be assessed carefully.53 If the transfer of the asset fulfills the criteria for a sale, the seller-lessee shall measure the RoU asset arising from the leaseback at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee. Therefore the seller-lessee shall recognise only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.54 (Further adjustments are made to the sales price if it deviates from the fair value of the transferred asset.55)
An industrial entity sells its administration building (carrying amout: 50 Mio. SEK) for the fair value (80 Mio. SEK) and leases back this building for 5 years. The transfer of the building satisfies the requirements of a sale according to IFRS 15. The lease payments discounted with the industrial entity’s incremental borrowing rate amount to 25 Mio. SEK. According to IFRS 16.100 a), the RoU asset arising from the leaseback is measured at the proportion of the carrying amount immediately before the sale takes place that relates to the right of use the industrial entity retains (i.e. 15,625 Mio. SEK = 25 Mio. SEK/80 Mio. SEK * 50 Mio. SEK). A profit realisation (difference between fair value and previous carrying amount: 30 Mio. SEK) takes only place as it relates to the (residual) rights transferred to the buyer-lessor (i.e. 20,625 Mio. SEK = 30 Mio. SEK * 55 Mio. SEK/80 Mio. SEK). The seller-lessee’s booking entry is as follows:
80,000 Mio. SEK
15,625 Mio. SEK
50,000 Mio. SEK
other (operating) gains
20,625 Mio. SEK
25,000 Mio. SEK
If the transfer of the asset by the seller-lessee does not satisfy the requirements of a sale according to IFRS 15, the transaction is accounted as a financing transaction. This implies that the seller-lessee shall continue to recognise the transferred asset and shall recognise for the proceeds from the transfer of the asset a financial liability. The financial liability is in the scope of IFRS 9, regularly it is measured at amortised cost (cost minus repayment portion of the lease payments using the effective interest method). The (lease) payments of the seller-lessee are subdivided in an interest component and the repayment portion of the financial liability.56
See IFRS 16.98.
See IFRS 16.100 sent. 1.
See IFRS 15.31 in combination with IFRS 15.34 and IFRS 15. Appendix B 64–76.
See IFRS 16.100 a).
See for details IFRS 16.101 f.
See IFRS 16.103 a).
General objective of the disclosures for lessees is to provide information in the notes that, together with the information provided in the statement of financial position, p/l-statement and statement of cash flows gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee.57 Schedule 5 shows the quantitative notes disclosure for lessees:
Quantitative disclosures in the notes to the lessee’s financial statements regarding
statement of financial position
statement of cash flows
additions to RoU assets (IFRS 16.53 h)
depreciation charge for RoU assets (IFRS 16.53 a)
total cash outflow for leases (IFRS 16.53 g)
carrying amount of the RoU assets at the end of the reporting period by class of underlying asset (IFRS 16.53 j)
interest expense on lease liabilities (IFRS 16.53 b)
application of the fair value model for RoU assets that meet the definition of investment property: disclosure requirements according to IAS 40 (IFRS 16.56)
expense relating to short-term leases according to IFRS 16.5 a) in combination with IFRS 16.6 (IFRS 16.53 c)
application of the revaluation model for RoU assets according to IAS 16.31: disclosure requirements according to IAS 16.77 (IFRS 16.57)
expense relating to leases of low-value assets according to IFRS 16.5 b) in combination with IFRS 16.6 (IFRS 16.53 d)
separate maturity analysis of lease liabilities comparable to IFRS 7.39 and IFRS 7. B 11 (IFRS 16.58)
expense relating to variable lease payments not included in the measurement of lease liabilities (IFRS 16.53 e)
income from subleasing RoU assets (IFRS 16.53 f)
gains or losses arising from sale and leaseback transactions (IFRS 16.53 i)
Schedule 5: Quantitative disclosures in the notes to the lessee’s financial statements
Under special conditions additional disclosures are necessary in order to reach the objective of IFRS 16.51, e.g. in the case of material variable lease payments (lease payments are extremely dependent on the net sales of leased stores)58 or sale and leaseback transactions59.
See IFRS 16.51.
See IFRS 16.59 b) (i) in combination with IFRS 16. Illustrative Examples. IE 9, Example 22 (Variable payment terms).
See IFRS 16.59 d). Compare in addition chapter 2.3.
3 IMPACTS ON FINANCIAL RATIO ANALYSIS
The transition from IAS 17 to IFRS 16 will trigger quite remarkable effects on the lessee’s financial statements. Despite of the exceptions of the single lessee accounting model mentioned under chapter 2.2.3, in general a significant higher number of lease contracts are recognised under the single lessee accounting model according to IFRS 16.22–16.49 than they would have been classified as financial leases under IAS 1760.61 Especially this changed treatment of lease contracts in the lessee’s financial statements, previously classified as operating leases under IAS 17, induce the following effects in the statement of financial position:
increase of the non-current assets (RoU assets) and the lease liabilities due to the extensive application of the single lessee accounting model;
in general negative effect on the equity as the lease liabilities decrease during the first phase of the lease term in comparison to the carrying amounts of the RoU assets only disproportionately low. This follows immediately from using the effective interest method to calculate the interest expenses; therefore the carrying amount of the lease liabilities which is in the first phase of the lease term significantly higher than in later periods is multiplied by the constant (effective) interest rate.62 Despite this, if at subsequent measurement dates the RoU assets are measured at fair value or revalued amounts the general negative effect on equity can be reduced, compensated or even exceeded by measuring the RoU assets with their current values.
From this follows, that by the transition from IAS 17 to IFRS 16 most of the balance sheet ratios will get worse, especially the equity to total assets ratio, the quotient of current and non-current assets, or the gearing ratio, but also liquidity ratios, if they are put in relationship to the total assets. Relatively small effects can be expected on the solvency ratios, if they are based on current liabilities, because only the short-term part of the lease liabilities increase the denominator of such ratios (e.g. current ratio defined as the quotient of current assets and current liabilities).
The overall effect on the p/l-statement is quite ambiguous. In comparison to a straight-line expense allocation of non capitalized (operating) lease contracts under IAS 17, the single lessee accounting model includes during the first periods of the lease term higher expenses than in later periods (induced by higher interest expenses in the first phase of the lease term as a direct consequence of applying a constant effective interest rate on the higher lease liabilities during these periods)63. In the later periods (or the second phase) of the lease term the overall expense effect changes, i.e. in later periods the total expenses of the leases accounted according to the single lessee accounting model are less than the expenses allocated on a straight-line basis.64 This periodic shift effect in the p/l-statement which leads to worse earnings in the prior years of a lease and better earnings in later years of a lease is generally intensified by the accounting rules for sale and leaseback transactions. As under IFRS 16 only in rare cases lease contracts are not accounted according to the single lessee accounting model (i.e. only the cases in which the exceptions of the single lessee accounting model apply), the surplus of the proceeds for the transfer of the asset and the carrying amount, previously recognised for this asset, is at least to some extent deferred and not immediately recognised.65 In the subsequent periods (i.e. during the lease term) this effect will be reversed by a lower sum of depreciations of the retained RoU asset and interests in comparison to the lease payments (including also the repayment portion of the lease liabilities).
Despite the above-mentioned periodic shift effect in the p/l-statement, it has to be taken into account that the interest portion of the lease payments is regularly presented below the operating results. If the single lessee accounting model applies, the operating results contain regularly only the depreciation charge and potentially impairments for the RoU assets. In the case of non-recognition of the lease contracts in the statement of financial position the lease payments (which also include an interest component) are recognized completely within the operating results. Therefore in general (the only exceptions are a few periods in which high impairment losses for the RoU assets are recognized) the operating results will increase due to the transition from IAS 17 to IFRS 16, as more lease contracts are recognized in the statement of financial position and the depreciations and possible asset impairments of these leases are in general lower than the corresponding lease payments for a period. Moreover, as the above described periodic shift effect in the p/l-statement affects only the interest expenses, the increase in operating profit is independent of the phase of the lease term.
From this follows, due to the transition from IAS 17 to IFRS 16 most of the return ratios that are based on the operating result will increase, e.g. the percentage of operating profit from sales or the percentage of cash flows from sales (i.e. cash flows from operating activites divided by sales or sales proceeds). Nevertheless if the operating result is put in relationship to the operating assets, the effect is ambiguous, as the operating assets increase due to the recognition of RoU assets under the single lessee accounting model.
Other profitability ratios, that are based on the capital employed or total assets will in general be reduced by the transition from IAS 17 to IFRS 16. This is an immediate consequence of the higher volume of lease liabilities recognised in the statement of financial position. Nevertheless, this effect could be compensated or even exceeded by a higher profit, if the period of use of the majority of the important lease contracts is within the second phase of their lease terms.
See for more details IAS 17.10–17.19.
Compare chapter 1 with regard to the abolishment of the former off-balance-sheet accounting.
Compare therefore example 1 and the surplus of the lease liabilities over the RoU assets during the whole lease term.
See example 1.
See for example schedule 3 (example 2 a).
Compare example 3. As the title of property passes to the buyer-lessor (see also IAS 17.15A), the leaseback would be classified as an operating lease according to IAS 17. Moreover, as the transaction takes place at fair value, the whole difference between proceeds and carrying amount would have be recognised immediately under IAS 17 (see IAS 17.61 sent. 1).
4 CONSEQUENCES OF IFRS 16 AND IMPACTS ON FINANCIAL STATEMENT POLICY
It is true that IFRS 16 and the right-of-use idea are better in line with other standards as well as Conceptual Framework.66 However, there is a risk that this change may affect both the behavior of the entity as well as how interested parties analyze the entity in general.
Since IFRS 16 affects almost all commonly used financial metrics different performance measures will be affected, some in a negative way and others in a positive way, see discussion chapter 3. IFRS 16 will also lead to that the expense of the lease is not constant over time; the expenses will be higher at the beginning of the period. The balance between operating profit and reported income will be changed as the component of the lease payments is recognized in the interest expenses.
Since both the income statement, the balance sheet and different ratios are commonly used in order to analyze both the performance of an entity as well as the management of the entity this is an important matter. One important example is bank covenants. In some cases there is a risk that these may be affected so the entity does not fulfill the requirements or the entity fulfills them too easily. Since balance sheet ratios in general will get worse, there is a risk that bank covenants including equity will not be fulfilled. In order to prevent negative consequences when implementing IFRS 16, it is important to analyze if different covenants will be affected.
From the entity’s perspective it will therefore be very important to analyze potential effects of the implementation of IFRS 16 as well as to inform interested parties as soon as possible and re-negotiate agreements if necessary, for example bank covenants. The implementation of IFRS 16 is not just a matter for the accounting department but also something that is important to the rest of the organization of the entity.
Entities access to bank lending might also be affected. Today Swedish banks tend to focus more on cash flow and the p/I-statement rather than the balance sheet when deciding if an entity should get a bank loan or not. An important tool in this process is different calculations including for example operating cash flows, reported income and operating profit as well as different ratios including reported income. As a consequence the loan offer might be affected by IFRS 16, that is the size of the loan as well as the risk and amortization of the loan.
Another interesting question is what impact IFRS 16 will have on existing business practices. Even though the ideas of IFRS 16 seem to be theoretically correct, it can be hard to foresee the consequences in practice. Not until the standard has been in use for a while the effects can be assessed and whether set goals are reached or not. Some parts of IFRS 16 will lead to additional work, for example reassessment of the liability, see chapter 2.2.2. It is though quite possible that the entities’ financial statement policy will be affected. There is an obvious risk that companies will try to influence the balance sheet by cautious assessments; the earlier motives for off-balance sheet leases still exist. IASB is aware of this fact and the definition of leasing has therefore become stricter.67 However there are exceptions, see chapter 2.2.3. The idea is though that there will be no possibilities to use these for more expensive and long-term leases. For example leasing arrangements where an expensive asset is divided in several leasing contracts or an asset is divided into smaller parts in order to classify the asset as a “low-valuable” asset.
There are though other possibilities besides the exceptions that might have substantial impact on both the balance sheet as well as the p/I-statement, which may be used by the companies. Variable lease payments based on net sales will not be included in the leasing debt, but will be included in the p/I-statement, see chapter 2.1. If the proportion of variable lease payments based on the net sales is large, different key ratios as well as the information in the balance sheet may be detoriated. In case the variable lease payments are based on a change in index, the payments will be included in the balance sheet. Thus, cautious assessments concerning variable lease payments may occur.
It is also quite possible that prolongation as well as purchase options may be affected. If it is not reasonable certain that the lease contract is extended or the underlying asset bought, the present value of the lease payments will not be included and therefore the lease liabilities will be lower. One more possible effect of IFRS 16, is that companies lease versus buy decisions will be affected. For example off-balance sheet financing options such as sale and leaseback will be removed and these contracts may not be as attractive in the future.
See IFRS- i teori och praktik Marton. J, Lundqvist, P. and Pettersson, A-K. 2016, Sanoma Utbildning, Stockholm.
IFRS 16 Leases – standarden där alla goda ting förenas? Krönika tidningen Balans 13 maj, 2016.
5 CONCLUDING REMARKS
The objective of IFRS 16 is to report information that (a) faithfully represents lease transactions and (b) provides a basis for users of financial statements to assess the amount, timing and uncertainty of cash flows arising from leases.68 An important reason for this shift is that 85 % of all lease commitments today do not appear on balance sheet.69
The discussion of this article indicates that the consequences of IFRS 16 may be substantial for the companies. The right-of-use approach means, in most cases, that off-balance-sheet accounting with former operating leases no longer is possible. An important effect is that the balance sheet, the income statement and as well the cash flow analysis will be affected. It is true that the total amount of cash flow will not change, but the proportions between cash from operating activities will rise and cash from financing activities will decline.
This means that important ratios will be affected. For example asset turnover will decrease and leverage will increase. Operating profit will, in general, increase which means that different profitability ratios will increase.
The above mentioned effects may affect how the financial statements are interpreted by interested parties of the entity. Since some ratios will be detoriated and some ameliorated, the performance of the entity will appear differently. One example is bank covenants which quite often depend on different agreed upon ratios based on financial information of the entity. It may also affect which risk class the entity will belong to, which may be important for the interest rate of loans for example.
IFRS 16 may seem easy to use in practice, but there are some issues that might require some efforts in practice. One example is the re-measurement of the carrying amount of the liability, compare discussion chapter 2.2.2. The implementation is not just an accounting matter; other parts of the organization will be affected as well.
Finally, the incentives for off-balance accounting still exist. Thus there is a risk that companies try to classify leases as service contracts and/or split up lease contracts into smaller parts in order to avoid IFRS 16 or change the proportions between fixed lease payments and variable lease payments in order to influence the balance sheet. The importance of sale-and lease back transactions will probably decrease and decisions concerning whether to buy or lease may be affected. If IFRS 16 will bring more useful and comparable information for economic decision making remains to be seen.
Hanno Kirsch is Präsident der Fachhochschule Westküste and professor at the Europa-Universität Flensburg, Germany.
Johan Lorentzon is PhD at Karlstads University, Sweden.