IFRS 16 is one of the most prominent changes in lease accounting. It is an International Financial Reporting Standard that was introduced in January 2019 by IASB (international accounting standards board). The IFRS 16 replaced the IAS 17 accounting standard.
Initially, it seemed a complex part of accounting legislation, but closer examination proved it could be easy to navigate and understand. The IFRS 16 is going to impact the financial statements of high-value equipment and property. It works on the “right of use” model, which means that the company has the right to use the asset that they rent.
According to new rules, it must be mentioned on the balance sheet of the company and will be classified as a lease for accounting purposes. It means companies now have to report information for their leased assets that will ensure transparency for the company’s liabilities and lease assets.
Let’s find out more about IFRS 16.
- Changes Under IFRS 16
The most significant change of IFRS 16 is that now leased items must be included as an asset in the company records.
It is also important to report the lease payments that companies make on the agreement according to the lease liability on the balance sheet. Accounting can be complicated under this new standard as companies have to report the cleaning and maintenance costs separately from main lease payments.
Additionally, the depreciation of interest and assets on lease liability must be shown on the company’s profit and loss accounts. You may also check out an IFRS 16 guide to better understand lease accounting under this new standard.
One of the benefits of IFRS 16 is that it allows companies to convert a large number of lease agreements into a portfolio. You do not have to report them individually, but it can only be done if you can show that you are not getting any financial gain by doing this. It is also important to know that IFRS 16 has not affected lessor accounting.
- Who Has To Follow IFRS 16
The IFRS 16 is applicable to the companies who report using IFRS, particularly international companies. If it also applies to your organization, then figure out whether your rental contracts actually come under the new standard or not.
A common example that you can consider in this regard is renting storage space on a long-term basis. If you rent a particular unit and you have sole access to the entire place till the contract is valid, then you have the “right to use.” You also have to mention it on your balance sheet as an asset. The other costs should be reported in your accounts separately.
In another situation, you rent a small portion in a large warehouse, and you do not have access to the entire facility. If the landlord has chosen the area that you occupy, then the contract can also be changed by them according to the availability of space. So, it is not a right-of-use asset and can not be considered a lease under IFRS 16.
It also implies that payments will be included in your profit and loss statements, and you do not have to create financial statements under IFRS 16.
- Role in Financial Reporting
Companies that are affected by the changes of IFRS 16 have to work in the same way as reporting other non-financial assets like equipment or property.
The lessees have to show their right-of-use asset in balance sheets as their asset. They also have to make lease payments as a liability. Also, lessees have to show depreciation of the interest and asset on the lease liability. The interest charges are higher in the initial years of the lease, which can hugely impact the P&L account. But the rentals remain the same throughout the lease term.
As already mentioned above, you do not require an account for all asset leases separately. Instead, you can combine these and make them a portfolio. It is only possible if a company can state that there is no financial benefit for them in it.
To complete IFRS 16 financial reporting, companies have to go through three stages. Firstly, it is important to identify assets that can be defined as leases under the new standard, like vehicles or property. You have to gather information on these leases, like the interest rate of the lease, payable rentals, and end-of-lease options. Remember that the interest rate of the lease is usually not available for operating leases. In such a case, the lessee has to think about the incremental borrowing cost, the rate at which they internally borrow.
Once all relevant information is collected, the calculation has to be done to complete the financial report. Collecting the required information can be time-consuming and difficult for companies that have large numbers of assets.
- Impact of IFRS 16 Leases
The IFRS 16 reporting has completely changed the treatment of assets that are acquired through operational leasing. Companies will likely continue to lease assets as most of the benefits remain the same.
It will allow companies to spread a fixed cost on the lease term of the right-of-use asset so they do not have to outlay capital. Furthermore, it will provide 50% VAT recovery if you have to finance specific assets like cars. It will also protect your company against residual value fluctuations, so you can outsource the services and operations easily.
- Cons of IFRS 16
The IFRS 16 can make affect the finances of the company significantly, especially the way it appears on the balance sheet.
The leasing equipment of the companies will appear in their balance sheets, making it asset-rich, but it will also increase the debt burden. The companies having a larger number of lease agreements will also hugely impact their balance sheet.
If an organization has a massive lease portfolio, then the changes can affect the primary financial and accounting ratios greatly.
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Conclusion
To understand IFRS 16, you have to recognize the item that you can show in your balance sheet as the right to use an asset. That item will be your asset, and you will be obliged to make payments for it as a liability.
Second, you must gather all essential information related to leases, such as lease payments, term, and end-of-term options. After doing that, separately show the payments that are not applicable to IFRS 16.
