Welcome to the ultimate guide on IFRS 16 and its transformative impact on the realm of accounting.
In the ever-evolving financial landscape, staying informed and prepared for change is paramount. IFRS 16, issued by the International Financial Reporting Standards (IFRS) Foundation, is one such monumental shift. We’ll highlight why this standard is not just significant but essential for modern businesses and why it represents a departure from previous standards.
IFRS 16 redefines how companies record leases, fundamentally altering the way lease obligations are reflected on balance sheets and influencing key financial metrics. Gone are the days of off-balance sheet accounting for many leases; instead, transparency and accuracy take centre stage. As we explore the intricacies of IFRS 16, you’ll gain insights into the powerful implications it holds for financial statements and business decisions.
We’ll shed light on which companies are mandated to adhere to these standards and underline the critical importance of doing so. Failure to comply, especially for listed entities, can result in significant penalties and erode stakeholder confidence.
In this guide, we aim to equip you with the knowledge and tools you need to successfully navigate the complexities of IFRS 16. Our journey together will encompass various facets of this accounting revolution, ensuring you emerge prepared to meet the new standard.
So, whether you’re a seasoned financial professional or someone looking to understand the impact of IFRS 16, this guide has something for you. Let’s embark on this journey to unravel the nuances of IFRS 16 and discover how it shapes the financial landscape and how Rubli IFRS 16 lease accounting software can assist you in mastering IFRS 16.
Key takeaways:
- IFRS 16’s Fundamental Shift in Lease Accounting: Unlike previous standards, IFRS 16 requires lessees to report nearly all leases on the balance sheet, significantly impacting financial statements and key performance indicators.
- Historical Significance & Transition from IAS 17 to IFRS 16: Introduced to increase transparency and comparability, IFRS 16 replaced IAS 17 to address off-balance-sheet financing and provide a more accurate representation of lease transactions.
- Compliance Challenges & Business Implications: Implementing IFRS 16 poses systemic and organisational challenges, necessitating changes in accounting practices and internal processes, with significant impacts on tax, financial performance, and business decision-making.
- Scope and Application of IFRS 16: The standard broadly applies to various lease types, but specific exclusions exist. Understanding its scope, including short-term and low-value leases, is critical for accurate compliance.
- Strategies for Effective Adoption & Best Practices: There are specific tools (including software) and practices a business can adopt when implementing IFRS 16 outlined in our comprehensive compliance checklist.
Table of Contents
What is IFRS 16?
So, what exactly does IFRS 16 affect? It transforms the way businesses handle leases, with a particular focus on the scope and definition of lease agreements between lessees and lessors. These changes have far-reaching implications for financial statements and are designed to bring greater clarity and transparency to lease accounting practices.
Before we dive deeper into the mechanics of IFRS 16, it’s worth understanding the history and significance of this accounting standard, specifically how it emerged and why it’s a critical aspect of modern financial reporting. We’ll also explore how it functions, delve into the various types of leases it addresses, and discuss the calculations involved—whether using basic tools or advanced IFRS 16 software.
What is IFRS 16 Lease Accounting?
Ultimately, IFRS 16 lease accounting is a seismic shift in the way companies worldwide account for leases in their financial statements. Its scope is vast, encompassing a wide range of lease arrangements. This global financial reporting standard brings unprecedented changes to the way leases are recognised, measured, and reported.
How is IFRS 16 Different from Previous Standards?
One of the most significant departures from previous standards is the elimination of the classification of leases as either operating or finance leases for lessees. Instead, IFRS 16 mandates that almost all leases be recognised on the balance sheet. This shift in approach has profound implications for financial transparency and how businesses manage their lease obligations.
What are the 4 Principles of IFRS 16 in Accounting?
IFRS 16 stands on four principles, each contributing to more transparent and accurate financial reporting. We’ll delve into each of these principles later in this post, explaining their significance and how they reshape lease accounting.
The principles are:
- the identification of a lease,
- the recognition of lease liabilities and right-of-use assets,
- the measurement and
- the remeasurement of these critical elements
These principles don’t affect all parties equally. In fact, they have distinct consequences for lessees and lessors. For example, due to IFRS 16, most leases are now recognised on the balance sheet by lessees, while lessors continue to classify leases as finance or operating leases. We’ll provide insights into these differing effects, shedding light on how businesses are adapting to them.
IFRS 16 History: When it Was Introduced, Changes & More
IFRS 16 has roots in its predecessor, IAS 17, which provided the framework for lease accounting before IFRS 16 was released. Understanding this historical context provides the context for comprehending the changes and implications of IFRS 16.
When Was IFRS 16 Introduced?
Why Was IFRS 16 Introduced?
The goal was simple: to offer more transparent financial reporting and provide a clearer, more accurate picture of a company’s financial obligations related to leasing contracts.
Predecessor to IFRS 16
Why Was IAS 17 Replaced By IFRS 16?
Have There Been Any Changes or Amendments to IFRS 16 Since its Introduction?
Accounting standards are not static; they evolve to meet the changing needs of the financial world. IFRS 16 is no exception. Since its introduction, there have been changes and amendments to fine-tune its provisions and ensure its continued effectiveness, albeit not extensive ones.
Some of these changes related to the COVID 19 period and aimed to provide relief from the impact of payment holidays and rent concessions on accounting, while other changes related to the subsequent accounting for sale and leaseback transactions.
When IFRS 16 did not include specific requirements for sale and leaseback transactions, it created uncertainty. Specifically, how to subsequently measure the liability arising from a leaseback transaction where the payments for the lease include payments that do not meet the definition of lease payments; for example, variable payments that do not depend on an index or a rate. As a result, in September 2022, the IASB issued an amendment to the lease liability in a sale and leaseback transaction, which to address the issue of subsequent measurement of the lease liability.
This is a very technical topic of IFRS 16, so don’t worry too much if you do not understand why there was a change. You can read more about lease liability on Viewpoint PWC.
How Does IFRS 16 Work?
IFRS 16 introduces a structured and methodical approach to lease accounting. Let’s dive into the mechanics of how this standard operates. At its core, IFRS 16 alters the way leases are recognised and measured, a departure from previous lease accounting standards.
To ensure compliance with IFRS 16, companies must follow a series of defined steps. These steps encompass initial recognition, measurement, and subsequent reporting requirements. It’s not merely a matter of acknowledging the changes; it’s about implementing them effectively and consistently in your financial reporting.
When Does IFRS 16 Apply?
No one would want to start with the complex standard of IFRS 16 if it could’ve been avoided from the start. So, a good starting point for any accounting transaction is to ensure that you fall within the scope and recognition criteria for leases.
We will briefly look at three easy questions to ask before accounting for a lease and then work through a flowchart that helps you to make your decision logically to account for a lease or not. Lastly, we will look at what types of lease do not need to be accounted for in terms of IFRS 16.
The Scope of IFRS 16
IFRS 16 changed the definition of a lease to enhance the clarity of its application to a broader scope of agreements. Initially, this resulted in a few more leases that had to be recognised by companies implementing IFRS 16 for leases.
The IFRS 16 standard gives the following definition:
“A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”.
In other words, if you pay to use an asset for some time, it is a lease.
A common error that someone new to IFRS 16 might make is to think that a finance loan from the bank to buy a vehicle falls within the scope of IFRS 16. Remember that, contractually, in a lease, the asset remains the property of the lessor (the owner). With a finance loan, there is a change in ownership.
Does IFRS 16 Apply to My Contract?
There are three questions to ask to determine if a contract meets the criteria of a lease:
- Is there an identifiable asset (i.e. do you know specifically which asset you will use)?
- Do you have the right to control the asset with both of the following?
- 2.1. Right to direct the use of the asset; and
- 2.2. Obtain the benefits from using the asset; and
- Are there any substitution rights for the asset?
This will help you determine if the contract is a lease. Another factor that can help is to make sure you know which asset is uniquely yours.
If you are unsure how to answer these three questions, the standard provides a lot of detailed guidance.
The flowchart below offers guidance on making an insightful assessment of whether a contract is, or contains, a lease:
Just keep in the back of your mind that any contract may contain a lease, because there is no requirement that it must be in a separate contract.
When Does IFRS 16 Not Apply?
While IFRS 16 brings most leases onto the balance sheet, there are exceptions. It’s crucial to understand the types of leases that are exempt from IFRS 16 and the criteria for these exemptions. Common exemptions include:
- short-term leases,
- leases of low-value assets,
- IAS 41 biological assets,
- and IFRIC 12 Service Concession Arrangements
Note, each exemption is tied to specific conditions and requirements.
Exemptions from IFRS 16 have significant implications for both lessees and lessors. Lessees may enjoy simplifications in lease accounting for exempted leases, while lessors may need to navigate a more complex landscape in certain cases. Understanding these implications is essential for accurately reporting lease obligations and managing financial statements.
Which Companies Need to Follow IFRS 16?
The applicability of IFRS 16 varies based on jurisdiction, company size, and other criteria. It’s essential to clarify the types of companies that are required to follow IFRS 16. While there is a global framework, local regulations and standards may influence who must adhere to IFRS 16.
In many countries, IFRS 16 is mandatory for listed companies. This means that companies whose securities are traded on public markets are typically required to adopt IFRS 16 in their financial reporting. This ensures uniformity and transparency in financial statements for investors and stakeholders.
Interestingly, in numerous countries worldwide, IFRS 16 is not solely reserved for listed companies. It may also be required or strongly encouraged for non-listed companies, driven by national or local laws and regulations. This broader application aims to enhance consistency and comparability in financial reporting across the board.
Which Countries Require IFRS 16 Accounting Standards?
- United Kingdom
- Germany
- France
- Australia
- Canada
- Japan
- Brazil
- South Africa
- Singapore
- United Arab Emirates
- European Union*
Which Countries Do NOT Require IFRS 16 Accounting Standards?
While IFRS 16 enjoys broad international acceptance, some countries have chosen alternative accounting standards or allow smaller companies to account with simplistic principles. For instance:
What Types of Leases Fall Under IFRS 16?
IFRS 16 introduces a fundamental shift in how leases are classified, moving away from the traditional distinction between finance and operating leases. We will go through the rules that IFRS 16 uses to classify your leases (the lessor) and simplify your lease accounting (the lessee).
IFRS 16 Lease Types
Finance Leases and IFRS 16
Finance leases are often similar to what was previously recognised as capital leases. Under IFRS 16, these leases typically involve transferring substantially all the risks and rewards of ownership from the lessor to the lessee.
Lessees recognise finance leases on their balance sheets, reflecting both lease liabilities and right-of-use assets.
These leases generally result in front-loaded expenses on the income statement, with higher interest and depreciation costs early in the lease term.
For finance leases, the recognition of lease liabilities and right-of-use assets on the balance sheet can impact a company’s financial position, debt ratios, and leverage. On the income statement, finance leases result in higher interest and depreciation expenses early in the lease term, affecting profit margins and earnings.
Operating Leases and IFRS 16
Operating leases, on the other hand, are leases where the lessor retains most of the risks and rewards of ownership. Under IFRS 16, lessees no longer classify leases as operating leases for accounting purposes. Instead, they recognise them on the balance sheet as right-of-use assets and lease liabilities.
Operating leases are still used as office jargon when a lease is exempt from the full scope of IFRS 16 for the lessee. Operating leases typically lead to a more even distribution of lease expenses over the lease term on the income statement because you apply straight lining of the expense.
“Operating leases”, in terms of IAS 17, are now recognised on the balance sheet for the lessee, providing a more comprehensive view of a company’s financial obligations and impacting its key financial ratios.
IFRS 16 Finance Lease For a Lessor
To classify a lease as a finance lease from the lessor’s perspective, certain criteria must be met. These criteria often revolve around whether the lessor transfers all the risks and rewards associated with ownership to the lessee. Key criteria may include the following:
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value.
- The lease term covers a significant portion of the asset’s economic life.
- The present value of the lease payments, including any residual value guarantees, equals or exceeds substantially all of the asset’s fair value.
When a lessor classifies a lease as a finance lease, it records the lease differently on its books compared to an operating lease. Here’s how it affects both the income statement and balance sheet:
- Balance sheet: The lessor recognises the lease receivable, which represents the present value of the lease payments. Simultaneously, the lessor derecognises the underlying asset from its balance sheet.
- Income statement: The lessor typically recognises finance income over the lease term, reflecting the interest income earned from the lease receivable. The depreciation of the asset may also be recognised as an expense on the income statement.
IFRS 16 Finance Lease For a Lessee
Identifying a finance lease from a lessee’s perspective has been simplified and the general rule is that all leases are ‘finance’ leases, except when the exemption can be applied.
There are specific accounting treatments required, leading to the recognition of a right-of-use asset and a lease liability:
- Right-of-use asset: The lessee recognizes the right-of-use asset on the balance sheet, initially measured at the present value of lease payments. This asset represents the lessee’s right to use the leased asset over the lease term.
- Lease liability: Simultaneously, the lessee recognises a lease liability on the balance sheet, also initially measured at the present value of lease payments. This liability represents the lessee’s obligation to make lease payments over the lease term.
IFRS 16 Operating Leases For a Lessor
To classify a lease as an operating lease from the lessor’s perspective under IFRS 16, specific characteristics come into play. These characteristics often revolve around whether the lessor retains most of the risks and rewards associated with ownership. Key characteristics may include the following:
- The lease does not transfer ownership of the asset to the lessee by the end of the lease term.
- The lessee does not have an option to purchase the asset at a price significantly below its fair value.
- The lease term does not cover a significant portion of the asset’s economic life.
- The present value of the lease payments, including any residual value guarantees, does not exceed substantially all of the asset’s fair value.
Operating leases, as opposed to finance leases, follow a different accounting treatment for lessors and have distinct implications on financial statements:
- Balance sheet: The lessor retains the asset on its balance sheet, and no lease receivable is recognised. Instead, lease income is typically recognised evenly over the lease term as the asset continues to depreciate.
- Income statement: Lease income from operating leases is recognised consistently over the lease term, resulting in a more even distribution of income on the income statement compared to finance leases.
Short-term and Low-value Leases Within IFRS 16 Lessee Accounting
Under IFRS 16, certain leases are categorised as short-term or low-value leases, each of which have their own criteria:
Short-Term Leases in IFRS 16:
These leases have a lease term of 12 months or less at the commencement date and do not include an option to purchase the underlying asset;for example, a company renting office space for less than a year.
Low-Value Leases in IFRS 16:
- Administrative efficiency: It reduces the administrative burden of tracking and recording assets and liabilities for short-term or low-value leases.
- Minimal impact: These leases often have minimal financial impact, so recognising them directly as expenses can simplify financial reporting without significantly distorting financial statements.
- Enhanced transparency: It provides transparency by distinguishing between material and immaterial leases, helping users of financial statements focus on more substantial lease obligations.
How Does IFRS 16 Practically Affect Businesses?
As mentioned, IFRS 16’s impact on lease accounting mostly relates to the lessee accounting side. IAS 17 to IFRS 16 did not change significantly for the lessor and, as a result, the standard has an impact on the business as well. As a result of the increased transparency, management can make informed decisions for the company.
The key areas that IFRS 16 impact within a business are liquidity and solvency of a company (due to the balance sheet impact), asset management considerations, and the impact of the income statement.
What Are The Implications of IFRS 16 on Business Decisions?
The change from IAS 17 to IFRS 16 did not change how businesses should make strategic decisions; however, the age-old comparison between leasing and asset versus purchasing assets is still as relevant as ever.
There are some points you should think of when considering how you will acquire your assets:
- Available capital
Not all companies have cash reserves or available lending facilities to purchase assets, and this is why they may choose to lease assets instead. There is no significant upfront payment required. - Flexibility
Leasing an asset makes it easier to switch/trade for a newer version of the asset. If the asset was bought, you would first have to sell it, which can sometimes be a prolonged transaction. - Investment decision
The downside of leasing an asset is that at the end of the lease period, you still do not own the asset, compared to an asset purchase transaction (acquired through a loan) where the asset can still be used after the loan has been paid off. - Responsibility
The last consideration is which party should be held responsible for any wear and tear or “normal” breakage of the asset, as this usually falls to the owner and not the lessee
What Are The Tax Implications of IFRS 16?
Due to the fact that an asset is being created, and is depreciated over its lifetime, the expense side of leasing changes. Under IAS 17, this was captured as purely a lease expense (if it was an operating lease).
However, for tax purposes, IFRS 16 is seen purely as an accounting entry and the true substance of the contract is considered. In other words, the tax will follow the cash payments (lease payments) that were made and will completely ignore the asset and its depreciation.
Because there is a difference between the tax treatment of lease accounting and the IFRS 16 treatment, deferred tax will play a role to align your tax expense recognised.
IFRS 16 Challenges and Implications for Businesses
System and Organisational Challenges
Most companies that have elected to pursue operational asset acquisition through leasing activities are not fully equipped to handle the accounting treatment of IFRS 16. The nature of calculating a lease asset and the value it should be recognised at is based on the preset lease payments. However, the whole purpose of companies wanting to invest in leasing assets is to have flexibility.
This means that the operational team of a company will continually monitor the company’s needs for a set of assets and make changes to the portfolio without giving it a second thought. This is especially prevalent in fleet management, such as vehicles. If the mileage is less than expected or more, the lease agreement and payments might change as well. Payment changes mean that frequent modifications and remeasurements will be required as well.
Very quickly, keeping track of the current status of the lease portfolio is not sufficient and a company would need system upgrades to increase their data retention of all the changes made throughout an entire financial year.
Financial Performance and KPIs
As mentioned before, there is a significant impact on the balance sheet due to IFRS 16 recognising both a right-of-use asset and a lease liability on the balance sheet. The right-of-use asset is recognised in the non-current assets section, and the lease liability is divided into the current and non-current liability section to mirror when the payments will be received. This already creates a significant impact on a company’s liquidity because there is recognition of a current liability, but not a current asset.
This is due to the increase in transparency that IFRS 16 aims to achieve, as under IAS 17, this was off balance sheet and only disclosed in the commitment schedule.
Another area that is significantly impacted by IFRS 16 is the considerations for EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation). The lease payments were recognised as part of the lease expenses line, and depending on the type of lease, this was already included in the operating profit of a company. Now, this expense has been divided into the depreciation (for the leased asset) and interest expense (for the lease liability), which is no longer included in EBITDA.
Companies that are considering their financial performance and KPIs (key performance indicators) will have to consider that IFRS 16 lease accounting will have a significant impact on both the liquidity and EBITDA of the company and adjust it accordingly.
Penalties and Repercussions for Not Adhering to IFRS 16 Accounting Standards
IFRS 16 and the requirement to adhere to its stipulations is no different than any other accounting standard. Especially for listed companies, the impact of not adhering to the leasing standard can be significant and, especially since it is still a relatively new standard, there is a lot of emphasis on the accurate and consistent application of the standard. You can read more about best practices for IFRS 16 compliance below.
Here are some penalties and/or repercussions if a company does not fully comply with IFRS 16:
- Qualified audit opinion: The results of IFRS 16 can be significant and pervasive for a company’s financial statements, and the auditors can evaluate that a qualified or adverse opinion will be required.
- Regulatory fines and sanctions: This is mostly applicable to listed entities, but the governing bodies of a country’s stock exchanges may decide that it is appropriate to impose suitable fines and sanctions against a company.
- Legal actions: The shareholders of a company can take legal action for financial misrepresentation as it impacts their considerations for investment, management and other crucial decisions.
- Reputational damage and erosion of trust: This point follows from the qualified audit opinion, as the user of the financial statements will lose trust in the governing body’s ability to accurately comply with IFRS and will cast doubt over the other sections of the financial statements as well.
- Contractual violations: Many contracts such as debt covenants with financial institutions will require compliance with accounting standards as it guides the criteria for the liquidity and solvency clauses. This can result in financial penalties, increased interest or even the calling in of loans.
How to Adopt IFRS 16?
- Full retrospective approach
- Modified retrospective approach
| Full retrospective approach | Modified retrospective approach |
| Restate prior period information (IAS 8) As a result, your prior year financial statements will include both IAS 17 and IFRS 16 | No restatement required Prior period will be IAS 17 Current period will be IFRS 16 |
| Equity opening balance restatement—start of the prior year | Equity opening balance restatement—start of the current year |
| Obtain and manage both the current year and the prior period’s lease portfolio | Only required to obtain and manage the lease portfolio for leases active at the start of the financial year |
| Comparative financial information presented | No comparative information to present |
| Demanding approach | Cost-effective approach |
Regardless of the approach you take, gathering the information is only one step up the IFRS 16 ladder. There are tools available that calculate what the financial disclosures and accounting should be, and one of those tools is Rubli’s IFRS 16 solution. Our solution will recalculate your lease portfolio’s accounting in terms of IFRS 16, and you will be assisted by our IFRS 16 experts to guide you in your adoption journey.
Best Practices for IFRS 16 Compliance
Ensuring IFRS 16 compliance requires you to think strategically, with foresight, and to have a structured approach for both the adoption of the standard and the continuous accounting thereof.
Below, we discuss the critical best practices to achieve and maintain compliance with IFRS 16 for your lease accounting.
Proactive Planning and Internal Communication
- Start early: Begin the process well in advance of the deadlines to ensure sufficient time for a comprehensive review of all lease contracts.
- Create cross-functional teams: Include members from the accounting, finance, IT and legal departments to ensure all aspects of leasing activities are considered.
- Internal education: Implement training programmes to familiarise all relevant personnel with the new standard and its impact on their specific roles.
- Effective communication channels: Establish open lines of communication between departments to facilitate the exchange of information and to address any issues promptly.
- Invest in technology: Consider the role of lease accounting software in managing the volume of data and calculations required by IFRS 16.
Periodic Review and Audits
Your ongoing compliance with IFRS 16 requires an iterative process of review and verification. It’s not enough to set up processes; they must be monitored and refined over time:
- Regular audits: Schedule internal audits to review the accounting of leases and ensure compliance with the standard.
- Update your lease portfolio: Keep a dynamic portfolio of leases that can be regularly updated as new leases are initiated or existing ones are modified or terminated.
- Reassess measurements: Regularly reassess and, if necessary, remeasure lease liabilities and right-of-use assets to reflect changes in the lease term or lease payments.
- Annual reporting: Include a comprehensive analysis of lease obligations in annual reports, and ensure disclosures meet the IFRS 16 requirements.
Documenting Lease Agreements
What would accounting be without the proper documentation as evidence. Proper lease documentation will be the backbone of how you will ensure compliance with IFRS 16. It’s not merely about recording all your lease transactions; it’s about capturing a comprehensive picture that aligns with the reporting standards.
Detailed documentation will safeguard the integrity of your financial reporting and ensure your organisation can stand up to scrutiny from auditors and stakeholders.
The Importance of Detailed Documentation
It will be crucial for you to maintain meticulous records for each lease. Should you have inadequate documentation, this can lead to misstatements in financial reports and a misunderstanding of the company’s obligations and rights, which can have significant financial and legal repercussions.
Detailed documentation will ensure that all your lease transactions are accurately reflected in the financial statements. Complete records provide you with the clarity to make information decisions and enhance the transparency of the company’s financial obligations. Make sure that the documentation is maintained as this will serve as your audit trail (the support for the accounting), facilitating a smoother audit process.
Components of Compliant Lease Agreements
To make sure that you are compliant with IFRS 16, lease agreements will contain information that captures the essence and complexity of leasing arrangements:
- Identification of parties: Make sure the names and details of the lessor and lessee are clearly stated.
- Description of asset: A full description and identification of the leased asset should be included to ensure clarity on what exactly is being leased.
- Lease term: Specify the commencement date, the non-cancellable period of the lease, and terms related to renewal or termination options.
- Payments: Provide a clear lease payments outline, including fixed payments, variable lease payments, and any other elements such as residual value guarantees should be part of the contract.
- Discount rate: Although this is not part of the agreement, the discount rate used for the present value calculation should be documented.
- End of lease terms: Make sure the documentation of the expectations and conditions upon the termination of the lease, including options to purchase, return conditions, or potential penalties, are included.
Ensuring that lease agreements are comprehensive and documented is essential for the successful implementation of and ongoing compliance with IFRS 16. It will cost time, effort and resources to get it right, but the consequences of inadequate documentation can be far-reaching, affecting not just your financial statements but the credibility and operational efficiency of the business itself.
Maintaining an IFRS 16 Compliance Checklist
This checklist will serve as a roadmap for your IFRS 16 lease accounting. It will ensure that all aspects of the leasing standard are addressed systematically and that you consistently apply it in the future.
An IFRS 16 compliance checklist is a comprehensive tool that outlines the steps you can take for adhering to IFRS 16. It offers a systematic way for you to tackle lease compliance, ensuring you do not overlook any critical IFRS 16 aspects. By covering all necessary points, it reduces the risk of non-compliance and associated penalties.
When to Consult Professional Advisors for IFRS 16 Compliance
You can see that the compliance with IFRS 16— – from adopting to maintaining necessary information—can be a challenging endeavour. This is especially true if your lease portfolio is complex. Consulting professional IFRS 16 advisors can quickly become a necessity. Let’s explore when to consider this path and the value advisors offer in terms of IFRS 16 lease compliance.
The Need for IFRS 16 Advisors May Arise Due to The Following Scenarios:
- Complex lease portfolios: Companies with extensive or complex lease arrangements may struggle to accurately account for IFRS 16.
- Dynamic lease portfolio: Lease portfolios with lease payments that are linked to external factors, such as local interest rates. They are prone to change frequently during the lease period and can become cumbersome very quickly.
- Resource constraints: Organisations with limited in-house accounting expertise or resources can benefit from external guidance.
- Ensuring accuracy: Businesses might seek guidance to validate that their IFRS 16 compliance processes are accurate in their lease reporting.
The Strategic Benefits Of IFRS 16 Advisors:
- Expert insight: Professional advisors offer specialised knowledge of IFRS 16, including the latest developments and interpretations.
- Risk mitigation: They help identify and mitigate risks associated with IFRS 16 lease accounting and compliance.
- Efficiency: Advisors can streamline your IFRS 16 compliance process, saving you time and resources.
IFRS 16 advisors (like Rubli) provide assistance across various stages and can be instrumental at different stages of your IFRS 16 journey.
What Are The Benefits of Professional IFRS 16 Advisors?
We will discuss some points an IFRS 16 advisor can help with at each phase:
- Initial planning and implementation:
- Assess your lease accounting practices against the IFRS 16 requirements
- Develop a tailored plan to transition you into compliance with IFRS 16
- Provide training for you and your team to understand and implement the standard
- Execution and transition:
- Assist in extracting and validating your data from all lease contracts
- Initial planning and implementation:
- Guide the integration of your lease accounting software solutions
- Help formulate internal policies and controls for lease accounting in your business
- Advisory and support:
- Offer solutions to complex technical issues that may arise in day-to-day operations
- Assist in preparing IFRS 16 reports and disclosures for stakeholders
In conclusion, professional advisors play a crucial role in ensuring that you can navigate the complexities of IFRS 16 effectively. Their expertise not only aids you in complying with IFRS 16 but also contributes to the strategic management of your lease portfolios, ultimately enhancing the financial integrity and transparency of your organisation. Rubli can assist with all your IFRS16 requirements.
IFRS 16 Initial Calculations
Establishing whether your contract is in scope for IFRS 16 is the first step. Then you need to calculate the value to bring on to the balance sheet. This will be in the form of the “lease liability” and “right-of-use asset”. Note that we will specifically look at the transaction from the lessee’s point of view, but the maths is very similar if you are the lessor.
Key Calculations in IFRS 16
One of the primary calculations under IFRS 16 is determining the present value of lease payments. This involves discounting future lease payments to their present value using an appropriate discount rate, typically the Incremental Borrowing Rate (IBR).
Accurate calculation of this present value is crucial because it forms the basis of the lease liability and the corresponding right-of-use asset recognised in the balance sheet.
IFRS 16 Lease Liability: Definition & Calulcation
A IFRS 16 lease liability is the present value of the lease payments, excluding payments before lease commencement date, discounted using the lease’s discount rate. This liability reflects the obligation to make lease payments, but adjusted for the time value of money.
Calculation for initial recognition and subsequent measurement:
- Initial recognition: At the commencement date, the lease liability is measured as the present value of the lease payments during the lease term.
- Subsequent measurement: The lease liability is increased for interest and reduced for the lease payments made. It may also be remeasured when there is a change in future lease payments due to a modification or reassessment.
IBR (Incremental Borrowing Rate)
The standard says to first consider the rate implicit in the lease. In this case, you need to know what the fair value of the asset is and then calculate the interest rate that equals that value. In other words, you would need all the inputs to determine the discount rate. Usually, lessors don’t disclose this because it is the “profit” they generate from this transaction.
In most cases, you’ll use your company’s incremental borrow rate (IBR). That’s just a fancy way to say what rate a bank would charge if you had to take a similar type of loan from them.
These are factors that will influence the IBR applied to a lease:
- The company’s credit rating: A better credit rating typically results in a lower IBR.
- Economic environment: This refers to the prevailing interest rates and economic conditions in the lessee’s country.
- Terms and security of the borrowing: The length of the lease term and the nature of the asset being leased.
Note that your IBR will typically be linked to the local interest rate but adjusted specifically for your entity. Assuming there are no changes to the lease, you would never have to update this interest rate during the lease period. You just use the rate at inception and don’t touch it again (unless you need to modify the lease, which we’ll discuss shortly).
Remember that you are allowed to use a single discount rate to a portfolio of leases if the IBR is used. In other words, you can apply one rate for all your vehicles, because it is in one asset class.
Practical Expedients and Estimations
To help entities account for IFRS 16 when it will have a significant impact, the IAASB considered including practical expedients to the application of IFRS 16. When a lease falls within the scope of IFRS 16, entities can consider whether this is a short-term or low-value lease, which will allow them to apply less cumbersome accounting rules. The criteria for these two exempt lease types are:
- Short-term lease: This is when a lease has a lease term of less than 12 months.
- Low-value lease: The value of each identifiable asset (in a new condition) can be of low value.
As mentioned, IFRS 16 is “shifting” the period in which lease expenses are being recognised, as more interest will be recognised up front compared to later in the lease term. The IAASB considered that a lease with 12 months will have an insignificant financial impact on the accounting treatment.
In comparison to a short-term lease, entities would have to apply judgement in considering what would be a low-value lease. IFRS 16 provides guidance and notes that $5,000 would be an appropriate value to apply in determining if a lease is of low value.
Exempt leases still fall within the scope of IFRS 16, but they are exempt from the requirement to be recognised as a lease liability and right-of-use asset on the balance sheet. The treatment to apply would be to recognise the lease expense directly in the income statement and, should it be applicable, you would have to apply straight-lining to it.
Remember that because these leases are not recognised on the balance sheet, if the lease term runs over a financial period, there is still a disclosure requirement for the commitment made with these leases.
IFRS 16 Subsequent Measurement
After the lease has been recognised, you need to process periodic journals (usually monthly) over the lifetime of the lease (the lease term). This includes the interest expense, depreciation and lease payments. As you account for the lease with the journals periodically, it will run down the balances to zero. If done right, at the end of the lease term the lease liability should be zero (if not, you made a mistake somewhere).
We will look at some methods of accounting for the right-of-use asset, how the periodic journals will look and what the extra journal at the end of the lease term is (more on that later). Thereafter, we will look at the lease liability, with the standard periodic journals.
Right-of-Use Asset
Once the right-of-use asset is recognised, it needs to be depreciated under the requirements of IFRS 16. In the vast majority of cases, it will be depreciated on a straight-line basis.
For the other methods, you can refer to the following models that are available:
- Cost model (IAS 16 – property, plant and equipment)
- Revaluation model (IAS 16)
- Fair-value model (IAS 40 – Investment property)
Throughout the rest of the guide we’ll assume straight-lining is used.
On the journal side of things, for the asset, it is quite simple and there is nothing new:
Period journals (each month or year):
Debit – Depreciation Expense
Credit – Accumulated Depreciation – Right-of-use Asset
Keep in mind that because the depreciation is accounted for against the accumulated depreciation, there will still be balances left for the asset. So, one more step is required.
The asset cost and accumulated depreciation balances would have to be removed from the balance sheet via a journal. This journal will have no net book value impact on the balance sheet as it is purely to keep your auditors smiling and your disclosure balances correct.
Termination journals (end of the lease):
Debit – Accumulated Depreciation – Right-of-use Asset
Credit -Right-of-use Asset (Cost)
If you have a sublease (where the leased asset is then leased to a third party) and the asset is property, IAS 40 is the right standard to use instead of IAS 16. You will have to apply the accounting of investment properties to your asset.
Lastly, just keep in the back of your mind that IAS 36 – impairment of assets – is applicable to leased assets recognised in terms of IAS 16.
Lease Liability
The subsequent measurement of the liability will be the periodic journals for the interest and lease payments. This is usually tracked through an amortisation table over the lease period. This table will help you to easily calculate income statement and balance sheet amounts per lease each period.
The journals will look as follows, and you will note that it is the same principle applied as if a loan were taken out from the bank (which we know IFRS 16 is mimicking).
Journal for the interest (each month or year):
Debit – Interest Expense
Credit – Lease Liability
Lease payment journals (each payment cycle of the lease):
Debit – Lease liability
Credit – Bank (Lease payment)
As mentioned in the previous guide, you continue to use the discount rate at commencement date (original rate) to calculate the subsequent interest journals.
Modifications and Remeasurements
Whenever there is a change in the contract or even if your own internal estimates change, the liability must be adjusted. For instance, if you initially thought that you will not renew the contract, but after the start of the lease your considerations changed, then you have to update the lease calculation and account for the change.
Any contractual change will usually require you to account for it as a modification. Any cash flow changes or estimate reassessments will be accounted for as a remeasurement.
In both types of changes, you will determine the updated lease payments, consider the appropriate discount rate to use and recalculate the present value. You will compare the new present value with the current lease liability and this ‘lease difference’ will be your adjustment.
The accounting treatment for the lease difference is slightly different between a modification and a remeasurement. The Rubli IFRS 16 lease accounting tool has a step-by-step guide that helps you make the correct adjustment to your leases.
Remeasurements
In most cases, when there is a cash flow change on your lease payments, this can be because of the inflation (CPI) increases that became effective or the local interest rate changed, impacting your lease payments.
Another common remeasurement change is the decision to exercise an option (like a renewal or extension), and usually we see this happening near the end of the lease contract.
After you have calculated what the new liability balance should be (with the updated lease payments), you compare this to the current lease liability balance, which will be the lease difference. The “lease difference” adjustment will be used to adjust the lease liability balance to the new calculation and the other side of the journal entry will be against the right-of-use asset.
In some instances, it might be a decrease in the present value, while the asset carrying value is already zero. In this case, the remaining “lease difference” will go to a separate profit and loss line item as a gain/loss on lease remeasurement.
For each type of remeasurement change, the standard is very specific on the discount rate that should be used when calculating what the new lease liability balance should be.
You would use an updated discount rate if:
- The Lease term changes (either increased or decreased lease period)
- You decided to purchase the asset at the end of the lease
- The payments changed because they are linked to the local interest rates (to follow IFRS 9 principles)
You would use the original discount rate (IBR at commencement) if:
- Any estimate changes (residual value guarantee amount)
- Lease payment changes linked to an index
Modifications
There are essentially three types of modifications to the leased asset. This can be an increase in scope (leasing more floor space) or a decrease in which a portion of the asset will be disposed of. The last type is any other contract change that does not fall within the above two types.
The rate to be used as indicated by the standard is an updated IBR, because you have to view this as a completely new lease.
In the case of an increase in scope, the added portion of the modification will be a new component. You can only apply this only if the payments increased by the same ratio as the value increase in scope. The result of this is that the first part of your lease would not be changed, and the new portion of this lease is a “new lease”.
When you have a decrease in scope, a disposal of your asset will have to be recognised in proportion to the change in scope. Then you perform your calculation for the “lease difference” adjustment and adjust the lease liability. Any difference will be recognised in profit and loss as a gain/loss on disposal of assets.
The last type is any other contract changes. Mathematically, to determine the new present value, you would follow the exact same calculation method as with a remeasurement using an updated rate (IBR).
Managing IFRS 16 Lease Accounting Using Basic or Advanced Software Tools
Choosing the right tools for managing IFRS 16 lease accounting is a bit like picking the right gear for a hiking trip – you need to consider the terrain (company size), the weather (complexity of leases), and your backpacking experience (reporting requirements).
While manual tools (like Excel) are your reliable, old compass -specialised software is the high-tech GPS – both have their place depending on the journey ahead.
Let’s dive into why the choice of software tool is crucial and how it can shape your journey in lease accounting.
Consider Your Requirements to Determine Your IFRS 16 Software Needs
Factors to consider:
- Company size: Smaller companies might find simpler tools adequate, while larger enterprises could benefit from more sophisticated solutions that provide integrations and centralised data centres.
- Complexity of leases: The more complex your leases, the more robust your tool needs to be.
- Reporting requirements: If you’re in a heavily regulated industry or a publicly listed company, your reporting needs will require a more comprehensive tool.
Manual Calculations Using Tools Like Excel
Excel, our familiar spreadsheet friend, can be a handy tool for IFRS 16 calculations, but it’s not without its quirks.
Pros of Excel:
- Familiarity and accessibility: It’s a tool most of us know how to navigate and it is easy to set up the mathematical formulas required for IFRS 16.
- Flexibility: You can twist and tweak it to fit your specific lease needs, like creating a spreadsheet for each lease contract and any lease modifications that may occur, with a summary sheet for all your lease accounting and reporting requirements.
Cons of Excel:
- Error-prone: Manual data entry can lead to mistakes and with the formula-driven method, so it is very easy for mistakes to creep in.
- Scalability issues: As your lease portfolio grows, Excel might start to groan under the pressure, because of the multitude of data and formulas in the Excel file.
Best practices for Excel users:
- Consistency is key: Keep your data entry and formulas consistent across the board.
- Regular checks: Periodically review your spreadsheets for errors and discrepancies.
- Backup your work: Regularly save your work and maintain backups to avoid data loss.
Use of Specialised Software for IFRS 16 Calculations
Pros of IFRS 16 software:
- Automated calculations: These tools can do the heavy lifting, reducing the chance of human error.
- Compliance ready: They’re built to align with IFRS 16, keeping you on the right side of compliance.
- Integrated reporting: Generating reports becomes a breeze, a real time-saver.
- Audit trails: They keep a neat record of your calculations, which is handy when audit season rolls around.
- Cost factor: These tools can be an investment, especially for smaller businesses.
- Learning curve: Getting to grips with new software can take a bit of time and training.
When choosing specialised software:
- Assess your needs: Match the software’s features with your company’s specific requirements.
- Seek user-friendly options: Look for software that’s intuitive and easy to navigate.
- Consider support and training: Ensure the provider offers adequate support and training resources.
- Consider the type of software: There are numerous benefits of cloud-based IFRS 16 software and having remotely backed-up data can be an important consideration.
There is also a plethora of software tools available in the market, so choosing the right IFRS 16 software can be daunting. You can read more about what to look for in IFRS 16 Software on Rubli’s blog.
In conclusion, whether you stick with the tried and tested Excel or gear up with specialised software, the key is to choose a tool that aligns with your company’s unique lease accounting landscape. Just like with hiking, the right gear can make all the difference in your journey to IFRS 16 compliance.
Final Thoughts on IFRS 16 and Lease Accounting
As we conclude our journey through the intricacies of IFRS 16, it’s clear that this standard is more than a regulatory hoop to jump through. It represents a fundamental shift in lease accounting, profoundly impacting financial statements and business decisions. Understanding IFRS 16 is crucial, not only for compliance but for achieving transparent and accurate financial reporting. The implementation and ongoing management of this standard require a careful approach, from choosing the right tools for implementing IFRS 16—be it the familiar Excel or more specialised software—to ensuring continuous compliance through regular reviews and audits.
For those keen on delving deeper into the nuances of IFRS 16, our IFRS 16 training and resources are excellent sources for insights and practical advice, featuring a wide range of articles and guides on various aspects of IFRS 16. And when it comes to practical solutions for managing lease accounting, exploring tools like Rubli’s IFRS 16 Software can be incredibly beneficial.
In essence, mastering IFRS 16 is not just about ticking a compliance box. It’s about enhancing the quality of your financial reporting and gaining a deeper understanding of your company’s leasing obligations. By staying informed and utilising the right tools and resources, you can navigate the complexities of this standard with confidence and precision.
If you are looking for the right IFRS 16 leasing accounting software solution for your company, reach out to Rubli to see what we can offer you.
