The financial world is up for major changes as the new International Financial Reporting Standard 16 (IFRS 16) enters into force on January 1st, 2019, heralding a new era of lease accounting with exceptionally strong impacts. IFRS 16, published by the International Accounting Standards Board (IASB), is going to replace the currently effective International Accounting Standard 17 (IAS 17), scaring the one or other controller and CFO. But what exactly is IFRS 16, what does it mean for companies, and why is it finally time to make the necessary preparations?
From IAS 17 to IFRS 16: an end to off-balance sheet items
How exactly is leasing accounting currently regulated? IAS 17 distinguishes between two types of leasing contracts:
- Finance leasing: The lessee balances the leased asset, leasing rates are divided into an interest and repayment portion; the leased asset is depreciated like a separate asset.
- Operating leasing: The lessor balances the leased asset, the lessee recognizes the lease rates as an expense. The leased asset is not included in the lessee’s balance sheet. This is the most common leasing contract type.
IAS 17 determines that only finance leases are included in the lessee’s balance sheet. This is similar to a leveraged purchase that results in an asset and a liability. At the same time, IAS 17 additionally regulates the classification of contracts as finance leases. Accordingly, any lease that is not a finance lease is classified as an operating lease. In the latter case, the obligations from leasing agreements are only recorded off-balance sheet in the attachment, a procedure that is not very time-consuming.
The new IFRS 16 removes this distinction, so that almost all leasing liabilities need to be reported in the balance sheet. The new standard needs to be applied to all financial years beginning on or after January 1st, 2019. At the latest by the first-time application point, the previous disclosures in the attachments therefore need to be converted into obligations. In short: the new leasing standard puts an end to off-balance sheet items.
Significant changes in key financial figures
IFRS 16 will therefore significantly change the lessee’s accounting treatment. What effects on the balance sheet and income statement will companies have to anticipate, and what changes will they have to face?
The new regulations are changing financial key figures, such as total liabilities, gearing, total assets, EBIT and the equity ratio – and, unfortunately, not only for the better. While some are rising, others are falling – depending on the key figure, this change is welcome or rather undesirable.
The freedom of choice coming with the IAS 17 was taken advantage of by many companies for balance sheet cosmetics, because the information in the attachments is not as strongly perceived as that in the balance sheet. Soon, this will no longer be possible, as all liabilities will have to be disclosed in the future. The new rule thus particularly forces large international corporations to disclose debts amounting to millions or even billions, and, in doing so, creating transparency about the actual asset situation. These parties in particular merit the benefits of leasing, because most retail groups rent sales areas, logistics companies rent large car or aircraft fleets, and telecommunication companies rent areas their transmission masts stand upon.
However, these negative effects are also met by positive effects, as leasing rates will no longer be recorded as part of the operating result in the income statement in the future, thus increasing the operating result before interest, taxes, depreciation and amortization (EBITDA).
What is to be done?
With the effectiveness of the new standard, many companies are up for a mammoth task. Because a number of important measures are needed in order for processes, guidelines, and IT systems to become IFRS 16-compliant.
First and foremost, all leasing contracts need to be reviewed and reassessed – especially those previously treated as operating leases. This requires the collection of previously undocumented data for accounting purposes and the definition of processes for continuous data management. Furthermore, the IT systems need to be adapted to the new regulations supporting accounting and other processes such as procurement, administration and tax treatment of leasing relationships. In order to be able to master these diverse challenges, specific knowledge of the requirements of the tax authorities as well as a sound understanding of business processes and system landscapes are needed.
Many still find themselves at the beginning of the IFRS 16 implementation. Even though at this moment, a new opportunity is opening up with a precise and systematic approach to optimize processes on the one hand, and to design a rule-compliant, lean and streamlined IT landscape on the other. Only by fulfilling legal requirements, companies can ensure improved transparency in their balance sheets – and thus gain a unique advantage over their competitors.
Author: Axel Broeker
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