IFRS and its impact on Lessees
To achieve more relevant and faithful information in financial statements involving Leases, the International Accounting Standards Board (IASB) undertook to rewrite “IAS 17 Leases”. In January 2016, they issued IFRS 16 Leases to replace the IAS 17 document.
In accordance with IAS 17, companies were able to finance assets by way of off-balance sheet debt in the form of operating leases. Lessees were only required to account for the lease payments as an expense on a straight-line basis over the lease term.
The only time the lease would affect the financial position of the entity would be if the lease payments escalated over the lease period or the lease contained a lease incentive. The effect on the financial position would also be minimal.
Although future payments to be made by the lessee in terms of an operating lease are required to be disclosed in the notes, the accounting treatment under IAS 17 did not give a true reflection of the financial position of the entity at the financial year-end.
If the future payments in terms of the lease agreements were recognised in the statement of financial position of the entity, it could have a negative effect on the solvency and liquidity of the entity. The return on assets would also be skewed, as the entity utilised assets in the generation of revenue not included in the statement of financial position.
This made it difficult for investors to compare entities or to make decisions based on the financial statements of the entity.
This is where IFRS 16 comes in.
Under IFRS 16 Leases, there is no difference in the accounting for finance leases and operating leases in the financial statements of the lessee.
For both leases, the lessee would recognise a right of use asset and a corresponding lease liability, thus bringing the asset and the financing thereof on to the statement of financial position.
There is, however, a little relief for lessees in the case of short-term leases (leases with a lease term of less than 12 months) or leases of low value assets (assets that when new costs the equivalent of $5 000). For these leases, the operating lease accounting as per IAS 17 can still be applied.
For leases that do not qualify for the exemption, the lessee must recognise a lease liability at the commencement of the lease. The value of this liability will be the total lease payments not paid as at that date, discounted to the present value thereof. The rate to be used to discount the payments is the interest rate that yields the present value of the lease payments and the unguaranteed residual value, equal to the fair value of the underlying asset and any initial direct costs, also known as the interest rate implicit in the lease.
A corresponding right of use asset must also be recognised at this date. The value of this asset will be calculated as:
- the value of the lease liability;
- any lease payments made on or before the commencement of the lease;
- any other direct costs incurred at inception.
Subsequent to the initial measurement, the asset should be measured by applying the cost model, thus at cost less any accumulated depreciation and accumulated impairment. Entities applying the revaluation model under IAS 40 Investment property or IAS 16 Property, Plant and Equipment may, however, elect to apply the revaluation method for right of use assets where the underlying asset qualifies as either investment property or property, plant and equipment.
Depreciation should be provided in accordance with the requirements of IAS 16 Property, Plant and Equipment. The depreciation should be calculated over a depreciation period equal to the lease term, unless the lease includes the option to purchase the asset at the end of the lease term, and it is reasonably certain that the entity will exercise that option. In this case, the depreciation period will be the useful life of the asset irrespective of whether this is longer than the lease term.
The liability, on the other hand, is subsequently measured at amortised cost, calculated as:
- the initial cost, plus;
- an interest charge, less;
- the lease payments made.
Modifications to the lease agreement such as a change in the lease term or lease payments may also affect the value of the right of use asset and the lease liability subsequent to initial recognition.
Impact on Statement of Financial Position
Due to the difference in the measurement methods of the right of use asset and the lease liability, it will not be equally valued at each reporting date and may have either a positive or negative impact on the net asset value of the entity.
Although IFRS 16 makes it easier for investors to compare the financial statements of similar entities and gives a more accurate representation of the financial position of an entity, it may leave entities with a sour taste in their mouths due to a possible negative impact on the financial indicators of the entity.
IFRS 16 is effective for financial year-ends beginning on or after 1 January 2019. Entities with a financial year-end of 31 December 2019 should already be accounting for leases under IFRS 16.
This article was written by Sindy Pretorius, National Technical Director at Moore South Africa. To get in touch with Sindy please email her here.
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