IFRS 16 GUIDE FOR FINANCE DEPARTMENTS

IFRS 16 is a lease accounting standard that requires companies to record their future lease payments as a liability in the balance sheet. This is to provide a more accurate representation of a company's financial obligations to its stakeholders. The standard specifies how to recognize, measure, present, and disclose leases.

It came into effect in 2019, replacing the previous standard IAS 17. Lessees are required to recognize assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. The future cash flows from leases are discounted using a discount rate determined by the company, typically the alternative borrowing rate.

What are the preconditions that make up a lease according to the IFRS 16 standard? When is there an IFRS 16 rental? The standard states that a “contract is, or contains, a lease if it conveys the right to control the use of an identified asset (the underlying asset) for a period of time in exchange for consideration.”

In addition, you need to be able to answer yes to the following questions:

• Do you obtain substantially all the economic benefits from using the asset?

• Do you have the right to direct how and for what purpose the asset is being used?

• If the answer to the questions above is no or unclear, it will still be a lease if you can answer yes to one of the following questions:

• Do you have the right to operate the asset without the supplier/lessor having the right to change that?

• Did you design the asset in a way that predetermines how and for what purpose the asset will be used?

Before IFRS 16 came into effect, leases were classified either as operating leases or finance leases. Operating leases did noxt appear on the balance sheet. Finance leases did appear on the balance sheet. For reporting periods starting on or after 1 January 2019, this distinction no longer applies where companies report under IFRS. 

IFRS 16 requires most leases to be “capitalized” by recognizing both “right-of-use” assets and lease liabilities on the balance sheet. This includes leases for property, equipment and vehicles – and more. The change affects lease accounting for all companies that report under IFRS. The only exemptions are for leases with terms of less than 12 months without purchase options or where the underlying asset is of low value. 

IFRS 16 makes financial statements more transparent. The standard makes it easier to compare companies that prefer to lease assets to companies that predominantly buy assets. Thus, IFRS 16 allows users of financial statements to make more informed comparisons between companies in particular sectors. 

“IFRS 16 results in an increase in assets, liabilities and net debt where leases are brought on to the balance sheet, and can also affect key accounting and financial ratios impacting a company’s attractiveness to investors and its ability to raise finance,” writes EY. 

An EY survey reviewed the financial statements and reports from 58 Fortune Global 500 companies across 12 sectors. “As well as the 14% increase in total assets, the survey found that liabilities had grown by more than 20% on average across the airline, retail and apparel, and shipping and transport sectors,” EY concludes.

The IFRS 16 discount rate is used to calculate the net present value of future cash flows from lease payments. This is because leases are considered to be a form of financing, in which the lessee is effectively borrowing the use of an asset from the lessor. The lease payments that the lessee makes to the lessor represent the cost of borrowing that asset, and the discount rate is used to adjust those payments for the time value of money. 

Specifically, the present value of the lease payments is the amount that the lessee would need to pay today in order to meet its future lease obligations, discounted at the appropriate rate. This present value is then used as the basis for recognizing a liability and a right-of-use asset on the balance sheet.

The discount rate used for IFRS 16 varies between companies depending on risk, currency, and the duration of a lease contract. The discount rate is the rate implicit in the lease, if it can be determined. The discount rate should represent the alternative borrowing rate if the company had purchased the asset rather than leasing it and financed the purchase with debt. 

Determining the discount rate is considered one of the most challenging elements in IFRS 16. As stated in the standard:

“If the lessee cannot readily determine the interest rate implicit in the lease, then the lessee uses its incremental borrowing rate. This is the rate that a lessee would have to pay at the commencement date of the lease for a loan of a similar term, and with similar security, to obtain an asset of similar value to the right-of-use asset in a similar economic environment.”

IFRS 16 requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases, except for short-term leases and leases of low-value assets.

To calculate the values of these assets and liabilities, lessees should use the following steps:

1. Determine the lease payments: The lease payments are the total payments to be made by the lessee over the term of the lease, including any variable lease payments that depend on an index or a rate, but excludes any payments for options to purchase the underlying asset.

2. Determine the lease term: The lease term is the period over which the lessee has the right to use the underlying asset, and can include any options to extend or terminate the lease.

3. Determine the discount rate: The discount rate is the rate at which the lease payments should be discounted to present value. This is typically the lessee's incremental borrowing rate, which is the rate that the lessee would have to pay to borrow the funds necessary to purchase the underlying asset.

4. Calculate the present value of the lease payments: The present value of the lease payments is the sum of the products of each lease payment and the discount factor for the corresponding period.

5. Recognize the liability and the asset: Recognize the lease liability, which is the present value of lease payments. Recognize a right-of-use asset, which is the difference between the lease liability and any lease payments made in advance. The right-of-use assets should be amortized on a straight-line basis over the lease term.

IAS 17 is the predecessor to IFRS 16, in which only the financial leases were recorded in the balance sheet, and not operational leases. At the implementation of IFRS 16, IAS 17 was repealed. A "financial lease" is a lease that transfers substantially all the risks and rewards of ownership of an asset. IAS 17 also had less requirements regarding disclosures outside the scope of the standard.

IFRS 16 requires companies to change the way they account for leases on their financial statements, so compliance with the standard requires a number of steps. Here are a few key actions that companies will need to take in order to comply with IFRS 16:

1. Identify leases: Companies will need to review all of their existing contracts to determine which ones qualify as leases under IFRS 16. This includes not only traditional leases of property, plant, and equipment, but also leases of assets such as vehicles and equipment, as well as service and licensing agreements.

2. Assess the lease term: For each lease, companies will need to determine the lease term, which is the period over which the company has the right to use the underlying asset. The lease term should include any options to extend or terminate the lease that are reasonably certain to be exercised.

3. Determine the lease payments: For each lease, companies will need to determine the lease payments, which are the payments to be made by the company over the term of the lease. This includes any variable lease payments that depend on an index or a rate.

4. Determine the discount rate: The discount rate is the rate used to calculate the present value of lease payments. It's typically the company's incremental borrowing rate, which is the rate that the company would have to pay to borrow the funds necessary to purchase the underlying asset.

5. Recognize right-of-use assets and lease liabilities: Once the lease payments, term, and discount rate have been determined, companies will need to recognize a right-of-use asset and a lease liability on their balance sheet for each lease. The right-of-use assets should be amortized on a straight-line basis over the lease term, and the lease liability should be recorded at the present value of the lease payments.

6. Disclose relevant information: Companies will also need to provide additional disclosures in the notes to the financial statements about the nature of their leases, the amount and timing of lease payments, and the carrying amounts of their lease liabilities and right-of-use assets.

It's important to note that compliance with IFRS 16 requires a significant amount of work, including both data gathering and analysis, and adjustments to accounting systems and processes. It's advisable to seek professional help from an accountant or an auditor to make sure the company will comply with the standard in the correct way.

IFRS 16 is effective for annual reporting periods beginning on or after 1 January 2019, with earlier application permitted (as long as IFRS 15 is also applied). Many organizations chose the simplified implementation to IFRS 16, where all contracts were listed with a lease liability equal to the net present value of the future cash flows from that date. The right of use asset was in most cases set to be equal to the lease liability on implementation and depreciated using a straight-line method.

IFRS 16 was introduced to provide more transparency and consistency in the way that leases are accounted for on a company's financial statements. Prior to IFRS 16, leases were accounted for in two different ways: operating leases and finance leases.

Under the previous standard, IAS 17, leases were classified as either operating leases or finance leases, with different accounting treatments for each. Operating leases were not reflected on the balance sheet, while finance leases were recorded as assets and liabilities. This meant that leases were not fully reflected in the company's balance sheet, making it difficult for investors and other stakeholders to understand the company's liabilities. The goal of IFRS 16 is to improve the comparability and transparency of financial statements, giving users a better understanding of a company's obligations and assets.

Furthermore, IAS 17 was criticized for providing too much discretion to companies on how to account for leases. Many companies used the operating lease treatment to avoid reflecting lease liabilities on the balance sheet, resulting in an incomplete picture of the company's liabilities and financial position. With IFRS 16, all leases (except for short-term leases and leases of low-value assets) are required to be reflected on the balance sheet.

In summary, IFRS 16 was introduced to improve the comparability and transparency of financial statements. It gives users a better understanding of a company's obligations and assets. Also, it reduces discretion and provides more consistency in lease accounting treatment.

IFRS 16 is an international financial reporting standard issued by the International Accounting Standards Board (IASB), while local Generally Accepted Accounting Principles (GAAP) refer to the accounting standards and guidelines that are specific to a particular country or region.

Most companies report on local GAAP before the group converts the GAAP figures into IFRS compliant numbers. Normally, the company reverses the locally recorded lease payments. Instead, the company records costs arising from interest and depreciation instead.

Regarding IFRS 16, many countries and regions have their own accounting standards for leases prior to its introduction, and some of them are similar to IAS 17 (the standard that was replaced by IFRS 16), while others have variations. So the impact of IFRS 16 adoption on companies in different countries and regions can vary, some companies may have a significant change in their financials while others may not be affected as much. It's important for companies to understand the differences between IFRS and local GAAP, and how they will be impacted by IFRS 16 in their specific circumstances.

Companies that report their financials under IFRS are required to comply with IFRS 16, and in some cases, are also required to reconcile their financial statements with local GAAP, for regulatory or other purposes. In such cases, the company will have to provide explanation in the financial statement notes on how the standards differ and how the reconciliations were made. It's advisable to seek professional help from an accountant or an auditor to make sure the company will comply with both standards correctly.

IFRS 16 can affect EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) in a number of ways. EBITDA is a commonly used measure of a company's operating performance, and it is calculated by adding back interest, taxes, depreciation, and amortization to net income.

As the costs according to IFRS 16 mostly relates to interest and depreciation, the standard will have a positive effect on the EBITDA compared to non-IFRS accounting.

IFRS 16 results in an increase in assets, liabilities, and net debt. That is because leases are brought on to the balance sheet. Moreover, other operating expenses will be reduced as lease expenses are reversed from the profit and loss statement, depreciation expenses will be increased due to capitalized right-of-use assets, and interest expenses will be increased due to higher liabilities in the balance sheet. 

IFRS 16 affects financial statements in a number of ways, primarily by requiring companies to recognize lease liabilities and right-of-use assets on the balance sheet for all leases, except for short-term leases and leases of low-value assets. This means that leases will now be reflected on the balance sheet in a similar way to finance leases under previous accounting standards, providing more transparency and comparability of a company's liabilities and assets.

Here are a few specific ways in which IFRS 16 affects financial statements:

Balance sheet: Lease liabilities and right-of-use assets will be added to the balance sheet, giving a more complete picture of a company's liabilities and assets. This also means that the equity section of the balance sheet will also be affected, as the lease liabilities are a form of long-term liabilities and will decrease equity.

Profit and loss statement: Lease payments, which were previously classified as operating expenses, will now be split into an interest expense and amortization of right-of-use asset in the income statement, which may affect the company's profitability measures.

Cash Flow statement: The lease payments will now be split between the financing activities and operating activities section of the cash flow statement, reflecting the financing nature of leases.

Notes to the financial statements: Companies will be required to provide additional disclosures in the notes to the financial statements about the nature of their leases, the amount and timing of lease payments, the lease term and the carrying amounts of their lease liabilities and right-of-use assets.

It's important to note that the impact of IFRS 16 on financial statements can vary depending on the nature and amount of a company's leases, and companies should review their lease agreements and assess the impact of the standard on their financial statements. Companies are required to provide additional disclosures in their financial statement notes to help users of the financial statements to understand the impact of IFRS 16 on the statement numbers.

A right-of-use (ROU) is the right to use an underlying asset. A lease liability is the obligation to make payments. A customer (lessee) measures the lease liability at the commencement date of the lease. The commencement date is the point in time when a lessor makes an underlying asset available for use by a lessee.

Lease liability = Present value of lease rentals + Present value of expected payments at the end of a lease.

At the commencement date, a customer measures the right-of-use asset at a cost that includes the following: Lease liability + Initial direct costs + Prepaid lease payments + Estimated costs to dismantle, remove or restore – Lease incentives received = Right-of-use asset.

We believe the following steps represent a useful checklist for implementing IFRS 16 and reporting for the first time:

1. Review existing contracts: Review all existing contracts to determine which qualify as leases under IFRS 16.

2. Determine the lease term: For each lease, determine the lease term, which is the period over which the company has the right to use the underlying asset.

3. Determine the lease payments: For each lease, determine the lease payments, which are the payments to be made by the company over the term of the lease.

4. Determine the discount rate: For each lease, determine the discount rate, which is the rate used to calculate the present value of lease payments.

5. Recognize the right-of-use assets and lease liabilities: Recognize a right-of-use asset and a lease liability on the balance sheet for each lease.

6. Amortize the right-of-use assets: Amortize the right-of-use assets on a straight-line basis over the lease term.

7. Update accounting systems and processes: Update accounting systems and processes to ensure compliance with IFRS 16.

8. Update financial statement disclosures: Provide additional disclosures in the notes to the financial statements about the nature of the leases, the amount and timing of lease payments, and the carrying amounts of lease liabilities and right-of-use assets.

9. Test the accounting: Perform testing on the new accounting to ensure it's in compliance with IFRS 16.

10. Review and finalize the financial statement: Review and finalize the financial statement with the new data and disclosures, and make sure that all the required information is presented.

All lease contracts with duration longer than one year related to an underlying asset of a value higher than USD 5,000 applies to IFRS 16. That means most property, parking, and land rentals are relevant for IFRS 16.

As software licenses are considered an intangible asset, not fixed assets, these contracts are normally disregarded in IFRS 16 reporting. 

Today, most software transactions are fees paid to the supplier to access the supplier’s application software running on the supplier’s cloud infrastructure (Software as a Service - SaaS). A contract that conveys to the customer only the right to receive access to the supplier's application software in the future is a service contract. Thus, a software lease is a licensing agreement outside the scope of IFRS 16. 

No. Under IFRS 16, the lessee does not distinguish between finance lease contracts (on balance sheet) and operating lease contracts (off balance sheet). 

Before IFRS 16 came into effect in 2019, it used to be the case under the IAS 17 standard that most businesses chose to categorize leases as operating leases to keep them off the balance sheet. The IFRS 16 way of lease accounting, however, is based on the principle that a lease contract is the acquisition of a right to use an underlying asset with the purchase price paid in installments. 

IFRS 16 led to a substantial increase in the amount of recognised financial liabilities and assets (when comparing to a world where operating leases dominated). The lease liability is measured at an amount equal to the present value of the lease payments during the lease term.

Under IFRS 16, the lessee does not distinguish between finance lease contracts (on balance sheet) and operating lease contracts (off balance sheet). According to IFRS 16 all leases should be treated (more than less) the same way finance leases were under the IAS 17 standard. Thus, the answer to this question is no.