Introduction to IFRS 16
The IASB lease accounting standard
In 2019, the latest IASB lease accounting standard, IFRS 16, began to go into effect for companies worldwide. Among other requirements, IFRS 16 required that most leases be capitalized and recorded on the balance sheet, changed how they’re reported, and eliminated most operating (non-capitalized) leases. According to AICPA approximately 90 countries have now adopted IFRS. Aligned closely to IFRS 16, there are many country-specific versions such as AASB 16 in Australia, NZ IFRS 16 in New Zealand, FRS 116 in Singapore, HKFRS 16 in Hong Kong, K-IFRS 16 in South Korea to name a few.
Why the standard was introduced
The financial statement fraud in Enron, WorldCom and others were drivers to the creation of the new lease accounting standard. IFRS 16 closed the loophole which allowed corporations to hide certain assets and liabilities off-balance sheet. Under the standard, companies are required to capitalize most leases on the balance sheet — reporting them as right-of-use assets and lease liabilities. As a result of the shift, capitalized lease obligations face increased auditor scrutiny, pushing companies to focus on ensuring accuracy and completeness of what they report as well as leading to greater transparency and comparability of financial statements.
The major changes for lessees
The most notable change is the elimination of the operating lease classification. Under IFRS 16, all leases, excluding those that meet the practical expedient for low-value and short-term leases, if elected, are treated as finance leases. The lease assets and liabilities are recognized on the statement of financial position, which may result in a significant increase in the amount of assets and liabilities many companies report. Finance leases are also reported differently on the profit and loss (P&L) statement than operating leases under the previous standard. Operating leases were reported as a straight-lined rent expense. However, under IFRS 16, all leases expenses are reported as a separate (usually straight-lined) amortization expense of the asset and a declining interest expense based on the liability being reduced with periodic payments. As a result of the standard, the lease expense will likely impact financial metrics such as EBITDA, as amortization and interest are excluded from the EBITDA calculation while lease expense is included in the EBITDA calculation.
The IASB also considers leases to be debt, and as such, debt to equity ratios may see a dramatic increase. This could impact debt covenants not covered by frozen GAAP contractual provisions as well as credit ratings, if the lease liability recognition resulting from the adoption of IFRS 16 is significantly different from analysts’ expectations. Lastly, remeasurements of the lease liability are required due to changes in variable rents, such as those based on an index or rate.
Lease accounting standard summary
Technical guides from the Big Four and accounting boards
Since the original publication of a IFRS 16 in 2016, the big four and accounting boards have released multiple guides to help companies understand the technical accounting of the new standard.