IFRS 16 is a new leasing standard which will be replacing the old leasing standard, IAS 17. This new standard is effective for annual reporting periods beginning on or after January 1, 2019.
Under the old standard, IAS 17 the substance of the lease agreement determined whether the lease was an operating lease or a capital lease. For example, a lease transferring ownership at the end of the lease term or a lease for a period representing a major part of the economic life of the asset etc. would both be treated like capital leases. IFRS 16 differs fundamentally from this approach.
In a nutshell, IFRS 16 requires all leases (with limited exceptions) to be capitalized. The only exceptions to capitalizing are for (i) short term leases (12 months or less with no purchase option) and (ii) low-value leases (The IASB has suggested this amount is approximately $5,000 USD).
The impact of this new standard will mostly be felt by lessees that have significant operating leases. As an example a car that is leased. Under IAS 17 this car lease, if it met the conditions not to capitalize, would only expense the lease payments in the year and disclosed in the commitments note future lease payments. Under IFRS 16, the right-of-use of the car would now be recognized as an asset on the balance sheet, and the related lease would be recognized as a loan liability on the balance sheet.
The initial measurement of the lease liability would be based on the present value of the future cash payments under the lease. The initial measurement of the lease asset would be based on the cost of the right-of-use of that asset.
Subsequent to initial recognition, leased assets would be depreciated, and are also subject to impairment testing. Liabilities would be reduced by the principal portion of the lease payments made.
Clearly one of the major changes from the adoption of IFRS 16 will be the introduction of a potentially significant asset and liability to the balance sheet. The new standard will also require a number of additional note disclosures. But, in addition to these major presentation differences and additional note disclosures, it will be very important to understand the impact that these changes will have on financial ratios and other financial metrics. Consider, this partial list of the possible effects of adopting IFRS 16:
- Current ratio – decreases because current liabilities increase (we recognize the current portion of a lease liability) while current assets do not change.
- Asset turnover (Sales/total assets) – decrease because total assets increase, and sales do not change.
- EBITDA (profitability) – will increase because expenses that would have been deducted under IAS 17 (e.g. rent expense or other operating lease expenses) will now, because of capitalization of the lease under IFRS 16, now be in the form of interest and depreciation expenses which are specifically excluded from EBITDA.
The main goal of this very brief introduction to IFRS 16 was to hopefully convince those that report using IFRS (especially those with operating leases) of the potentially very significant effects of this changeover. Even though 2019 seems far away, a change of this magnitude and complexity should be addressed well in advance.
Contributed by Trevor Reef, CPA, CA – Senior Manager, from Segal LLP. This piece was produced as a part of the quarterly Canadian Overview, a newsletter produced by the Canadian member firms of Moore Stephens North America.
This article is from the quarterly Canadian Overview, a newsletter produced by the Canadian member firms of Moore Stephens North America. These articles are meant to pursue our mission of being the best partner in your success by keeping you aware of the latest business news.