The 2019 financial year requires an entity that uses International Financial Reporting Standards (IFRS) to account for its lease transactions using the new standard IFRS 16, Leases.
Words: Milton Segal
From a financial theory perspective, the concept of leasing makes economic sense. When an entity requires the use of an asset or a resource to enhance an economic activity, it need not specifically purchase the asset outright but can rather gain the ability (or right) to use the asset for a particular period. This would be in exchange for compensating the asset’s owner, most likely by way of payment.
This previous accounting standard, IAS 17, did not focus primarily on what an operating lease was but rather defined an operating lease as a lease other than a finance lease. It was the failure to prove a finance lease which resulted in an operating one. This could be interpreted as an emphasis on what a finance lease is and, perhaps in terms of hierarchy, ranks it more highly than the operating lease.
While the difference in classification of finance versus operating leases was neither overly controversial nor ambiguous, the difference between the accounting of operating versus finance leases was both significant and material. For an operating lease, no leased asset was required to be raised, and consequently, no corresponding liability either. This resulted in the accounting for operating leases being predominantly off-balance sheet.
With the implementation of IFRS 16, Leases, a significant change in the way leases are recognised, measured and disclosed has occurred. No longer will lessees be required to determine, with reference to the criteria in IAS 17 para 10, whether the lease meets the criteria of a finance lease, or not. Instead, IFRS 16 requires all leases to be accounted for, effectively, as finance leases from the lessee’s perspective. All lessees, with the exception of those contracts, deemed low value or short term (12 months or less) are now required to recognise a right of use (ROU) asset (IFRS 16, para 23), with a corresponding liability on their balance sheet (IFRS 16, para 26).
The intention of the standard has conceptual merit and does embody the spirit of the revised conceptual framework. The new standard requires the asset, which is the economic resource to be capitalised, and the matching liability, which is the obligation to transfer an economic resource, to be presented in the financial statements.
Much has been written and speculated about the effects of this change in accounting. This requires detailed analysis and also a measured amount of user education in order to interpret the effects of the adoption of the new standard. The focus of this article, however, is on the practical implications of the standard and how the increase in quality of the reporting ought to be seen in a positive light and effectively embraced.
From a reporting perspective and with reference to the conceptual framework, what is being disclosed now are simply the contractual and commercial obligations that a lessee has always had. This is an important point that should be considered. If an entity entered into no more lease contracts in its 2019 financial year and, for the sake of brevity, all its lease contracts that were in place in 2018 were still in effect in 2019, then the contractual cash flows for the entity would be exactly the same as they were irrespective of whether the accounting methodology used us that of IAS 17 or IFRS 16. In other words, the cash position of the entity represented through the cash flow statement remain unchanged. The adoption of the new standard has not obligated the entity to incur any more debt, rather it aims to be more transparent in disclosing the actual future cash flow implications.
There are, of course, consequences to a somewhat radical change to lease accounting. An entity’s ratios will change due to predominantly undisclosed debt now forming part of key ratios such as debt: equity and capital structuring ratios. However, one should not focus too highly only on the credit side, that is, the new lease liability. An asset has been created, known as the right of use asset (ROU). This represents to an entity the future economic benefits under the control of the entity which should produce and increase in future economic benefits. It is indeed the right to use the asset (as specified in the lease agreement) that has incurred debt, that is, the future contractual cash outflows.
The IASB has thus, other with the effect of two minor exclusions that relate to short-term leases and low-value (read non-material), levelled the playing field in so far as lease accounting is concerned. Lessees simply record the lease liability and the lease asset at related to the contracts. The liabilities, depending on terms within the contract bare interest and that interest is calculated using the effective interest rate and disclosed in the income statement. Payments against the lease liability first offset accrued interest and then reduce the capital balance outstanding. The simple application of compound interest to what is a financial instrument. Again, a return to greater transparency and a truer reflection of the effects of the transactions in so far as the costs and implications of borrowings are concerned.
The asset too gets reduced as the right to its use reduces. The mechanism used in the simple approach of amortisation reflected through the income statement, much the same as the mechanism that an owned asset’s consumption is recognised, but with arguably easier rules of impairment.
So in summary, we have open disclosure of an entity’s debt obligations, cash flow effects of settling the debt, the ROU asset acquired and its consumption. It paints a truer painting and the IASB should be acknowledged for this.
Why the hype? Why the discomfort with the new standard? In short, it has the potential to cause operational movements which may come at a cost. Records for existing lease contracts will have to be found, updated and checked. Depending on the quantum of lease contracts that the lessee has, this may require system changes and integration and result in a case that the much-beloved Excel spreadsheet may no longer suffice as the tool for lease accounting. It will require more attention to be paid in this regard which can only be seen as a positive move in creating a set of financial accounts that are a truer representation of an entity’s financial status. The users of the financial statements ought to and will appreciate this. Consider this then too as a mechanism of installing greater governance within the accounting system, again adding the usefulness and accuracy of corporate reporting as a whole.
A point to note, too, is that all entities are affected by IFRS 16, not just certain ones. Of course, some sectors such as retail and telecommunication who traditionally have a lot more lease type operational contracts will be more affected, in so far as the quantum of their contracts, than others. However, all retailers will apply the same judgements and methodologies required by IFRS 16, which should level the playing field. While the financial ratios will change in comparison to prior periods, they will change consistently across all affected entities. Once the 2019 transition has occurred, going forward, there should be a return to greater consistency win the ability to analyse the entity’s financial results.
Mature and informed users, once they become more informed and aware of the new standard, should be able to reach a similar conclusion in the analysis of a lessee’s AFS, before and after the IFRS 16 application. Indeed, perhaps the initial panic over the implementation was a trigger reaction to change.
In a world of rapid change, continuous evolution within this fourth industrial revolution, artificial intelligence replacing human intelligence and processes on an almost daily basis, IFRS 16 can be seen as welcomed return to tradition accountancy and almost old-fashioned basic accounting. Indeed, greater transparency at a time that the accounting world perhaps needs it the most.
References are available on request
AUTHOR l Milton Segal CA(SA) is Senior Executive: Corporate Reporting at SAICA