January 2019 marks the entrance of IFRS 16 into force – the latest and updated of the International Financial Reporting Standards, which will change the way in which companies should record, estimate, provide and disclose such leases.
With changes to come, here are a few core things you need to consider when implementing IFRS 16:
1. Prepare To See New Assets In Your Balance Sheet
In calculating rents, tenants must now differentiate between the capital lease and the operating lease, but according to the International Accounting Standards Board, this will create some sort of off-balance sheet financing.
When IFRS 16 becomes effective, almost all leases will need to be recorded in the balance sheet as assets and liabilities to resolve the problem.
2. Evaluate Your Contracts Carefully
The definition of a lease is broader under IFRS 16 than is stated in the current IAS 17, so companies will need to assess their contracts whether they fall under the new guidance.
IFRS 16 provides that a contract is a lease if it “transfers the right to control the use of a specific asset for a period of time against a benefit” (IFRS 16: 9).
To determine whether a contract can be considered as a lease, companies will therefore need to determine whether there is a specific asset and whether they are entitled to all economic benefits arising from the use of that asset and can control the asset as well and direct its use. Therefore, for example, if your company rents 60m and the lessor has the right to change from one location to another then it wouldn’t be identified asset. But, on the other hand, if you are going to rent location XYZ it would be identified asset.
3. Appreciate the potential impact on your debt covenants and KPIs
Companies should expect on their periodic reporting date or if they have debt with some covenants that IFRS 16 will impact performance measures and financial ratios such as:
- Current ratios
- Leverage ratios
- Interest coverage ratio
- Activity ratios of assets
- Profitability ratios
The impact will also extend to the classification of cash flows.
Companies that are in their process of filing in stock markets should analyze the potential impact of applying IFRS 16 on their measures.
4. Take a benefit of the available exceptions in IFRS 16
IFRS 16 allows for two exceptions: leases of 12 months or less with no option to purchase or renew, and leases in which the underlying asset has a low value when it is new.
In all these cases companies are exempted from following the capitalization and can consider the related rent payments as an expense in the same period immediately.
‘A study on the impact of lease capitalization’, issued by the International Accounting Standards Board in February 2016, identified that the retail industry is one of the most heavily impacted, and that it would see a median increase in debt of almost 100% and in EBITDA of 41%. 35% of entities would have an increase in debt of over 25%.
Some of the significant challenges for lessees as they transition to the new standard are:
- Determining whether renewal options should be considered in the initial measurement;
- Treatment of variable lease payments; and
- Identification of triggering events that might require an assessment of the lease
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About the author:
International Accounting and Finance Trainer who’s organized and taught accounting and finance courses and workshops for more than a decade for some of the leading training companies in the Middle East.
With nearly two decades of practical financial experience for major multinational and international organizations in the banking, retail and manufacturing sectors, Hesham brings an extraordinary depth of first-hand knowledge to his teaching.
Hesham is a Certified Management Accountant (CMA) and member of the Institute of Management Accountants (IMA – US) since 2006 as well as a Chartered Business Consultant (CBC – Canada) and member of the Chartered Association of Business Administrators since 2007
Hesham is currently teaching the following courses for LEORON Institute: