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Moore Stephens North America
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IFRS 16: a new standard for leases
The new IFRS 16, Leases, will replace the former IAS 17, Leases. This new standard will be effective for financial years beginning on or after January1, 2019.
Under the previous IAS 17, it was the content of the lease contract that determined whether it was an operating or a capital lease. For example, a lease with transfer of ownership at the end of the contract, or a lease for a period that constituted the major part of the asset’s economic life, and so on. were both considered to be capital leases. IFRS 16 takes a fundamentally different approach.
In a nutshell, IFRS 16 requires all leases (with a few exceptions) to be capitalized. The only exceptions to this rule are (i) short-term leases (i.e. leases with a term of less than 12 months and no purchase option) and (ii) leases where the underlying asset is of low value (i.e. a value of around US$5,000, as suggested by the IASB).
The effects of this new standard will be felt most by lessees with large operating leases. Let’s take the example of a car rental. Under IAS 17, this lease, if it met the conditions for not being capitalized, would only record lease payments during the year and disclose future lease payments in the note on commitments. Under IFRS 16, the right to use the car is now recognized as an asset on the balance sheet and the lease of this car is recognized as a loan liability on the balance sheet.
The initial measurement of lease liabilities is based on the present value of future lease payments. The initial measurement of the lease asset is based on the costs associated with the right to use the asset.
After initial recognition, leased assets are depreciated and tested for impairment. The capital component of lease payments will be deducted from liabilities.
Clearly, one of the main changes resulting from the adoption of IFRS 16 will be the introduction of potentially significant assets and liabilities to the balance sheet. The new standard will also require the presentation of additional notes. In addition to these major differences in presentation and the addition of notes, you’ll need to understand the impact these changes will have on financial ratios and other financial indicators. Let’s take a look at this non-exhaustive list of the possible effects of adopting IFRS 16:
- The working capital ratio decreases as current liabilities increase (the current portion of a lease liability is recognized) while current assets remain unchanged.
- The asset turnover ratio (sales/total assets) falls because total assets increase, while sales remain unchanged.
- EBITDA (profitability) increases because expenses that would have been deducted under IAS 17 (such as leasing costs or other operating lease expenses) will now be presented as interest and depreciation charges, under IFRS 16 on capitalized leasing, which are specifically excluded from EBITDA.
The main aim of this very brief presentation of IFRS 16 was, we hope, to convince those who present their financial information under IFRS (particularly those who have entered into operating leases) of the significant effects this change could have. Although fiscal 2019 may seem a long way off, a change of this scale and complexity needs to be addressed well in advance.
With contributions from Trevor Reef, CPA, CA – Senior Manager at Segal LLP. This article was written as part of the Quarterly Canadian Snapshot, a newsletter published by the Canadian member firms of Moore Stephens North America.
