IFRS (International Financial Reporting Standards) issued a new lease standard, IFRS 16, taking place from 1 January 2019. It replaces the previous IAS 17 standards. This new lease standard means that businesses will be required to record their leases on balance sheet. As a result, increasing leased assets and financial liabilities on their balance sheet. The purpose of the new standard is to create transparency in the business’s financial overview (or situation?).
This standard is beneficial for investors and stakeholders to have a clear financial statement of companies, enabling them to compare businesses’ lease commitments with businesses that buy assets. There is a level playing field between
Operating leases and financial leases
There are two main types of leases:
Financial lease: A long term contract for the lessee to use the lessor's asset in exchange for periodical payment. The lessee is responsible of maintaining the asset. Once the term has ended, the ownership is passed onto the lessee. The asset may also be purchased at the end of the agreement. A financial lease is required to be recorded into the accounting balance sheet.
Operating lease: A short term contract for the lessee to use the lessor’s asset. However, at the end of the agreement, the asset remains under the lessor’s ownership. Under IAS 17, an operating lease is not required to be recorded into the balance; it is called an off-balance lease.
From January 2019, leases will no longer be categorised as operating lease or financial lease. All leases will be considered as a financial lease, hence will be required to be recorded into the balance sheet. As a result, the lessee’s balance sheet will have an increases asset and liability, and profit and loss statements will have increased interest cost and asset depreciation.
If the contract duration of a lease is under 12 month, businesses are not required to record into their financial statements. Hence, they will be exempted from IFRS 16, in order to reduce financial concerns.
Low value asset………
Effect on financial statement
Balance sheet: Under the previous standard, IAS 17, balance sheet consisted of the following:
- Assets: financial asset, tangible asset, receivables
- Liability and equity: Shareholder’s equity, liabilities, payable
Under the new standard IFRS 16, balance sheets now consist of the following:
- Assets: financial asset, tangible asset, receivables, and Right-of-use assets (at cost)
- Liabilities: Shareholder’s equity, liabilities, payable, and Lease payable (present value of the lease payment)
The right of use asset recorded in the balance sheet, is the initial amount of the lease liability, in addition to direct costs and initial payments made.
As a result, all industries (excluding retail and transport) had an effect on their balance, by an increase in asset and liability of 6.4% and 9.4%, respectively.
Income statement: As lease is considered to be a fixed asset, asset depreciation must be recorded, hence depreciation expense will increase in the balance sheet. A lease is also a loan, therefore, there will be an interest charge, increasing the interest expense.
Depreciation expense is an Earning Before Interest, Tax, Depreciation and Amortization (EBITDA), which is increased in the balance sheet. Interest expense is an Earning Before Interest, Tax (EBIT), which also increases.
Financial ratio: As a result of increased liability EBITDA and EBIT, there will be a significant increase in Financial ratio to EBITDA, and EBITDA and bank interest.
Effect on UK businesses
The new IRFS 16 standards have been affecting companies globally, including the UK. All businesses taking lease will be affect by the new IFRS 16 standard. Retail and transport industries have the largest number of operating lease, causing a much significant impact.
Retailers: retailers such as house of Fraser and Debenhams have been negatively affected by the changes. According to Financial Times, Tesco has an increase of net debt of £17.6Billions, Some companies went to liquidation due to the balance sheet debt, such as HMV.
Future Connect training, provide accounting training for all levels of accounting. If you would to learn more about how leases affect the balance sheets, income statements and cash flow. Our Finance accounts course all financial reporting such as balance sheet, income statement, report of the accountants and profit and loss accounts. Our course help you gain a deeper understanding or how leases asset and liabilities are reported.