In this article we discuss the changes in lease standards and impact of it on accounting. The new Standard eliminates a lessee's categorization of leases as either operating leases or finance leases. Instead, almost all leases are 'capitalized' by recognizing a lease accountability and right-of-use asset on the balance sheet. There is little change for lessors. Leasing is a common form of finance.
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. The new lease standards mean 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.
What are the Changes made under IFRS 16?
On the whole, the changes relate to the procedure accounting is done within a firm for lease agreements that were made by that company on PPE (Property, Plant and Equipment). Previously, these were divided into finance leases and operating leases. Generally, operating leases were not integrated into balance sheets as resources but were just added to profit and loss accounts. The most significant IFRS 16 change is that now most leased items have to be integrated as a resource in the company books, following the new 'right to use' model. In total, the payments you make on the lease agreement have to be reported as the accountability on your balance sheet. Also, accounting can be further complex by the new standard as costs for preservation, cleaning etc. have to be separated from the central lease payments, if they’re incorporated in them, and reported independently. Added to these, the reduction of the asset and interest on the lease liability are presented on your profit and loss accounts. One 'pro' for IFRS 16 is that, if your company carries several lease agreements, it can be probable to merge them into a portfolio, as an alternative of having to report them independently. This can only be fulfilled if you can illustrate that there is no financial benefit for you in doing this.
What are the different types of 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 for 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 contract.
From January 2019, leases will no longer be categorized as an operating lease or finance lease. All contracts 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.
Lease vs Non-lease components:
The lease component is the element of account for lease accounting. Lessors and lessees need to recognize, and usually separate, lease and non-lease parts of applying the new standard. To do this, they need to assign the deliberation in the contract between the components that they account for separately.
For example, a lesser may lease a truck and also consist of a prerequisite to operate the car on behalf of the lessee. Given that a driver, preservation and gas are not related to securing the use of the truck, and these costs would be considered non-lease components.
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.
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 contract 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.
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 £17.6 Billions, Some companies went to liquidation due to the balance sheet debt, such as HMV.
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