Transparency In Finance: How IFRS 16 Is A Positive Change For Accounting
IFRS 16 Lease Standard will replace IAS 16 Lease Standard for reporting periods beginning on or after 1 January 2019.
The new accounting standard is expected to impact all companies in general and certain sectors in particular—retail, airlines, shipping, healthcare, and transport and logistics—with the release onto balance sheets of about $3.3 trillion of lease commitments.
Retailers, for instance, are struggling with the transition because the sector typically leases property in addition to a large number of assets used within stores and their other premises. According to Julie Carlyle, chair of the Institute of Chartered Accountants in England and Wales (ICAEW), it isn’t unusual for a large retailer to have as many as 10,000 leases.
In the past, retailers may not have been concerned about having comprehensive operating lease data, but this will change under IFRS 16. Retailers will have to collect as many as 80 data points for each lease, with some of the information relating to contracts going back 30 years. This headache is made worse when information must be collected on rent payments and rent increases over lengthy lease periods, sometimes pre-dating their electronic records.
Although International Financial Reporting Standard (IFRS) 16 adoption and compliance seems like a daunting task at the outset, including all leases on the balance sheet, will provide more accurate, comparable data, and far greater financial transparency than exists at present.
The Change Needs To Happen
Pre-IFRS 16, investors were forced to make an educated guess about the material relevance and impact to the financial reports of off-balance sheet leases. When work first began on the new accounting standard in 2005, the US Securities and Exchange Commission (SEC) estimated that US public companies had about $1.25 trillion of lease commitments off balance sheet.
This is increasingly nonsensical in an age of data analytics when so many enterprises already have processes in place that inspect, cleanse, transform and model data with the purpose of finding useful information, suggesting conclusions and supporting decision-making. Clearly, accounting standards have to change to provide businesses and stakeholders with data that is similarly accurate, comparable and transparent.
IFRS 16 is the culmination of a joint project between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), the US national standard-setter. Its purpose is to improve the accounting for leases in International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP).
What Will Be Different With IFRS 16?
The biggest change that will result from IFRS 16 is around operating and finance leases. In the past, leases have been categorised as either operating leases, which are disclosed only in the notes to financial statements, and finance or capital leases reported on the balance sheet.
In order to comply with IFRS 16, companies will be required to report all leases on their balance sheets as assets and liabilities. This change is likely to bring £1.7 trillion onto balance sheets, globally, and will impact every area of finance, from asset turnover, net income and cash flows, to interest cover and operating profit.
The starting point will be to determine if a contract meets the definition of a lease, which applies when “a customer has the right to control the use of an identifiable asset for a period of time in exchange for consideration”. IFRS 16 Leases has detailed information to guide companies through the various issues that determine if a contract contains a lease or a service, or both.
The most significant outcome of the new standard on businesses will be an increase in lease assets and financial liabilities. Businesses that have material off-balance sheet leases, will need to change the key financial metrics obtained from the company’s reported assets and liabilities.
Lessees are not required to recognise as assets and liabilities: short-term leases of 12 months or less, and leases of low-value assets—an asset with a value, when new, of about $5,000. Both the Financial Accounting Standards Board (FASB) and the IASB have proposed the exclusion of small ticket leases from the balance sheet to help reduce the impact and costs of transitioning to the new standard.
Lessor accounting will remain unchanged for now. The International Accounting Standards Board (IASB), along with investors and analysts, believe the cost of changing lessor accounting outweighs any benefit that may be derived from change.
How IFRS 16 Will Improve Financial Transparency
The new standard will improve issues that have arisen in the past 30 years with the previous standard (IAS 17 Leases and related interpretations) in the following ways:
- Improve policies for lease management, procurement and accounting.
- Produce positive adjustments and pragmatic improvements to processes.
- Highlight systems gaps and inefficiencies in IT infrastructure.
- Enhance portfolio optimisation.
- Implement advanced lease management software.
- Increase transparency of financial statements.
- Provide opportunity for savings and ROI through best-practice lease portfolio management.
- By bringing much-needed transparency to companies’ leased assets and associated liabilities, comparability between companies that lease and those that borrow to buy will significantly improve.
The new standard will lead to a more faithful representation of a company’s assets and liabilities and improved financial transparency concerning a business’s financial leverage and capital employed. It’s envisaged that this will reduce the need for investors and analysts to make adjustments to amounts reported on a lessee’s balance sheet and income statement and for companies to provide ‘non-GAAP’ information about leases.
IFRS 16 will also improve comparability between companies that lease assets and companies that borrow to buy assets, providing transparent information about leases to all market participants. A company will more accurately measure assets and liabilities arising from leases applying IFRS 16 as compared to the estimates made by only more sophisticated investors and analysts when companies applied IAS 17.
If you would like to find out more, download the 7 Step Guide To Lease Accounting Compliance. The free best practice guide explores the practical considerations and steps companies should take when preparing for the new standards, whilst also providing practical guidance on a variety of technical and strategic issues. To access your copy just follow the link below: