Big changes are coming for the accounting profession in the form of the new IFRS 16 leasing standard under International Financial Reporting Standards (“IFRS”), redoing International Accounting Standard 17 (“IAS 17”) and IFRS Interpretations Committee 4 (“IFRIC 4”). This is effective January 1, 2019.
This leasing standard is expected to have wide reaching implications for all industries from large manufacturers to small professional practices that lease equipment. Therefore, it is prudent for CFO’s, controllers and other accounting professionals to understand the implications of IFRS 16 in order to be ready for the January 1, 2019 effective date.
In this article, we will:
The International Accounting Standards Board (“IASB”) determined that the current lease model does not accurately portray the full extent of an entity’s obligations. IFRS 16 will require most leases to be recognized by lessees on their balance sheet, which is in line with the trend being adopted throughout the world. The stated purpose is to increase the transparency companies give to the public about their debt obligations.
It is important for accounting professionals to read and understand the scope paragraph of IFRS 16, where restrictions on the applicability are placed.
Organizations that report financial results using IFRS are required to adopt IFRS 16. Organizations reporting under Accounting Standards for Private Enterprises (“ASPE”), are exempted from IFRS 16. In addition, there is no plan to change ASPE 3065, Leases, which is similar to IAS 17 and requires companies to determine if they are entering into a finance or operating lease (from either the Lessee and Lessor point of view).
For IFRS users, there are some areas where you will not have to apply IFRS 16, namely:
Low value leases aren’t defined in IFRS 16, but in the basis of conclusions the IASB indicates that a lease with a “when new” value of $5,000 or less is considered low value. This means you cannot scope out a lease that has a value remaining on a contract of less than $5,000, where the original value of the lease was greater than $5,000. Low value leases are analyzed lease-by-lease and not by category of underlying asset.
Certain specialized asset leases are exempt from IFRS 16 and will continue to be accounted for under their existing IFRS standards. These exemptions are:
The exemptions are restrictive to ensure that most leases are captured by IFRS 16.
The definition of a lease is different under IFRS 16 than it was under IFRIC 4. IFRIC 4 did not deal with differences between service contracts and operating leases, because the accounting treatment was the same. The obligation was recognized as incurred in net income and no obligation was present on the balance sheet.
Under IFRS 16, service contracts must be identified and separated from leases. Leases will focus on whether a company has the right to control and use an identifiable asset for a period of time, and for consideration agreed. This could cause problems in accounting for what you previously thought was a single operating lease. For instance, you could have a lease for equipment and the lease specifies that the price paid per month also includes monthly maintenance service. Under IFRS 16 you may need to account for a portion of the monthly payment as a service contract for monthly maintenance, and the remaining contract value will become the lease obligation for the equipment. Such an analysis may require the lessee to get information from the lessor on service call rates to be able to determine the portions of the contract that are for the equipment lease, and the service contract.
On a lease-by-lease basis, the determination of whether renewal options are likely to be exercised will need to be considered, including how often a company has exercised renewal options for similar equipment in the past, is the equipment under lease critical to the business, is the lessee planning on moving locations prior to renewal periods being executed, etc. Such a discussion should not happen only at the accounting department level, but should include input from operations and senior management.
The biggest change for leases surrounds the lessee accounting for almost all leases on balance sheet on initial recognition, with no distinction between finance and operating leases. Each lease will have a “right-of-use” asset on the balance sheet, with a corresponding lease obligation in liabilities (current, non-current, or a combination thereof depending on the terms). The initial value of the right-of-use asset and lease obligation will be measured at the present value of the lease obligations, taking into consideration the fixed payments for the initial term and any options to extend, purchase options, residual value, termination payments, indexed payments and restoration obligations.
IAS 17 required operating lease payments be recognized in net income as an operating expense. Under IFRS 16, expenses will be broken down into depreciation of the right-of-use asset (following the provisions of IAS 16, Property, plant & equipment), interest expense and an operating expense for any services included in the contract. Depending on the amortization method applied you could experience higher initial costs than under IAS 17, but the net impact to income will be the same under IFRS 16 and IAS 17 by the end of the lease.
Tax rules in Canada aren’t changing to match the new accounting rules of IFRS 16, as such new temporary differences may be created on the application of IFRS 16. In Canada, as your actual payments aren’t likely changing, your current tax payable shouldn’t be impacted. Some foreign countries assess tax payable based on accounting net income. If you have foreign operations, the potential impact of tax assessed on accounting income could be higher tax in some years and lower tax in some years. We recommend that companies with foreign operations consult their foreign tax return preparers to discuss the potential issues IFRS 16 may cause.
IFRS 16 will require more note disclosure than IAS 17, because you will be required to transition from a model that included operating leases to one that is purely on-balance sheet. Finance leases under IAS 17 had more disclosure requirements than their operating lease counterparts, and so too will the lease disclosure under IFRS 16. The handbook standard for IFRS 16 does a good job in laying out the disclosure requirements.
There is a concern that IFRS 16 could result in renegotiation of leases with lessors, or a change in how companies make lease versus buy decisions.
We believe there are three important areas that companies should address over the next six months. These include debt agreements, bonus plans and accounting systems.
For debt agreements that contain debt-to-equity or total debt covenants, the new lease standard could impact your financial ratios and ability to meet those covenants. IFRS 16 will result in an obligation on the balance sheet, with a portion classified as current. Depending on how your debt agreements are worded, the new current lease obligation could put you offside on covenants. We recommend that you look at your debt agreements with IFRS 16 in mind, confirm with your bank whether the expected changes to your balance sheet will impact covenant calculations, and, if necessary, investigate rewording those covenants with the lenders to ensure your business is not negatively impacted by IFRS 16.
Bonus plans could be impacted as EBITDA might be expected to increase under IFRS 16. Previously, companies had one operating expense related to operating lease payments. That expense is now split, with only the portion related to service contracts (if any) included in operating expenses. The rest of the historic operating expense will be split between depreciation and interest. Thus, bonuses could be higher in the future because of IFRS 16, not company performance. Companies may wish to revisit their bonus plans to minimize the IFRS 16 impact, prior to adoption.
Companies must ensure that their accounting and related IT systems can handle the new accounting rules that are being put in place and should test account for a lease under IFRS 16 to see if the existing IT systems are capable of processing the lease data in an IFRS 16 compliant format. Work with your IT resources to ensure systems are IFRS 16 capable or are upgraded ahead of the application of IFRS 16.
Lessees that are already involved in finance leases under IAS 17, and lessors in general, will carry-over their existing balances on January 1, 2019 with no restatement of prior period amounts. There is one exception to this rule, that being a lessee who is subleasing. In that case, the lessee accounts for the original lease they entered under IFRS 16 using one of the two transitional options available.
IFRS 16 has two options for transition: a full retrospective approach or a modified retrospective approach. Application choice will be based on management preference.
The full retrospective approach requires entities to restate and present their opening and comparative balance sheets at January 1, 2018 and December 31, 2018, as well as their comparative statement of operations for the year ended December 31, 2018. Companies cannot wait until December 31, 2019 to apply the retroactive changes, because the balance sheet impacts will need to be shown as comparatives in 2019 quarterly financial statements as early as March 31, 2019.
The modified retrospective approach does not require a lessee to restate comparative information. Instead, the lessee must calculate the cumulative adjustment resulting from adoption of the new standard and record it as an adjustment to opening equity as at January 1, 2019.
The full retrospective approach will result in better comparable information by displaying what the historic lease obligations were. The modified retrospective approach will require all the calculations needed in the full retrospective approach, but in terms of financial statement adjustments will take less time to apply.
Most mining companies in BC are exploration stage. Leases over property for the exploration of non-regenerative resources are exempt from the provisions of IFRS 16. These companies tend to have only minor low value office equipment under lease along with office space, so it is possible that exploration mining companies would only be impacted to the extent of their office lease. Development stage or producing mining companies will likely have mine site equipment under lease and would have to do an analysis of their leases to determine to what extent they need to bring operating leases on balance sheet.
In real estate, property managers tend to be lessors and won’t need to adjust the accounting for tenant leases. For their own office space, if a property manager leases that office space from a third party, then they will need to account for it under IFRS 16. Property developers will have leases of equipment and vehicles under which they are the lessee (in addition to office space). Property developers need to do an analysis of their various leases to comply with IFRS 16.
Use the time between now and December 31 to analyze your leases and agreements and consult with your bankers, accountants and other service providers to ensure a smooth transition to IFRS 16.
As always, please don’t hesitate to contact us with any questions you may have.