By: Ivan Marx Olarte, CPA
The year 2019 is drawing near. Comes with the change of year is the change in the accounting for leases through the implementation of International Financial Reporting Standards (IFRS) 16. This is a new accounting standard superseding the old standard for leases, International Accounting Standards (IAS) 17.
Issues on Old Standard
IAS 17 requires companies to identify whether they have substantially all the risks and rewards related to the leased asset and accounts for the transaction either as a finance lease or an operating lease in accordance with this assessment.
Finance lease requires companies to recognize a leased asset and lease liability measured at the present value of the minimum lease payments. Payments will be recognized in two ways: as payment of interest on lease liability and reduction of the lease liability. Depreciation expense is also recognized related to the leased asset.
Operating leases do not recognize any leased asset or lease liability on the balance sheet. Hence, all payments are recognized as expense. This is, in effect, keeping the liability relating to the lease out of the financial statements while maintaining the right to use the asset. This is called off-balance sheet financing.
Off-balance sheet financing is popular among small businesses because it does not require them to recognize assets and liabilities on their financial statements relating to the lease and reporting only a single expense related to the lease. However, this does not provide a clear picture of the financial position and performance of the business. After all, leases are, in effect, loans which businesses enter to obtain rights to use assets.
Features of the New Standard
IFRS 16 focuses on the rights transferred and obligations incurred in relation to the lease rather than the risks and rewards transferred by the lease to the business. The IFRS now requires businesses to recognize assets (right of use) and liabilities (present value of minimum lease payments) relating to the lease, with two exemptions, namely: the leased asset is of relatively small value (i.e. lease of personal computer), and the lease term is twelve months or less. Distinction between an operating lease and finance lease is less relevant because of the recognition of assets and liabilities in the balance sheet. Lease payments will be treated as a reduction of liability and interest expense. In addition, depreciation will be recognized on the leased asset. The new standard, in effect, phases out the off-balance sheet financing related to leases.
A comparison of the two standards can be made as follows, from a lessee’s viewpoint:(1)
(1) The tables were taken from the IFRS 16 Effects Analysis published by the IASB.
As shown above, there will be no material difference in profit before taxes under the two standards despite increases in EBITDA and operating profit. What happened is merely splitting the rent expense into two: depreciation and interest.
It is worthy to note that the difference lies mostly on the balance sheet. The IFRS 16 eliminates off-balance sheet financing relating to lease by requiring lessees to recognize leased assets and lease liabilities on their balance sheet. This effectively presents the financial condition and performance of the businesses more accurately.
IFRS 16 for Lessors
IFRS 16 did not make any significant change in the accounting of lessors. It merely requires the lessor to prepare additional disclosures which provides information about the assets leased out and risks it retains relating to the lease of assets.
We all want to present a financial report that portrays the financial condition and performance of our business and useful for our decision making. Therefore, the introduction of IFRS 16 is a welcome development to achieve this. Certainly, first time adoption of this change is going to cost us some resources. But if the benefits to be derived from the change outweigh the costs of implementation, then it is a good investment on our part. Let us always strive and present a report not only useful for decision making, but is also faithfully representing the real financial conditions of the business we run.
Disclaimer: This article is for general conceptual guidance only and is not a substitute for an expert opinion. Please consult your preferred tax and/or legal consultant for the specific details applicable to your circumstances. For comments, you may also please send mail at info(@)taxacctgcenter.ph, or you may post a question at Tax and Accounting Center Forum and participate therein.
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