IMPACT OF IFRS 16 - LEASE Srinivas.K.R Asst. Professor, DOS in Commerce, PBMMPG Centre, Mysore. Dr Bhavani M Associate Professor DOS in Commerce, PBMMPG Centre, Mysore. Arun kumar.g Asst. Professor, DOS in Business Administration Sri Krishna Devaraya University Bellary. Abstract IFRS (lease) is issued by IASB is applicable with the effect from 1 st Jan 2019. The new standard is issued to address, how off balance sheet lease items bring back to the balance sheet and stop guesswork about to know actually leased assets and corresponding liability to the inverters and other users of the financial reports. IFRS 16 has simplified accounting process on lease and no classification like operating or financial lease, all assets under lease considered as a finance lease and also separate disclosure of interest and depreciation. The new standard will stop guesswork and bring transparency while calculating lease assets and liability. Introduction: The international accounting standards board (IASB) issued IFRS 16 lease in 13 Jan 2016. IFRS 16 set out the principals for the recognition, measurement, presentation & disclosure of leases for both parties to a contract i.e. lessee & lessor. IFRS 16 is effect from 1 st Jan 2019. The company can choose to apply IFRS 16 before that date but only if it is also applies IFRS 15 revenue from contracts with customers. IFRS 16 replaces the previous leases standard IAS 17 leases and related interpretation IFRS 16 eliminates the classification of leases as either operating leases ISBN : 978-93-5254-333-5 1
or finance leases for a lessee. Instead all leases are treated in a similar way to finance leases applying IAS 17. Leases are capitalised by recognising the present value of the lease payments and showing them either as lease assets (right-of-use assets) or together with property, plant and equipment. If lease payments are made over time, a company also recognises a financial liability representing its obligation to make future lease payments. The most significant effect of the new requirements in IFRS 16 will be an increase in lease assets and financial liabilities. Accordingly, for companies with material off balance sheet leases, there will be a change to key financial metrics derived from the company s assets and liabilities. For companies with material off balance leases, IFRS 16 changes the nature of expenses related to those leases. IFRS 16 replaces the typical straight-line operating lease expense for those leases applying IAS 17 with a depreciation charge for lease assets (included within operating costs) and an interest expense on lease liabilities (included within finance costs). This change aligns the lease expense treatment for all leases. Although the depreciation charge is typically even, the interest expense reduces over the life of the lease as lease payments are made. This results in a reducing total expense as an individual lease matures. The difference in the expense profile between IFRS 16 and IAS 17 is expected to be insignificant for many companies holding a portfolio of leases that start and end in different reporting periods. Main Features It is obvious to list out significant changes and features of the new standard, different than the present IAS 17 and related interpretations. 1. IFRS 16 abolished concept of lease categorization, called Finance Lease and Operating Lease, instead all leases will be treated like Finance Lease (as per IAS 17) in the books of lessee. 2. Future payment of lease agreements will be capitalized (in the books of Lessee) at their net present value, called Leased assets or Right of Use assets along with other assets of the entity. Corresponding liability called Leased Liability also to be recognized, representing all future payments. Thus all off Balance Sheet notes to accounts till now will form part of Balance Sheet. 3. Present value of only those leased liabilities will be considered, where payment is unavoidable and fixed. Any variable or uncertain future payments are not to be considered. ISBN : 978-93-5254-333-5 2
4. Lease payment (amount spent by the lessee to the lessor) will have two components, depreciation of leased assets and interest expenses on leased liabilities to be recorded in the entity s Income Statement and actual cash outflow will be settled against leased liabilities under Balance Sheet. 5. The new standard will be applicable only when the Lease agreement period exceeds 12 months or more and lease payment is substantial. Like small lease rental payment for furniture, office equipment etc. is not forming part of this standard. 6. Service contract is not forming part of IFRS 16 and not required to bring in to the balance sheet. If an agreement has component of both element service and l ease, IFRS 16 applies to lease component only. 7. The Lessor s books continue to recognize the leased assets in accordance with IAS 17 with certain enhanced disclosures. a. All component of lease income to be disclosed separately in accordance with IFRS 15 (revenue from contract with customer). b. Disclosure and explanation about, how the lessor manages risk involved in residual value of assets. c. Separate information about different class of operating leased assets. 8. The new Standard replaces, a. IAS 17, Leases, b. IFRIC 4, determining whether an Arrangement contains a Lease, c. SIC 15, Operating Lease Incentives and d. SIC 27, Evaluating substance of Transactions, involving Legal form of Lease 9. IFRS 16 is applicable from 1st January, 2019. Early application is permitted, as long as IFRS 15 also applies. Impact of IFRS 16 Most significant changes are its accounting model in the books of lessee. All we aware about Pre Payment of Rent/ Lease and amortization of Rent/ Lease expenses over the period of agreement, will become stuffs of past. This lease payment will be adjusted against future financial liabilities created into the Balance Sheet by the Lessee under the agreement. ISBN : 978-93-5254-333-5 3
As a professional it is prudent to understand whole conceptual framework, changes in accounting& measurement and changes of different ratios of Income Statement, Balance Sheet and Cash flow Statement by applying IFRS 16. Let us closely look at an example, where an Entity A, inter into an agreement for five year effective 1st January, 2019 and hired equipment with yearly lease payment schedule stated below. All the payments are made at the end of the period. At the end of five years, the equipment will be returned back to the lessor. The lease payment schedule (INR) Year 1 Year 2 Year 3 Year 4 Year 5 2,00,000 2,50,000 3,00,000 3,50,000 4,00,000 Accounting in the Book of Lessee Under current (IAS 17) accounting standard, above example is categorized under operating lease and accordingly at the time of making lease payment, transaction will be recorded as: Settlement of Lease Payment under IAS 17 Year 1 Year 2 Year 3 Year 4 Year 5 Total Lease (Operating Dr. ) 2,00,000 2,50,000 3,00,000 3,50,000 4,00,000 15,00,000 Cash /Bank Cr. 2,00,000 2,50,000 3,00,000 3,50,000 4,00,000 15,00,000 Settlement of Lease Payment under IAS 17 Year 1 Year 2 Year 3 Year 4 Year 5 Total Lease Liabilities Dr 1,36,100 1,92,900 2,52,600 3,15,200 3,81,000 12,77,700 Finance Charges(Operating ) Dr 63,900 57,100 47,400 34,800 19,000 2,22,300 ISBN : 978-93-5254-333-5 4
Cash/bank 2,00,000 2,50,000 3,00,000 3,50,000 4,00,000 15,00,000 From above, it appears, lease expenses treated as operating expenses forming part of EBIDTA and no impact on balance sheet under IAS17, while IFRS 16 makes a partial settlement of financial lease liabilities and interest expenses impacting both income statement and balance sheet. At the end of first year closing, a note explained that the entity has future lease liability for Rs. 13, 00,000 (amount pertains to year 2 to year 5). This amount called off Balance sheet item, since the amount not recorded or recognized by the lessee and Rs. 13, 00,000 disappears from the Balance sheet under IAS 17. Also, present value of the future liability opens a guesswork for user of the financial statement is cause of concern and real liability and corresponding assets remain unknown. To overcome this deficiency, the new standard (IFRS 16) steps in. Under this, lessee will measure and record leased assets and liabilities by applying Net Present Value (NPV) on a reasonable and logical discount factor based on current market scenario. In the above example, if discount rate taken as 5%, NPV will be Rs. 12, 77,700. Accordingly, at the time of entering into The agreements, lessee will recognize leases assets and liabilities in its book by passing following journal. Dr. Right of Use (Lease) Asset Rs.12, 77,700 Cr. Lease Liabilities Rs. 12, 77,700 (Asset and liabilities created based on present value of lease payments @5% discount) Impact of above in the financial statement in next five years if compared with existing standard (IAS17), the resultant income statement would be as follows. Certain figure of interest adjusted during Y5 to equalize. Standard Applies Item of Year 1 Year 2 Year 3 Year 4 Year 5 Total IAS 17 Operating 2,00,000 2,50,000 3,00,000 3,50,000 4,00,000 15,00,000 IFRS 16 Depreciation 2,55,500 2,55,500 2,55,500 2,55,500 2,55,500 12,77,700 Interest 63,900 57,100 47,400 34,800 19,000 2,22,300 ISBN : 978-93-5254-333-5 5
Total charged P&L to 3,19,400 3,12,600 3,03,000 2,90,400 2,74,600 15,00,000 Difference Changes in the Net Profit / Equity 1,19,400 62,600 30,000 (59,600) (1,25,400) - IFRS 16, it impacted EBITDA, net profit and related operational ratios, as compared to IAS 17 into the Income Statement, where Balance sheet significantly changes due to creation of assets and financial liabilities. Cash flow statement changed by cash generated from operation activities changes to financial activities to the extent amount charged to interest. Since leverage ratio changes, bank s covenant will also get changes significantly. In due course, banks will alter their covenant parameter or suitably adjust the financial data to measure the covenant. Applying IFRS 16 IASB expects more transparent accounting and assessment. At the same time, business house, required to do much while applying the new standard, this includes and not limited to changes internal system process, educate to staff and cost involve in transformation. The lessee should have look at the impact on tax liabilities, borrowing cost and meeting leverage ratios. Though Lessor s books continue to be the same as of now, IFRS 16 expect much discloser, which may requires internal system transform etc. Since it is applicable from 2019, accordingly the entities should have to make the corresponding changes in 2018 and opening equities of 2018 if it differs significantly from the present one. CONCLUSION: IFRS 16 no longer requires a lease to classify as either operating lease or finance lease which reduce complexity and also a model separately present depreciation and interest for all leases reported on the balance sheet provides information that is useful to the broadest range investor and analysis. IFRS 16 also has simplified measurement approach regarding information linked payments that do not require a lessee to estimate future information. The IASB has ISBN : 978-93-5254-333-5 6
simplified the reassessment requirements regarding various lease payments and optional lease payments. References: 1. Asish k Bhattacharya, Indian Accounting Standards, Tata MC Graw hill Publishing house 2. Journal of Management Accounting Vol 51 3. Charted accountant & Cost and Management Accounting Website ISBN : 978-93-5254-333-5 7