A brief introduction of IFRS 16 - Leases

Date:  2018-01-31    Autor:   Jing JIN

Key words: New definition of lease,Recognition of right-of-use asset, Influence of IFRS 16 on accounting

In January 2016, IASB issued new leasing accounting standard IFRS 16 –Leases, which will be applied to reporting periods beginning on or after 1 January 2019. For companies that prepare group consolidated financial statements according to IFRS, it is therefore important to comprehend the changes.

IFRS 16 is also relevant to companies that do not prepare group financial statement. Due to the fact that the Chinese Accounting Standards for Business Enterprises will keep in step with IFRS according to CaiKuai (2010) No. 10 “Roadmap for Continuing Convergence of the Chinese Accounting Standards for Business Enterprises withthe International Financial Reporting Standard”, it is expected that China will publish new leasing accounting standards in year 2018. We are then interested to know what has actually been changed by IFRS 16 and what will be its impact on the business operation of the company.

1.     Major changes of IFRS 16:

IFRS 16 gives further guidance on how to identify a leasing contract. The lessee does not classify leases as operating or finance anymore. For contracts that are identified as leases, assets and liabilities are generally required to be recognized on the balance sheet of the lessee. Meanwhile, the lessor accounting remains substantially unchanged as its predecessor, IAS 17- Lease. So the IFRS16’s approaches for lessee and lessor are asymmetric.

Change 1: Definition of lease

A contract is, or contains,a lease if it conveys the right to control the use of an identified asset for aperiod of time in exchange for consideration [IFRS 16:9]. The new definition mphasizes further the actual use control of the underlying asset. It is sometimes necessary for the lessee to make lots of judgements based on the elements of the definition.

Step I Identified assets

The lessee has to determine whether assets can be identified in the contract.

An asset can be easily identified for being physically independent. But if the underlying asset is the portion of assets, further determinations have to be made. A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of afibre optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset. [IFRS 16:B20]

In addition to that, the substitution rights of the lessor should also be considered. If the lessor has the substantive right to replace the underlying assets (for example, a large number of underlying assets that can be replaced discretionally and at low costs, such as non-specific vehicle rental) and to obtain economic benefits from it, no assets can be identified.

Step II Substantially all of the economic benefits

The lessee can obtain the main economic benefits and other interests within the scope of the right of use.

Step III Right to direct the use

The lessee has the right to direct how and for what purpose the asset is used throughout the period of use. (for example, the contract stipulates that the leased plant could be reconstructed

Change 2: Right-of-use asset and lease liability

IFRS granted the lessee the right not to recognize anything on the balance sheet for:

Ø  Leases with a lease term of 12 months or less – if the lessee has the renewal intention, the lease period should be calculated continuously

Ø  Leases when the underlying asset is of low value – as the Chinese standards are not yet published, there is no specific information about the exact limit

The lease expenses are then allowed to be recognized on either astraight-line basis over the lease term or another systematic basis. [IFRS16:6]

Except for the above recognition exemptions, right-of-use asset and lease liability willbe recorded on the balance sheet at the commencement date of lease.

Lease liability presents the present value of the future lease payments. The lease liability is decided by the lease term, in order to determine which, renewal options and break clauses should be taken into account. The lease payments should be discounted using the interest rate implicit in the lease, if that can be readily determined. If not, the lessee should use the lessee’s incremental borrowing rate. [IFRS 16:26] The lease liability reflects indexation or rate linked variable lease payments.

Right-of-use asset reflects the cost of the lease that comprises lease liability, initial direct cost, estimated cost of dismantling or restoring the leased assets and advanced lease payments less any lease incentives received.[IFRS 16:24]

After the commencement date, the lease liability should be measured subsequently by the effective interest method. The right-of-use assets should be depreciated by applying IAS 16 Property, Plant and Equipment.Any impairment loss should be identified by applying IAS 36 Impairment of Asset. The lease term and the discount rate, as well as the lease liability are subsequently re-measured to reflect the occurrence of certain events.

2.Impact of IFRS 16 on the financial statement

- Balance sheet

Compared to its predecessor IAS 17’s off-balance-sheet-approach, the assetsand liabilities of the companies who engages in operating leasing will both increase when applying IFRS 16. The total assets and the assets-liability ratio will also increase, the asset turnover will but decrease.

- Profit and loss statement

Generally speaking, the right-of-use asset will be depreciated on a straight-line basis,while the lease liability being measured at the amortized costs. When IFRS 16 comes into effect, the lease expense of the lessee will be high towards the start of the lease period and low towards the end, even the lessee pays the same amount of rent each year. IFRS 16 results thus in an early recognition of expenses compared to the straight-line expense of IAS 17. Consequently, the net profit of the lessee will drop at the beginning of the lease, so will the earnings-per-share. Furthermore, IFRS 16 will have a significant impact on the lessee’s Earnings Before Interest, Taxes, Depreciation and Amortization(EBITDA). As subsequent measurement mainly affects depreciation and interest,which are not part of the EBITDA, the reported value of EBITDA of the lessee will increase.

- Cash flow statement

IFRS 16 treats the lease as buying an asset by borrowing. The rent paymentis no longer classified as cash outflow from operating activities, but rather as a financing activity. As a result, the lessee's operating cash outflow will decrease and the financing cash outflow will increase.

3.Counter measures of the companies

Ministry of Finance issued “Letter on Seeking Comments for the Accounting Standards for Business Enterprises No. 21 – Leases (Revised) (Draft forComment)” on 8 January 2018. It is expected that new accounting standard willbe introduced within year 2018 to ensure the convergence with IFRS. Besides,IFRS will be applied by oversea listed company to reporting periods beginning on or after 1 January 2019. We suggest the companies to follow its guidelines and the subsequent interpretations.

As IFRS 16 strengthens the disclosure requirements, it will have more or less influence on enterprises that have leasing arrangements. It is thus our suggestion that the companies evaluate the possible impact of the new standard according to their own business operations and respond actively. The counter measures to be taken may include:

-       Analyze whether financial and information systems need to be adjusted to accurately record and calculate lease contracts.

-      Analyze existing lease agreements and decide whether it is necessary to arrange some or all of the contract terms.

-     Analyze the impact on key financial indicators and assess their business impact (e,g. banking covenants such as loan contracts,etc.).

-      Consider the tax implications and strive for the maximum tax benefits. As for the corporate income tax, the implementation of the new standard will objectively result in deferred tax payment as for the moment. One should pay attention to the possible amendments to the taxation laws, which might be properly adapted to the new standards so as to avoid book-tax-difference. Examples are the entities for depreciation deduction and interest deduction before tax etc.  In terms of the value-added-tax, one should focus on the tax category of the lessor, which could be leases, interest or service. That determines whether the input VAT of the lessee is allowed to bededucted from the output one. Last but not the least, the stamp tax item of the lease contracts should also be considered.

ECOVIS Ruide Team will follow up the updates of the new lease accounting standards and give you our professional opinions. We are also glad to provide you with professional explanations or training.

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