IFRS 16 lease model: Ready your balance sheets by year-end

IllustrationIf you’re a finance director who works best when up against a deadline, your company will be in good shape to meet the first requirement of the IFRS 16 lease accounting standard. The deadline is coming right up.

Companies applying IAS 17 to leases in the EU and Britain will be obliged to change to IFRS 16. That first deadline? Completing a balance sheet transition project by Dec. 31, 2017.

At that time, balance sheets for the year must conform to the new model prescribed by IFRS 16. Though balance sheets will then be in compliance, reporting won’t change for another 12 months. The standard is effective for accounting periods beginning on or after Jan. 1, 2019.

While the time for preparation is now short, the standard has been out for almost two years. In January 2016, the International Accounting Standards Board (IASB) issued IFRS 16, intending to ensure lease transactions are faithfully represented and financial statements accurately assess lease cash flow.

The change will be significant. Unlike the current model, there won’t be a distinction between an operating and a finance lease. Instead, all leases will funnel to a single model. IFRS 16 will fundamentally alter how operating leases are accounted for, potentially bringing many leases onto the balance sheet.

The following Q&A may help you understand what is required of your company.

How do we start the transition? You’ll need to shift your balance sheet to the new model by the Dec. 31 deadline. You’ll have time in 2018 to make further changes, given these transition provisions:
  • Existing finance leases can continue to be treated as finance leases.
  • Existing operating leases have the option of a full or limited retrospective restatement to reflect IFRS 16 requirements.

What key items are needed on our balance sheet? According to the new model, your balance sheet should include:
  • A credit entry – Present the lease liability separately from other liabilities. Calculate the liability as the present value of the expected payments over the term of the lease. Payments will reduce the liability.
  • A corresponding debit entry – Capitalize a right-of-use asset, but not the underlying asset. Present it adjacent to similar nonleased assets.

Will all leases go on the balance sheet?The short answer is ‘no.’ Capitalization will not be across the board. Practical expedients will allow straight-line expensing of some leases:
  • Leases with a maximum duration of 12 months
  • Leases in which the underlying asset is of low value

What will be considered low value?Though not spelled out in the standard, the IASB has specified in its basis of conclusions that low-value assets are those valued under $5,000 when new. Under IFRS 16, low-value assets do not need to be recognized on the balance sheet.

Examples of low-value items are personal computers, tablets and telephones. Property, cars and items subleased or expected to be subleased are not considered to be low value.

Will our operating performance look different on the balance sheet?You’ll need to consider how future arrangements and banking covenants factor into your reporting.  Gearing will increase, due to recognizing more liabilities.
Profit will be reduced by:
  • Interest expense, which unwinds the discount on the liability, resulting in an initially higher finance cost
  • Reductions in the carrying amount of the right-of-use asset, including depreciation or impairment

For a rough estimate of expected liability, calculate the present value of your operating leases’ future minimum commitments. Also take into consideration your potential future lease transactions.

On the positive side, interest-based covenants might be initially affected, but EBITDA will look better.

How will maintenance contracts be treated?Contracts that contain both lease/right-of-use and nonlease (e.g., a service) components are allowed a practical expedient and are treated as a single-lease contract. Embedded lease derivatives must be separated.

How do we know if we have embedded leases?
Contracts with nonleased or service components might contain an embedded lease. Because all leases must now be recorded on the balance sheet, companies have to identify which are embedded leases. They must be accounted for separately.

For example, agreements with third-party contractors that include the exclusive use of an identified asset must be examined to determine if they contain an embedded lease.

What are the first major practical steps?
  • Identify all leases, including those leased out
  • Determine usefulness of practical expedients
  • Estimate implementation costs, including new systems and training
  • Tally dilapidations, onerous leases and transaction costs
  • Classify items for the $5,000 low-value threshold
  • Consider benefits of transition reliefs
  • Schedule notification to stakeholders

What challenges will we face in 2018 and beyond?
  • Estimating the term of a lease with options to break or extend it
  • Modifying leases and re-estimating payments
  • Identifying discount rates for unwinding a liability
  • Gathering detailed data for to implement IFRS 16

This article was originally published by Grant Thornton UK.

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