Lease Accounting Pursuant IFRS 16 Vs. IAS 17

The US standard deviates from the new IFRS standard, in particular with regard to lessee accounting.

The years of struggle for uniform lessor accounting and for simplification of lessee accounting have come to an end with the so-called “right of use approach”.

The impact

After the massive objections, in particular from the European leasing industry but also from the economic sectors involved as lessees, the IFRS accounting of leases by lessees will change. The changes will be less serious and complex than initially expected, but there may still be significant financial effects that may influence “lease or buy” decisions.

Right of use approach

According to the new standard, lessees reporting in line with IFRS must recognise most leases as lease liabilities and capitalise them as rights of use for the leased asset in accordance with the “right of use approach". "Off-balance" accounting is therefore also omitted in “operating leases”, contrary to IAS 17.

Lessor accounting

Compared to the previous regulation in IAS 17, lessors reporting in line with IFRS will not experience any accounting changes. The new leasing standard takes into account the objections that were widely raised against the exposure draft or re-exposure draft. 

As under the previous standard (IAS 17), lessors will have to classify leases into two types in accordance with the new standard. Following the considerable resistance from the leasing industry in recent years, the IASB has decided to maintain the previous accounting method set out in IAS 17. The presentation of the lessor’s balance sheet is thus essentially based on the “finance lease” and “operating lease” structures described in IAS 17. In simplified terms, the lessor derecognises the asset under a finance lease when the lessor no longer bears the majority of the risks and rewards incident to ownership of the leased asset.

Lessee accounting

For lessee accounting, the “right of use approach” is now the only model available for the recognition of all types of leases under the new standard.

IFRS 16 contains an exception for “operating leases” for lease agreements not recognised in the balance sheet in accordance with IAS 17. The prerequisites for using this exemption are:

• Leases with a lease term of 12 months or less (i.e. short-term leases) and
• Leases for which the underlying asset is of low value (≤ USD 5,000).

According to IFRS 16, when evaluating the short-term nature of a lease in order to estimate its useful life, particular attention must be paid to extension options. When assessing low value, any dependencies on other leased assets must be examined.

Under IFRS 16, at the inception of the lease the lessee is required to recognise a lease liability as well as an asset (right of use of the leased asset) in the balance sheet.

• The lease liability is calculated at present value based on the lease payments to be made over the basic lease term. The present value must be compounded in subsequent periods. 
• In addition to the value of the initial recognition of the lease liability, the “initial direct costs” incurred by the lessee must also be included in the right to use of the leased asset, which is generally depreciated on a straight-line basis. The latter may consist of prepaid lease instalments or direct costs attributable to the lease. So-called “leasing incentives” must be eliminated in this respect.

In general, it becomes clear that the focus of the Board was not on the lessor’s accounting but on the lessee’s accounting for leasing contracts. This was in particular due to the "off balance" accounting for “operating leases”, often criticised by the Board, now prevented by the new standard.

IFRS 16 requires lessees to recognise all leases in the balance sheet. Consequently, “sale and lease back” transactions, which served to avoid accounting under the “lease back” method, in accordance with IAS 17 “operating lease”, will also be omitted in future.

Separation of contractual relationships

Leasing and non-leasing components must be separated in leasing agreements. Accordingly, other contractual services or materials (e.g. service components) purchased in addition to the lease must be accounted for by the lessees as pending transactions. Lessors can account for these contractual services in accordance with IFRS 15, the new revenue recognition standard.

In compliance with an accounting option granted to lessees, leasing and non-leasing components, in future, may be accounted for as a uniform leasing component. This exception results in a higher level of recognition of leasing liabilities in the lessee’s balance sheet than if the accounting option were not exercised.

Income booked

The classification of leases determines when lessors are required to achieve income from leases and which assets are to be recognised. In principle, it is not to be assumed that the new standard will have any effect on the lessors' profit or loss statement compared to the currently applicable IAS 17.

Under the new standard, lessees will also have to recognise depreciation and interest expenses in their profit and loss statement. The expenses to be shown in future are then divided into a repayment and expense component with the effect of relieving the result before financing activity.

Effects on lessees' accounts

The new standard is expected to have a significant impact on lessees’ accounting simply because of the upcoming balance sheet extension.

Under the new regulations, the necessary recording of leasing related assets and liabilities will make some decision-makers sit up and take notice for the following reasons in particular:

• "Financial covenants" could be affected,
• Significant financial figures could change, and
• Willingness of banks to lend could be affected as well.

First-time application

The new IFRS 16 Leases applies to annual periods beginning on or after 1 January 2019.

The first-time application of the new leasing standard will be effected retrospectively. This means, that the reporting company must also apply the new standard for the previous year’s comparative year, i.e. for financial years ending before 1 January 2019. 

Alternatively, however, a modified retrospective application can also be made in the course of initial accounting in accordance with the amended regulations, in which leases that were previously classified as “operating leases” do not have to adjust the comparative prior-year information. Under this approach, however, the total effect of the first-time application of the new standard would have to be disclosed in equity (in retained earnings, if applicable) in the “notes”.

The approach or method chosen by the companies for the first-time application of the new standard will not have to be changed in subsequent years for contractual relationships declared as “operating leases” - with the exception of subleases.

If sub-leases are in force, the first time the new standard is applied, it is necessary to re-examine which contract classification has to be made.

Peter Lenz
Managing Director (Auditor)
Vistra Cologne
[email protected]