Old rules give way to new the ones: IFRS 16 on leases

CaseWare IndiaAccounting and Financial Reporting

Finally, the International Accounting Standards Board on 13 January 2016, issued the long waited standard on improved lease accounting requirements, IFRS 16. IFRS 16 on leases supersedes the 30 years old IAS 17 and is applicable with effect from 01 January 2019.

Hans Hoogevorst, the chairman for IASB, is excited about the release and said “these new requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligations. The new Standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy”.

What is the need for such a change?

IAS 17 on leases classified leases into two, financial as well as operating. This was based on the concept of economic similarity of the lease to a purchase transaction. If the substance of the transaction is similar to purchase of an asset, according to the conditions laid out by the standard, the same was considered to be a financial lease where the lease liability was recognised along with the assets in the balance sheet. Others were simply called as operating leases and was accounted as expenses in the profit and loss statement on a straight lining concept.

Let us take an airline service provider as an example to understand how this distorted the picture and affected the users of the financial statements. We all love to fly!! Have you ever thought how costly those massive birds can cost? A lot will be my guess!! As a result, some of the companies go for institutional financing to add fleets to their business. They also lease get aircrafts on lease, which normally extends more than 10 years.

In the above example, company A bought an aircraft on a mortgage where its balance sheet reflected both the asset and liability. Interest on the loan was charged to the profit and loss statement. Company B chose to lease from one of the leasing companies. As per IAS 17 company B recognised the transaction, based on the terms and conditions as mentioned in the standard, as an operating lease and went ahead. At the year end when the financial results are released (assume they both had only one plane and similar profitability) company A will look more geared than company B which is not economically true. The liability which was not recognised by company B was called an off balance sheet debt. An ordinary investor may not know these intricacies in detail and may take decisions based on the results as represented.

IFRS 16 is now trying to avoid such a situation by improving comparability so that Company B has left with no choice other than recognising the asset and liability in the books.

The effect analysis report released by IASB says “the absence of information about leases on the balance sheet meant that the investors and analysts were not able to properly compare companies that borrow to buy assets with those of that lease assets, without making adjustments”. However expert analysts used to extrapolate the liability while doing their data drilling using arbitrary multipliers. This again creates an issue where the analysis can result in an over statement of liability.

Benefits

The IASB expects to significantly improve the quality of financial reporting for companies with material balance sheet leases with the following benefits drawn out clearly:

  • Improved comparability
  • Improved transparency
  • Improved investor confidence
  • Conclusion

    As the standard if effective only from 01 January 2019, it gives ample time for companies to assimilate, understand and make the changes accordingly to their financials. With respect to the Indian context, we still follow the same concepts of IAS 17 (more or less) guided by AS 19 or Indian AS 17 as appropriately. We will wait for the updates from ICAI and MCA, two regulatory bodies in relation to financial reporting in India, to understand about Indian implications of the change.