In 2016, the IASB introduced the new accounting standard IFRS16 Leases (effective from 1/2019 with early adoption permitted) which requires what were previously classified as finance and operating leases to be classified and included on the lessee’s balance sheet.
What is the rationale behind this decision? Provide your reason with references.
What are the implications that would have for the lessee and the lessor? (Note: you are expected to
specify (with references) which types of companies are likely to be affected and how they are affected?)
The issue that has been presented in the question is that the International Accounting Standards Board (IASB) had introduced the new accounting standard IFRS 16 Leases that have been recognized to be effective from the month of January of the financial year of 2018. This particular accounting standard has brought about the much-needed change in the classification of the finance and the operating leases that in the current times needs to be classified and included in the balance sheet of the lessee.
This particular study aims to provide an overview into the rationale behind the decision that is taken up by the accounting regulatory bodies. Moreover, the particular implications that this new accounting standard would have on the lessee and the lessor has also been discussed in this particular study.
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IFRS 16 – Key principles
The current standard that has been established by the International Accounting Standards Board in the form of IFRS 16 aims to define the new accounting standard. The definition has been deduced in regards to the fact that a lease is essentially a contract or part of a contract that conveys the right to utilize an asset or an underlying asset for a stipulated period in exchange for certain consideration. The major factor that has to be identified in order to carry out a leasing transaction is that the particular contract must constitute of the terms in which the right to control the utilization of a particular asset has been clearly mentioned (Pellenscaes et al., 2017). Here, it must be noted that a contract will successfully transfer the right to take control of the utilization of an identified asset if during the entire stipulated period the customer gets the right to:
• Obtaining of the complete substantial advantages or the economic benefits that are derived from the utilization of the particular identified asset
• Directions in regards to the usage of the identified asset and the purposes solved by the asset has also been mentioned in the contract
The new accounting standard also facilitates the separation of the leasing and the non-leasing components of a leasing contract. To be precise, a contract might consist of an agreement in regards to the sale and purchase of goods or services like the aspect of maintenance. In regards to these types of contracts the non-leasing components are identified different accounting treatments are utilized for the treatment of the non-leasing components. The lease components on the other hand are treated differently.
Under the scope of the newly introduced IFRS 16, the lessees will be required to have a particular model of accounting for all the leases. It must be noted here that the lessor accounting in case of the newly introduced accounting standard remains unaltered. Moreover, the requirement to provide additional disclosures in the financial report is another major consideration of IFRS 16. The picture that has been provided below, shows the particular changes in regards to the lessee and lessor accounting(Pellenscaes et al., 2017).
It must be noted here that the new accounting standard in regards to the accounting treatment for leases is likely to have a significant impact on the particular way in which the lessees carry out the accounting for the leases. Moreover, the implications of IFRS 16 will also be far reaching as the finances and the operations of the lessee firm will be affected. The requirement that has been stated by IFRS 16 leads to the recognition of most of the leases on the balance sheet of the lessee company irrespective of the industry in which the firm is operating.
Rationale behind the establishment of IFRS 16
The International Accounting Standards Board had carried out the issue of IFRS 16 that essentially requires the lessees to recognize the assets and liabilities for most of the leases. The IASB issued the selected standard and made the declaration that the new standard will be effective for annual periods initiating on the particular date or after 1st of January, 2019. Therefore, it can be understood that the particular rationale behind the introduction of IFRS 16 had been that the lessee company should prepare a financial statement that reflects a fair image of the liquidity position of the corporate entity. This is because initially the omission of the leases in the financial statements would facilitate the reflection of the financial position of an organization different from what the real picture is. Thus, the introduction of IFRS 16 has resulted in the proper recognition of the leases as assets and liabilities in the financial statements of the company. This will further result in the proper economic decisions by the third party investors who take the major investment decisions on the basis of the financial position of the company that has been interpreted from the accounting statements of the organization (Öztürk and Serçemeli 2016).
Entities that are to be affected by the change
The entities that deal in retail and consumer products are more likely to get affected by the alteration in the accounting regulation. This is because the retail units require spaces that are generally leased and forms a significant part of the business model of the entity. The telecommunication industry and the banking industry are also likely to b significantly impacted by the newly introduced leasing standards. This is because the telecommunication industry deal in facilities like tower arrangements, devices for the transmission of signal and retail outlets that need to be revised for the purpose of removing the burden of liabilities in the financial statements of the corporate entity. The banking industry on the other hand, deals in an extensive range of network of branches along with numerous call centers that are located in the different parts of the country. This requires a humongous amount of space that in all regards is leased by a bank. Therefore, the banking institutions also need to visit the leasing agreements carefully. Moreover, banks also require leased spaces in the form of ATMs thus, increasing the lease liability in the accounting statements further. Similarly, the mining corporations, the oil and gas corporations will be significantly impacted by the introduction of the new accounting standard (Edeigba and Amenkhienan 2017).
Impact on the lessees by the introduction of IFRS 16
The particular impact that IFRS 16 is likely to have on the financial statements of the lessees are as follows:
•Data collection and management of data –
The new accounting standard of IFRS 16 has resulted in the collection and management of data. The companies that readily have lease administration and accounting functions might simply result in the evaluation of their existing systems, processes, policies and controls for the adoption of the new accounting standard. However, the companies that do not have the proper leasing administration might have to withstand a certain degree of challenge for the purpose of determining the completeness and accuracy of the lease portfolio (Arrozio, Gonzales and da Silva 2016).
•IT systems and controls and the processes –
The lessees in order to fulfill the presentation requirement and disclosure requirement of the financial statements will require the evaluation of the existing system and the implementation of the new system. The lessee company might opt for applying the new leasing standards on a retrospective basis when it is initially applied. Therefore, it must be understood that the particular requirement in regards to the application of the new leasing standard in accordance to the specified basis will require the restatement of the comparative reporting periods(Arrozio, Gonzales and da Silva 2016).
•Impact upon the financial statements of the lessees –
The impact upon the financial statements of the lessees will be that the recognition of the leases will result in the deterioration of the financial position of the lessee company. This is because the debt ratios of the firm is likely to grow worse. Moreover, the return on assets will also deteriorate and other related ratios will also be affected(Arrozio, Gonzales and da Silva 2016).
•Tax considerations –
The introduction of the new accounting standard will in all probabilities, result in the addition of a number of considerations that are related to tax. To be precise, the changes in the leasing standards will require the evaluation of the tax positions that will need to be revised for making the payment of the taxes. Here, it must be noted that the particular impact that the accounting standard will have on the payment of taxes by the lessee organization depends on the specific tax jurisdiction and how they have been altered in order to reflect the requirements of the new standard (Nobes 2015).
Impact upon lessors
The particular impact upon the lessors have been that they need to understand the change in trend in regards to the behavior of the clients or the lessee firms. This will aid the lessors to carry out the proper negotiations in case of the leasing arrangements for the purpose of meeting the needs of the customers. This is the only way in which the lessor will be impacted by the new accounting standard(Nobes 2015).
Arrozio, M.M., Gonzales, A. and da Silva, F.L., 2016. Changes in the financial ratios of the wholesale and retail sector companies arising from the new accounting of the operating lease. RevistaEniacPesquisa, 5(2), pp.139-159.
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Sari, E.S., Altintas, A.T. and Ta?, N., 2016. The Effect of the IFRS 16: Constructive Capitalization of Operating Leases in the Turkish Retailing Sector.
Xu, W., Davidson, R.A. and Cheong, C.S., 2017. Converting financial statements: operating to capitalised leases. Pacific Accounting Review, 29(1), pp.34-54.