The impact of IFRS 16 on the development of financial statements
The introduction of IFRS 16 has had a major impact on the way companies report various types of leases and long-term asset use arrangements in their financial statements under the International Financial Reporting Standards (IFRS). This standard revolutionizes the way leases are recorded on a balance sheet.
Currently, a simple invoice or lease payment schedule is not enough to fully reflect lease obligations on a balance sheet. This makes the work of accounting departments more complicated and evidences the impact of IFRS 16 on financial statements.
Why was the standard amended?
During one of his flights, the Chair of the IASB serving from 2001 to 2011, noticed an inconsistency: the plane he was travelling on was not recorded on the carrier's balance sheet.
This observation has prompted broader discussions about the reliability of lease information contained in financial statements, particularly the information on debt associated with leased assets.
Experts analysed the reliability of data concerning the level of debt incurred for the use of leased assets. The greater the capital intensity of the industry was, the more significant (material) the problem.
IFRS 16 equalizes the status of all external financing agreements made for the purpose of purchasing assets. From now on, loans and leases will appear on the liabilities side of the balance sheet. The loophole that allowed companies to ‘hide’ some operating lease liabilities as off-balance-sheet items has been closed.
IFRS 16 states that a lease occurs when the right to control and use an identified asset is conveyed in exchange for consideration.
After this more specific definition is implemented, most lease or use agreements will meet its criteria.
(It is important to remember the exemptions: from paragraph 9 of the standard, i.e. the short-term exemption and the low-value exemption (up to USD 5,000).
Further sections of this article explain in detail the implications of IFRS 16 for the components of financial statements, including balance sheet, income statement, statement of cash flows and notes to financial statement.
Balance sheet: Implications of IFRS 16 for assets and liabilities
Under IFRS 16 leases should be recognized in a balance sheet, including both the measurement of the lease liability for the full term of the lease and the corresponding asset resulting from the right to use the asset.
This will increase the balance sheet total on the assets and liabilities sides by an identical amount. In capital-intensive industries, the value of such an adjustment will be higher.
The value of lease assets and lease liabilities will begin to diverge over time. Their accounting will no longer be parallel.
The asset is depreciated in line with its assumed useful life, whereas the liability is accounted for at the discount rate adopted by the company.
Financial analysis of companies after implementation of IFRS 16
The introduction of IFRS 16 will impact financial ratios through faster depreciation of assets compared to slower accounting for lease liabilities. As a result, assets will lose value more quickly with liabilities remaining at a high level.
It is expected that the debt-to-equity and debt-to-asset ratios will deteriorate, just like the current ratio.
It is also important to consider the effects of IFRS 16 on debt covenants, credit ratings and borrowing costs that companies have faced under the new regulations.
Income statement: The impact of IFRS 16 on expenses
Although IFRS 16 does not change the sum of costs for the whole lease term, it does change the way they are recorded in financial statements.
Instead of recognizing lease costs as ‘third-party services’, IFRS 16 requires that the costs of using an asset be reported in a way that allows for them to be compared against the costs of assets purchased with external financing.
Consequently, an income statement must now detail depreciation and amortization expenses as well as financial expenses, which represent interest on debt that could be incurred to purchase such assets.
The impact of IFRS 16 on operating and financial expenses
In a nutshell, the introduction of IFRS 16 will affect income statements in the following way:
Operating expenses (OPEX)
- (-) Third-party services – costs of lease payments no longer included
- (+) Depreciation of tangible assets and amortization of intangible assets – recognition of depreciation expenses of a tangible asset recognized under IFRS 16
Financial revenue/expenses
- (+) Interest – recognition of interest expenses determined according to the discount rate adopted for measuring a lease liability under IFRS 16
- (+/-) Foreign exchange gains/losses – recognition in the income statement of the effect of a change in the present value of a lease liability resulting from changes in foreign exchange rates (the effect occurs only for lease agreements denominated in foreign currencies)
In light of the foregoing, the introduction of IFRS 16 is expected to improve the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBIT (Earnings Before Interest and Taxes).
At the same time, IFRS 16 raises the cost of capital.
The impact of IFRS 16 on net profit/loss
The implementation of IFRS 16 may modify the distribution of expenses over time, affecting the net profit/loss amount. For contracts with regular payments, the impact on profit/loss for a given period is usually minor.
However, in the case of contracts that include irregular payments, e.g. temporary rent reduction at the beginning of the contract term or the right to buy an asset at the end of the term, IFRS 16 means a different distribution of expenses.
This may affect the amount of net profit/loss, and, by extension, deferred tax assets or liabilities, and the value of the company’s equity through changes in profits/losses brought forward.
As already mentioned, all differences are counterbalanced by the end of a contract term.
Cash flow: The impact of IFRS 16 on the statement of cash flows
Under IFRS 16, in the statement of cash flows cash payments for a lease liability must be recognized within financing activities.
This is a significant change compared to previous practices, where operating leases did not directly affect the liabilities in a balance sheet and were recorded only as off-balance sheet items.
Prior to the introduction of IFRS 16, operating lease liabilities were not recognized directly in balance sheets. Although their materiality was known, it was not directly visible in the statement of cash flows.
Prior to the introduction of IFRS 16, operating lease liabilities were not recognized directly in balance sheets. Although their materiality was known, it was not directly visible in the statement of cash flows.
Notes to financial statement: IFRS 16 disclosure requirements for financial statements
Considering the significant changes introduced by IFRS 16 in balance sheets, income statements and statements of cash flows, in many cases it has become necessary to make additional disclosures.
The list below contains sample titles of notes to financial statement related to IFRS 16:
depreciation expenses associated with right-of-use assets by class of underlying asset,
interest expenses on lease liabilities,
expenses associated with short-term leases,
expenses associated with leases of low-value assets accounted for, applying paragraph,
expenses associated with variable lease payments not included in the measurement of lease liabilities,
income from subleasing right-of-use assets,
total cash outflow for leases,
additions to right-of-use assets,
gains or losses arising from sale and leaseback transactions, and
the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset.
The impact of IFRS 16 on financial statements: Advantages of FlexiEPM
FlexiEPM actively supports the process of measurement of leases under IFRS 16, ensuring accurate calculations at each balance sheet date. In addition to guaranteed compliance with IFRS 16, the system speeds up and simplifies reporting thanks to advanced features:
determination of the initial value of a liability based on the duration of contract, preset payment schedule and discount rate,
keeping records of depreciation of a tangible asset and calculating depreciation expenses to be charged to income statement in consecutive periods,
calculation of interest expenses on a lease liability,
remeasurement of a liability and asset in the event of amendment to lease agreement,
monthly revaluation of a liability and calculation of corresponding foreign exchange gains or losses according to applicable foreign exchange rates,
reporting the balance of a lease liability by maturity dates and by nominal payment and discount on future interest,
summary presentation of the impact of IFRS 16 on particular financial statement items,
automatic generation of a report that enables posting of IFRS 16 measurement,
preparation of notes to financial statement based on a layout determined by the company.
