In January 2016, the IASB (International Accounting Standards Board) issued IFRS 16 (International Financial Reporting Standard) Leases which takes effect January 1, 2019. The purpose of IFRS 16 is to eliminate off-balance sheet financing and to ensure that both lessors and lessees provide relevant information that faithfully represents lease transactions on their financial statements. Under IFRS 16, all leases will be capitalized and reported on the balance sheet as an asset. These changes will have a significant potential impact on the financial results and reporting of organizations.
Major changes to lessees
In the past, lessees would classify their leases as either operating or financing leases. Currently, most leases are operating leases reflected as expenses on the income statement and are off-balance sheet. Under IFRS 16, the distinction between the two categories of leases is removed. Companies will be required to report their off-balance sheet liabilities on their financial statements.
Benefits of IFRS 16
The implementation of IFRS 16 will lead to increased transparency and a more faithful representation of a company’s assets and liabilities. There will also be improved comparability between companies that lease versus companies that borrow to buy assets. Additionally, users of financial statements such as investors no longer have to make adjustments to account for off-balance sheet leases in order to obtain useful information.
Effects of IFRS 16
In general, companies that currently have operating leases will experience an increase in asset and liability and a higher EBITDA. At the same time, their EPS will be lowered in early years and their net assets will also decrease. As financial data adjusts, financial ratios such as debt-to-equity ratio and interest coverage will also change accordingly. In addition, companies may incur additional costs as they will be implementing new policies, systems and controls to comply with the new standard.
Companies in specific industries that have a significant amount of off-balance sheet lease-related liabilities will be affected the most as they will be required to report them on the financial statements starting in 2019. For instance, organizations in the retail or manufacturing industry will experience significant changes as these companies typically lease retail or production space.
Additional consideration is needed in industries where tangible assets are involved. For example, in the software industry, if a company buys a software from a reseller, whether or not the purchase is considered a lease under IFRS 16 will largely depend on the structure and terms of the transaction.
All in all, companies currently with more off-balance sheet financing will experience a greater impact with the implementation of the new standard.
IFRS 16 and US GAAP
Although IASB and FASB are committed to creating a single converged leases standard, there remains significant differences in several key areas. For example, with IFRS 16, most leases will be capitalized and reported as an asset with an offsetting lease liability on the balance sheet, eliminating reporting of off balance sheet leases that were reported as operating expense on the income statement. In contrast, under US GAAP, companies can continue to classify most leases as one of two types: finance leases and operating leases. This difference also means that some companies may incur additional costs in maintaining two reporting systems.
Preparing for IFRS 16
Companies should prepare for the implementation of IFRS 16 by understanding the standard, exploring the implications of the standard and identifying its impact on the organization. Companies who report under both IFRS and US GAAP will also need to understand the changes in US GAAP and what differences remain after the implementation of IFRS.
Talk to us about IFRS 16 and its impact on your software acquisition and deployment. Or read our article here.