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A Balance Sheet Full of Leases – Implementing IFRS 16

By Helen Lloyd

When IFRS 16 becomes effective, for periods beginning on or after 1 January 2019, there could be a significant effect for entities that make use of leases.

Even small and straightforward companies usually have at least some leases, whether these are of office or manufacturing space, or of machinery or office fittings such as photocopiers. Under IAS 17, many of this kind of leases would have been treated as operating leases – for land and buildings, they were often for only a short part of the property’s life, and for equipment they would usually be on a short renewal period. Assuming this meant they did not meet the definition of a finance lease, these arrangements would in the past have been treated as operating leases and so the only recognition in the accounts would have been of the annual rental or hire cost, with some disclosures about annual commitments buried in the back end of the notes.

Under IFRS 16, though, as a rough rule of thumb all leases now appear on the balance sheet. With some exceptions, lessees will need to recognise an asset (technically representing the right to use the underlying asset) and a liability (the present value of committed future lease payments) on the balance sheet. In the income statement, instead of a single line for operating lease expenses, there will usually be two lines of costs: one for finance expense on the notional liability, and the other for amortisation of the right of use asset. So as well as a “grossed up” balance sheet (with higher assets and liabilities), lessees of former operating leases will also have a lumpier profile in profit, since the old straight line operating lease charge has been replaced in part with an interest charge that will decrease as the outstanding “liability” falls.

To allow at least some mercy to preparers, the IASB did introduce some very limited exemptions when leases are low value, or of a short life (defined as 12 months or less). The low value exemption isn’t particularly clear in the standard, as it is not a defined term, but we do know that it refers to the value the asset had when it was new, and the Basis for Conclusions suggests that it refers to an order of magnitude of around $5,000 (US) or less. When a lease falls into one of these exemption categories it is still accounted for, but only as a straight line expense rather than on the balance sheet, so much more like the old operating lease accounting.

In the past there might have been some incentive to structure leases to force a classification that would keep them off the balance sheet, but now that would be very hard to achieve: it is usually no advantage to either party to have a very short lease term (and transparently artificial 12 month break clauses do not count, if it is very clear that they will never realistically be invoked). And an attempt to separate a lease into many low-value components would also be looked through, with linked arrangements being assessed together against the lease criteria.

So with no short cut, the exercise of documenting leases and working out the new accounting entries needs to be done well before the standard is effective, with a good system in place for new leases so that the calculations are not too painful. 

May 2018 

 

Disclaimer
This article is published with the understanding that SWAT UK Limited is not engaged in rendering legal or professional services. The material contained in this article neither purports, nor is intended to be, advice on any particular matter. This article is an aid and cannot be expected to replace professional judgment. SWAT UK accepts no responsibility or liability to any person in respect of anything done or omitted to be done by any such person in reliance, whether sole or partial, upon the whole or any part of the contents of this article.