Sue Lloyd - IFRS

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January 2016Investor PerspectivesA New Lease of LifeSue LloydSue Lloyd, a member of the International Accounting Standards Board (the Board), discusses the changes to lessee accounting introducedby IFRS 16 Leases. The new requirements are a response to concernsexpressed by investors and others about the lack of informationabout leasing transactions when companies applied previousaccounting requirements.Sir David Tweedie, the Board’s previous chairman,is famously known for saying that one day he wouldlike to fly on an airplane that actually appears onthe airline’s balance sheet. Well, get ready David—because your wish is about to come true! At long lastthe Board has changed the requirements for leaseaccounting. The new Standard, IFRS 16, supersedes therequirements in IAS 17 Leases. Companies are requiredto apply the new requirements from 1 January 2019.1In this Investor Perspectives article, we discusssome of the key changes to financial statementsthat investors will see when companies apply thenew lessee accounting requirements in IFRS 16.We also provide context for the new requirementsby comparing them to former IFRS requirementsand the future US GAAP requirements, including anillustrative example.2IFRS 16 changes lessee accountingsubstantially. It will reduce the need forinvestors to make adjustments, by providinga richer set of information than was availablewhen companies applied IAS 17, providingfurther insight into a company’s operationsand funding.Why change lease accounting?For many years we have been told that leaseaccounting does not meet investors’ needs. Becausethe accounting applying IAS 17 depended on whetherthe lease qualified as an operating lease or a financelease in the financial statements of lessees, some leaseswould end up on balance sheet while most wouldresult only in rent expense in the income statementand no balance sheet items. As a result, over85 per cent of all leases are estimated to be off balancesheet today. Investors would then often adjust thefinancial statements to recognise estimated assets andliabilities arising from off balance sheet leases, andwould also often adjust EBIT or EBIDTA and interest.To address this issue we have substantially changedlessee accounting.1 A company can choose to apply IFRS 16 before 1 January 2019 if it also applies the new revenue Standard IFRS 15 Revenue from Contracts with Customers.2 US GAAP requirements for leases will also change. In this document we use ‘US GAAP model’ to refer to the decisions of the FinancialAccounting Standards Board (FASB), the body responsible for setting Generally Accepted Accounting Principles in the United States (US GAAP), as at31 December 2015.Investor Perspectives—A New Lease of Life January 2016 1

What will change?IFRS 16 eliminates the classification of leases aseither operating or finance for lessees and, instead,introduces a single lessee accounting model.This model reflects that leases result in a companyobtaining the right to use an asset (referred to in thisarticle as the ‘lease asset’) at the start of the lease and,because most lease payments are made over time, alsoobtaining financing. As a result, the new Standardrequires lessees to account for all of their leases in amanner similar to how finance leases were treatedapplying IAS 17.3 Applying IFRS 16, a lessee will:(a) recognise lease assets (as a separate line item ortogether with property, plant and equipment) andlease liabilities in the balance sheet;4(b) recognise depreciation of lease assets and intereston lease liabilities in the income statement; andWe believe that the lessee accounting model in IFRS 16is easy to understand. A lessee recognises assetsand financial liabilities relating to its leases, andcorresponding amounts of depreciation and interest.This will reduce complexity in financial statements.It will also allow comparisons to be made betweenthose companies who lease assets and those whoborrow to buy assets.At a high level, this means that investors no longerhave to estimate the assets and liabilities resultingfrom off balance sheet leases when, for example,calculating return on capital employed and leverageratios. The new accounting will result in moreinformation about leases both on the balance sheetand in improved note disclosures. It will also provide amore accurate reflection of the economics of leases inthe financial statements.(c) present the amount of cash paid for the principalportion of the lease liability within financingactivities, and the amount paid for the interestportion within either operating or financingactivities, in the cash flow statement.In this article we provide you with information tohelp you understand the effects of the new leaserequirements on companies’ financial statements inpreparation for the implementation of IFRS 16.For more detailed information, see ourEffects Analysis of IFRS 16.What does this mean for investors?What about lessors?From a practical perspective, there are a few importantpoints that investors should bear in mind as theydigest the implications of this change.There is little change for lessors. Applying IFRS 16,a lessor continues to classify its leases as operatingleases or finance leases and to account for those twotypes of leases differently. This is because we weretold that the lessor accounting model in IAS 17 is not‘broken’ and that the cost of making any substantialchanges to lessor accounting would outweigh thebenefits at the moment. Nonetheless, IFRS 16 requireslessors to provide enhanced disclosures about theirrisk exposure, particularly to residual value risk.❶ Some sectors will be more affected than others:some sectors that use off balance sheet leasesextensively (for example, airlines, retailers, travel andleisure) will be affected more significantly by thischange than other sectors. In addition, even withinindustries, some companies use off balance sheetleases more extensively than others and, thus, will bemore affected.❷ Balance sheets will get bigger: bringing theseassets and liabilities onto the balance sheet means thatcompanies with material off balance sheet leases willreport higher assets and financial liabilities than theycurrently do.Convergence with US GAAPThe Board worked jointly with the US nationalstandard‑setter, the FASB, to improve lease accounting.The FASB expects to publish its new lease requirementsin early 2016. The Board and the FASB have reached thesame conclusions in many areas of lease accounting.However, different conclusions on lessee accounting werereached for some leases with respect to the recognitionof expenses and the reporting of cash flows.3 IFRS 16 includes two exemptions from recognising assets and liabilities for (a) short-term leases (ie leases of 12 months or less) and (b) leases of low-valueitems (such as personal computers).4 These are initially measured at the present value of unavoidable lease payments. Note that these are not the underlying leased assets but the assetsarising from the lease contracts.2 Investor Perspectives—A New Lease of Life January 2016

The table below provides an overview of the lessee accounting requirements in IFRS 16, showing thesimilarities and differences between IFRS 16 and the forthcoming US GAAP model. For lessor accounting,like IFRS 16, US GAAP will be essentially unchanged.IFRS 16Balance sheetUS GAAP model5Former ONFormer OFFbalance sheetbalance sheetleasesleasesAll leases on balance sheet❶ RecognitionExemption for short-termleasesExemption for leases oflow-value assetsLease liabilities on adiscounted basis❷MeasurementDepreciation of lease assets❹Lease liabilitiesPresentation6--66Initial lease asset allystraight-lineTypicallyincreasing7IAS 18SeparatepresentationSeparatepresentationPPE or own lineitem9(from former offbalance sheet leases)(from former onbalance sheet leases)DepreciationDepreciationSingle expenseInterestInterest---Operating activitiesInterest10InterestInterest andprincipalFinancing activitiesPrincipalPrincipal---Lease assetsIncome statement❻Operating costsFinance costsCash flow statement❼5 For leases already reported on the balance sheet applying previous lease accounting requirements (ie finance/capital leases), the US GAAP model requiresa lessee to account for them as for IFRS 16. For leases not reported on the balance sheet applying previous lease accounting requirements (ie operatingleases), the US GAAP model requires a lessee to (a) recognise lease assets and liabilities (measuring lease liabilities as for IFRS 16), (b) recognise a singlelease expense typically on a straight-line basis over the lease term and (c) present total cash paid within operating activities.6 Lease liabilities are measured in the same way applying IFRS 16 and the US GAAP model, except that inflation-linked payments are reassessed when thosepayments change applying IFRS 16, but are not when applying the US GAAP model.7 Lease assets are measured at an amount that achieves the recognition of a single lease expense typically on a straight-line basis.8 IAS 1 Presentation of Financial Statements requires a company to present financial liabilities separately from other liabilities. In addition, IAS 1 requiresa company to present additional line items (for example, lease liabilities) when such presentation is relevant to understand the company’s financialposition.9 Lease assets are presented on the balance sheet either (a) together with owned property, plant and equipment (PPE) or (b) as their own line item(s) if thatpresentation is relevant to understand the company’s financial position.10A pplying IFRS Standards, interest payments can be presented within operating, investing or financing activities.Investor Perspectives—A New Lease of Life January 2016 3

Balance sheet❶ Recognition on the balance sheetIFRS 16 requires a lessee to recognise assets andliabilities arising from all leases on the balance sheet.This is the most significant change to lease accountingintroduced by IFRS 16. This change brings financialreporting closer to portraying how most investorsconsulted view the underlying economics of offbalance sheet leases.❸ Measurement of lease assetsA lessee measures lease assets initially at the sameamount as lease liabilities, including costs directlyrelated to obtaining the lease. Lease assets are thendepreciated in a similar way to other assets such asproperty, plant and equipment. This is expected tooften result in a straight-line depreciation charge overthe lease term.Similarities and differences: IFRS Standards vs US GAAPAre there any exemptions?Recognition and measurement on the balance sheetYes. In response to concerns expressed about costand complexity (and, in particular, the costs to applythe requirements to large volumes of ‘small’ items),IFRS 16 does not require a lessee to recognise assetsand liabilities for (a) leases of 12 months or less(short‑term leases), and (b) leases of low-value items(such as personal computers and office furniture orother items with a value of less than US 5,000). If theexemption is applied, then basically the old ‘operatinglease accounting’ is applied, so rent expense isrecognised in the income statement.The Board and the FASB have reached the same conclusionson the following important aspects of lease accounting:❷ Measurement of lease liabilitiesLeases can provide lessees with flexibility. Forexample, leases often include extension options orbreak clauses, and can include payments that varybased on sales or the use of an asset.IFRS 16 requires a lessee to measure lease liabilities atthe present value of future lease payments. However,to reflect the flexibility obtained by a lessee andto reduce complexity, lease liabilities include onlyeconomically unavoidable payments. In addition,there is a simplified approach to deal with variabilityin payments.11(a) the definition of a lease;(b) the recognition of lease assets and liabilities; and(c) the measurement of lease liabilities.12The same population of leases is brought onto the balancesheet by both IFRS 16 and the US GAAP model except thatIFRS 16 allows leases of low-value assets to be exempt fromrecognition.13As a result, the most significant effect of applying the newlease requirements—ie the increase in financial liabilitiesfor lessees and the measurement of those liabilities—will besimilar for most companies applying IFRS Standards andmost companies applying US GAAP.Differences arise between IFRS 16 and the US GAAP modelfor leases that were previously off balance sheet. Applyingthe US GAAP model, a lessee will generally depreciate leaseassets more slowly in the earlier years of a lease than whenimplementing IFRS 16 (where, typically, the depreciation oflease assets is on a straight-line basis).Accordingly, the Board expects the carrying amount oflease assets, as well as reported equity, to be higher whenimplementing the US GAAP model than when applyingIFRS 16. However, these effects are not expected to besignificant for most companies.The example in the appendix to this article illustrates theexpected effects for companies with significant off balancesheet leases.11 Lease liabilities include fixed payments (including inflation-linked payments), and only those optional payments that the lessee is reasonably certain tomake. Lease liabilities exclude variable lease payments linked to sales or use.12 See footnote 6.13 Because low-value asset leases are expected to not be material for most lessees, the Board does not expect any significant differences in the amountsrecognised by companies applying IFRS Standards and companies applying US GAAP in this respect.4 Investor Perspectives—A New Lease of Life January 2016

Effects on the balance sheet Lease assets Financial liabilities EquityFor companies that have material off balance sheetleases, IFRS 16 is expected to result in an increase inlease assets and financial liabilities.The carrying amount of lease assets will typicallyreduce more quickly than the carrying amount oflease liabilities. This will result in a reduction inreported equity compared to IAS 17 for companieswith material off balance sheet leases. This effectis not unique to leases. It is similar to the effecton reported equity that arises from financing thepurchase of an asset, either through a former onbalance sheet lease or through a loan.Similarities and differences: IFRS Standards vs US GAAPPresentation of lease liabilitiesAccordingly, there will be a change to key financialratios derived from a lessee’s assets and liabilities(for example, leverage and performance ratios).The Board and the FASB have both concluded that leaseliabilities meet the definitions of financial liabilities inIFRS Standards and US GAAP.The example in the appendix to this articleillustrates this.Neither IFRS 16 nor the US GAAP model prescribesany particular presentation for lease liabilities, exceptthat the US GAAP model requires a lessee to present leaseliabilities relating to former on and off balance sheetleases in different line items. In contrast a lessee applyingIFRS Standards will make this distinction (or a morerelevant one) only if that is relevant to understandingits financial position.❹ Presentation of lease liabilitiesLease liabilities are considered to be financialliabilities. IFRS 16 requires a lessee to disclose leaseliabilities separately from other liabilities. Applyingthe requirements in IAS 1, a lessee is required topresent lease liabilities as a separate line item,or together with other similar liabilities, in amanner that is relevant to understanding the lessee’sfinancial position. A lessee will also split leaseliabilities into current and non‑current portions,based on the timing of payments.❺ Presentation of lease assetsIFRS 16 requires a lessee to present lease assetson the balance sheet either (a) together with ownedproperty, plant and equipment (if not presented asa separate line item) or (b) as their own line item(s)if that is relevant to understanding the lessee’sfinancial position.Investor Perspectives—A New Lease of Life January 2016 5

Income statementInvestors should be aware that the lease accountingmodel will change what they see in the incomestatement. Applying the new model, the incomestatement will disaggregate the presentation oflease expenses for former off balance sheet leases(ie splitting the expense into two components) andin a manner that explicitly recognises the financingelement inherent in leases. This will change thepattern of expense recognition on an individual lease.❻ Single lessee modelIFRS 16 requires a lessee to account for all leasesrecognised on the balance sheet in the same way.This is because all leases result in a lessee obtainingthe right to use an asset at the start of the lease and(if payments are made over time) also obtainingfinancing. Consequently, IFRS 16 requires a lessee torecognise and present (a) depreciation of lease assetsseparately from (b) interest on lease liabilities.Individual leases—for an individual former offbalance sheet lease, IFRS 16 results in a different totalexpense recognition pattern compared to IAS 17. Thisis because interest expense is typically higher in theearlier years of a lease than in the later years. Whencombined with typically straight-line depreciation oflease assets, this results in a total lease-related expense(interest plus depreciation) that is higher than astraight-line lease expense during the first half of thelease term. The opposite is true in the second half ofthe lease term. Over the lease term, the total amountof expense recognised is the same.Portfolio of leases—nonetheless, lessees typically holdportfolios of leases, which generally neutralises anysignificant effect on profit or loss when applying IFRS 16compared to IAS 17. For example, if a lessee’s leaseportfolio is evenly distributed (ie the same number ofleases start and end during a period and the terms ofthe new leases are similar to those that have completed),then the overall effect of IFRS 16 on profit or loss willbe neutral. If the composition of a lessee’s portfolio isnot evenly distributed, then there would be an effect onprofit or loss. However, a lessee’s lease portfolio wouldusually have to change quite significantly to have anynoticeable effect on profit or loss.14Effects on the income statement EBITDAOperating profit and finance costsProfit before taxFor companies that have material off balance sheetleases, IFRS 16 is expected to result in higher profitbefore interest (for example, operating profit or EBIT)compared to the amounts reported applying IAS 17.This is because, when applying IFRS 16, a companypresents the implicit interest in lease payments forformer off balance sheet leases as part of financecosts. In contrast, when applying IAS 17, the entireexpense related to off balance sheet leases wasincluded as part of operating expenses. The size ofthe increase in operating profit, and finance costs,depends on the significance of leasing activitiesto the company, the length of its leases and thediscount rates applied.The example in the appendix to this articleillustrates this.14 See sub-section on ‘recognition—portfolio of leases’ and Appendix D of the Effects Analysis of IFRS 16 (pages 45–46, 98–101) for further information aboutthe likely effects on a portfolio of leases.6 Investor Perspectives—A New Lease of Life January 2016

Cash flow statementSimilarities and differences: IFRS Standards vs US GAAPIFRS 16US GAAPRevenuexxOperating costs15---Single expense16 Depreciation andamortisationDepreciationDepreciation17Operating profit InterestInterest17 18 EBITDAFinance costsProfit before taxAlthough the accounting for leases changes, thecash paid for leases does not. However, investors willsee the classification of reported cash flows changecompared to IAS 17.❼ Leases are financing activitiesTo retain the link between the balance sheet, incomestatement a

10 Applying IFRS Standards, interest payments can be presented within operating, investing or financing activities. The table below provides an overview of the lessee accounting requirements in IFRS 16, showing the similarities and differences between IFRS 16 and the forthcoming US GAAP model. For lessor accounting,

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