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IFRS 16 marks the end of off-balance sheet treatment for leases

Building

Posted on April 21, 2016

In January 2016, after concluding their 10-year long project, the International Accounting Standards Board (“IASB”) published IFRS 16, Leases, which marks the end of off-balance sheet treatment of operating leases by lessees.        

IFRS 16 is effective for annual periods beginning on or after January 1, 2019, with early application permitted for entities that have adopted IFRS 15, Revenue from Contracts with Customers

What are the key changes?

The accounting for lessors will remain substantially unchanged. However, IFRS 16 will overhaul the accounting by lessees. The key changes for lessees are highlighted below:  

1. All leases, with limited exceptions, will be recognized on the balance sheet 

IFRS 16 eliminates the current requirement to classify leases as either finance leases (which are recognized on the balance sheet) or operating leases (which are only disclosed in the notes to the financial statements). Lessees will be required to recognize all leases on the balance sheet resulting in the recognition of a leased asset (i.e. right-of-use asset) and a corresponding financial liability representing its obligation to make future lease payments. Lessees will be provided an exemption for short-term leases (with a term of 12 months or less) and leases of low-value assets (an example provided in IFRS 16 is a personal computer, which has a value of US$5,000 or less when new), which can be accounted for in a manner similar to current operating leases with expenses recognized over the lease term. This is expected to significantly impact companies operating in the retail and travel sectors as well as other companies that have significant off-balance sheet obligations for operating leases. 

2. New definition of a “lease” 

Under IFRS 16, a lease can only exist if the customer has the right to control the use of an identified asset for a period of time and obtain substantially all of the economic benefits from its use. IFRS 16 provides detailed guidance on how to evaluate control, which centres on which party, the customer or the supplier, has the right to direct “how and for what purpose” the asset is used throughout its period of use. If the customer has the right to direct “how and for what purpose” the asset is used, and other criteria are met, the contract is, or contains, a lease. In contrast, if the supplier has the right to make such decisions, the contract is not or does not contain a lease, but may be a service contract. Determining whether a contract qualifies as a lease versus a service contract will be the new accounting hurdle to overcome as leases will be recognized on the balance sheet, whereas service contracts are generally not. Significant judgment will be required in making this assessment.

3. Leasing and non-leasing services will need to be unbundled

In some leases, the lessor provides a customer the right to use an asset as well as providing additional services, such as maintenance services. Under IAS 17, companies were required to separate lease components and service components. A lack of diligence in performing this exercise may not have presented an issue for operating leases under IAS 17 as both components were treated in a similar fashion from an accounting perspective (i.e. they would normally be expensed over the term of the contract). Under IFRS 16, because the lease component is required to be recognized on the balance sheet, the accuracy of the separation and allocation of payments between lease and service components will become more important. As a practical expedient, a lessee may elect to account for the lease and non-lease components together as a lease; however, the result of doing so is that the service element is recognized on the balance sheet. 

4. Re-assessment of the lease liability

Under IFRS 16, a lessee would need to reassess the lease term if something significant occurs that is within the lessee’s control and affects the lessee’s assessment of whether it will exercise an option to extend the term of a lease, terminate a lease or purchase the underlying asset. A change to the lease term will result in re-measurement of the right-of-use asset and the lease liability, using a current discount rate at the re-measurement date. Judgment will be necessary to identify significant events or changes in circumstances that trigger re-assessment.

5. Assessment of the lease term

Under IFRS 16, the lease term is considered to be the non-cancellable period of the lease plus:

  • any optional renewal periods (if it is reasonably certain that the lessee will extend the lease), and
  • any period after an optional termination (if the lessee is reasonably certain not to terminate early).

The lease term will impact the total lease liability recognized. As such, judgment will be necessary to identify all relevant facts and circumstances that may impact the lease term and more specifically, the reasonable certainty of options being exercised based on an economic incentive to do so. In this regard, entities must take into consideration all economic factors relevant to that assessment – contract-based, asset-based, market-based, and entity-based. Examples of economic factors to consider include, but are not limited to, contractual terms and conditions for the optional periods compared with market rates, existence of significant leasehold improvements, costs relating to the termination of the lease, the importance of the underlying asset to the lessee’s operations, and a lessee’s past practice regarding the period over which it has typically used particular types of assets (whether leased or owned) and its economic reasons for doing so.

Financial Statement Impacts

Overall, the balance sheets of lessees are expected to grow as right-of-use assets and lease liabilities associated with former operating leases will be recognized on the balance sheet. In addition, the “straight-line” expense, which was previously recognized for operating leases, will be replaced by a depreciation charge (which is typically even over the life of the asset) and an interest expense (which will be declining over the term of the lease as periodic payments are made). This change will result in a pattern of declining total lease-related expenses as the lease matures, which is similar to the current expense recognition pattern for finance leases. 

How will it impact financial metrics?

There may be some significant changes to a company’s key financial metrics, including the following:

Expected change Why?
Current ratio Red arrow down Decrease because current lease liabilities will increase whereas current assets will not
Debt to equity ratios Green arrow up Increase because lease liabilities will increase total liabilities on an entity’s balance sheet, thereby increasing the reported debt load
Asset turnover (e.g. sales to total assets) Red arrow down Decrease because leased assets will increase an entity’s reported asset base with no change in sales
EBIT Green arrow up Increase because the operating lease expense will be eliminated and replaced by a smaller amortization expense
EBITDA Green arrow up Increase because operating lease expense is no longer included, and depreciation and amortization are excluded from this profit measure

Companies should consider whether they need to renegotiate any loan or other agreements due to changes in their financial metrics.  

How else might this change affect my business?

Management needs to begin pulling together data from a variety of sources in order to assess the impact on their business. We anticipate there may be wider business implications on adoption, including:

  1. System changes - Companies may need to consider whether their current accounting systems are sufficiently robust to capture and track the necessary data to initially recognize leases as well as cope with changes to those leases down the road. Systems may also need to be upgraded in order to provide adequate information to compile the enhanced disclosures.

  2. Internal controls - Management should assess the adequacy of employees’ accounting knowledge regarding the requirements of the new standard and the impact on internal control activities.

Tax Accounting Considerations

In general, for Canadian income tax purposes, lease payments are deductible as incurred. As a result, the change to IFRS 16 is not expected to impact the amount or timing of current income tax deductions claimed on an income tax return with respect to leases. However, it is anticipated that there will be tax accounting consequences upon the adoption of IFRS 16. Since capitalized lease assets and lease liabilities recorded on the balance sheet are expected to change, their related temporary differences will change, impacting the deferred income taxes.

What about transition?

A lessee will have to choose to apply IFRS 16 using a fully retrospective approach or a modified retrospective approach (i.e. reflecting the cumulative impact of adoption on opening retained earnings without the restatement of comparatives). As a practical expedient, a lessee does not have to reassess on transition whether an existing contract is, or contains, a lease under IFRS 16. 

What are the next steps?
Although we are still three years away from the transition, it is not too early to start planning. This includes:

  • Taking inventory of all lease agreements and gathering the necessary data, including, among others, lease terms, renewal options and payment terms
  • Identifying “data gaps” including information required from subsidiaries and affiliates operating in foreign jurisdictions
  • Prioritizing the analysis of those lease arrangements that are significant and/or have complex elements
  • Preparing pro-forma financial information to assess the impact of the changes to the financial statements
  • Determining whether any changes need to be made to debt covenants, loan agreements, bonus or compensation agreements
  • Discussing the changes with relevant stakeholders, such as the company’s board of directors, creditors, analysts, key management personnel, etc.

As you start to analyze the implications of the new standard, questions of interpretation and application will inevitably arise. As always, please don’t hesitate to reach out to your Deloitte advisor for more information.

Diana De Acetis

Diana De Acetis
Partner, National Services

Diana is a partner in Deloitte’s National Services Accounting Group.  With more than 20 years experience, Diana has served a diverse group of clients operating in manufacturing, retail, telecommunications and mining in the accounting for complex transactions involving Accounting Standards for Private Enterprises (ASPE) and International Financial Reporting Standards (IFRS).  She is currently a member of the Private Enterprise Advisory Committee (PEAC) and is a frequent public speaker on the emerging issues involving ASPE and IFRS.

Kayla Macfarlane

Kayla Macfarlane
Senior Manager, National Services

Kayla is a manager in Deloitte’s National Services Accounting Group. In this role, she researches technical positions under various frameworks. Kayla also develops and reviews technical accounting resources aimed to assist engagement teams across the country.

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