The difference between IAS 17 and IFRS 16: How lease accounting is changing

Out with the old and in with the new. The new – and hopefully improved – lease accounting standard from the International Accounting Standard Board (IASB) changes the way leases affect reported financial metrics as IAS 17 is replaced by IFRS 16.
Operating leases have long appealed to businesses for their ability to avoid recognising assets and liabilities on financial statements. Now, after a decade of deliberation, there is a new IFRS accounting standard for leasing that brings these figures onto the balance sheet. What exactly does that mean, though? How does IFRS 16 differ from IAS 17?

This lease accounting article should help clear things up, as we take a look at IAS 17 vs IFRS 16.

IFRS 16 Summary

The most obvious and impactful difference is how operating leases will be brought onto the balance sheet. Under IAS 17, a lessee is not obligated to report assets and liabilities from operating leases on their balance sheet and they are instead referred to in the footnotes. This has typically provided financial statement users an inaccurate account of a company’s outstanding expenses, forcing them to estimate the off balance sheet obligations, which often results in overestimations. Similarly, it is difficult to compare businesses that lease assets with those that buy them as a clear indication of the operating leases are left out of the equation.

IFRS 16 changes this by requiring a lessee to recognise arising right of use (ROU) assets and lease liabilities on their balance sheet. Undoubtedly one of the biggest changes to leases accounting, the consequences of recognising operating leases will see a large difference in various financial metrics.

See more: IFRS 16 Overview and Lease Accounting Summary

IFRS 16 vs IAS 17

Operating lease accounting treatment

IAS 17 – Operating leases off-balance sheet as a single expense. Finance leases on balance sheet

IFRS 16 – Operating leases recognise assets and liabilities on balance sheet. Operating leases to report depreciation and interest separately.

Why the difference? Improved comparability and transparency on balance sheet. Financial statement users can clearly see the effect of operating leases and have a useful basis for comparability with other companies. Currently, under IAS 17, it is difficult to compare companies who lease with those who buy.

Potential impacts:

• Financial report impact - As operating leases will be capitalised, there will be a shift in financial metrics for businesses that have a particularly large number of this type of lease.
  Asset turnover, equity and operating expenses will likely see a decrease. Conversely, liabilities, reported debt, recorded assets, EBIT and EBITDA will all see an increase.
• Covenants and shareholder relationships - With a change in financial metrics, ratios and liabilities, companies will need to take extra care with their disclosures to explain the shift figures. This could lead to a possible breach of financial based agreements and contracts, both internally (performance KPIs and metric based compensation payments/bonuses) and externally (bank covenants, stakeholder relationships, investor relationships).

Definition of a lease

IAS 17 – Focus on whether lessee or lessor carries the risk and reward. Both lease and non-lease components accounted off balance sheet.

IFRS 16 – More focus on who controls the ROU asset, linking with IFRS 15. Non-lease components still excluded, but lease components will need to be reported on.

Why the difference? – Another change in lease classification affects what actually constitutes a lease agreement as IFRS 16 contains a new lease definition. The actual wording of the definition in IFRS 16 does not change too much from the IAS 17 one. However, there is a greater emphasis and weight surrounding how a lease differs from a service. This is aimed at improving the comparability of financial statements, capturing useful material information on leases rather than additional components.

Potential impacts – Lessees are required to identify and separate non-lease components (i.e., services components such as maintenance) to ensure only the necessary ones are accounted for on balance sheet. This mean that Non-lease components will receive an increased focus in negotiation phases and their separation from a lease is more important. However, IFRS 16 does permit an accounting policy election (the practical expedient), whereby lessees can recognise the lease and non-lease comment as a ‘single lease component' on the balance sheet. If lessees choose to utilise this election, this would in effect, increase the lease obligations stated on balance sheet. (Note, if this expedient is adopted, lessees are not permitted to account for the combined lease and non-lease component as a ‘service’).

Lessor interaction

Lessor accounting remains largely unchanged under IFRS 16. However, with operating leases losing their off balance sheet accounting treatment, the types of agreements lessees favour may shift, as companies focus more on the operational benefits of leasing over accounting ones. Lessors typically use operating leases as a tool to price more competitively.

IAS 17 – Focus on lease type from an operational perspective. Many lessees used operating leases to avoid balance sheet recognition. Others prefer the reduced risk and reward, as well as the competitive pricing that operating leases offer.

IFRS 16 – Lease type has a lower impact from an accounting standpoint, however, a greater focus is placed upon on the deal types that can be negotiated.

Why? – Although lease accounting is removing the operating lease and finance lease classification for lessees, lessor accounting remains largely unchanged and the operational differences between operating leases and finance leases remain. Businesses may look for more inventive ways to lease to continue to get the most out of their assets.

Potential Impacts – Buy vs. lease becomes a more important decision if you rely on the off balance sheet reporting capabilities of an operating lease. New types of lease arrangement may be created by lessors to keep leasing competitive. Greater focus on the operational benefits vs. accounting benefits, such as asset refresh, risk and reward etc.

Accountant involvement

Accounting departments will be greatly impacted by the new standard, especially in the first year of reporting. The way they interact with leasing within the company is likely to change as they need to know more information about operating leases and how their inclusion affects the financial reporting when accounting for leases under IFRS 16.

IAS 17 – The accounting treatment of operating leases is less complex than the treatment of finance leases and the volume of operating leases is predominantly higher than that of finance leases. So, currently, accounting departments have a lower volume of the challenging calculations to make.

IFRS 16 – Under the new standard, however, as all leases will be treated under the same accounting treatment, accounting departments will have a higher volume of complex amortisation calculations to perform.

Why? – As operating leases have not needed to appear on balance sheet, accountants have had a less challenging interaction with them. The difference will be particularly for internal accountants, where the company does not have many finance leases.

Potential Impact – Much greater interaction between accountants and other departments involved in leasing, mainly in the first year of application. Must ensure figures within procurement, for example, match those of the accountants. More strain on small accountancy teams, especially with IFRS 15 and IFRS 9 occurring at a similar time.

Measuring PV and rate

IAS 17 – Finance leased assets and liabilities are measured at the fair value of the leased property or, if lower the PV of the minimum lease payments. The discount rate to be used in calculating the PV of the minimal lease payments is the implicit rate if known, otherwise, the lessee’s borrowing rate. Any initial direct costs of the lessee are added to the value of the asset.

IFRS 16 – Measures the lease liabilities at the PV of the lease payments that are not paid at the date discounted using the implicit rate if known, otherwise, the incremental borrowing rate. There is no reference to the fair value and the measurement does not relate to the minimal lease payments. Instead, the lease payments that are not paid.

IFRS 16 is more specific as to the definition of the payment to be included in the measurement of the lease liability. Lease payments included in lease liability include:  a) Fixed payments; b) variable lease payments dependent on an index or a rate, initially measured using the index or rate at the date of commencement, c) amortisations expected to be payable by the lessee under residual value guarantees; d) the exercise price of a purchase option if the lessee is reasonably certain to exercise the option; and e) payments of penalties for terminating the lease.

The measurement of leased assets differs to IAS 17 whereby any lease incentives received may be deducted and lease payments made at or before commencement date may be added; as too can an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the underlying asset to the condition required by the terms and conditions of the lease.

Why the difference? – One of the main aims of IFRS 16 is to provide a consistent view of lease obligations in financial statements. To achieve this, the definitions of the leased asset and liability measures need to be specifically defined to ensure a consistent measurement approach.

Potential Impact – The biggest impact is in the measurement of operating lease liabilities and assets which did not previously have to be performed. This can be an onerous task and the data collation exercise is key to ensuring all relevant measurement components are captured before the measurement and recording task can begin.

Disclosures

IAS 17 – Disclosures cover the specific requirement of finance leases separate from operating leases.

IFRS 16 – Disclosures do away with the separate presentation of finance and operating leases for lessees and instead requires disclosures of the right of use assets and liabilities. There are also additional disclosures to specifically state whether the lessee has elected not to apply IFRS 16 to short-term and low-value leases. Specifically, disclosures are required for short-term and low-value lease express if these elections have been made, so too are variable lease payments not included in the measurement of lease liabilities.

Why? – As IFRS 16 requires all the lessee leases to be shown on balance sheet, the distinction between finance and operating leases is mute. It, therefore, makes sense to redefine the disclosure requirements to give more information on the leasing activity to achieve the goal of lessees reporting on a level playing field.

Potential Impact – When collating and measuring lease data it is important to bear in mind the disclosure requirements and ensure you capture the data in such as fashion to enable you to fulfil the disclosure requirement analysis with ease.

To get an overview of the changes to IFRS 16 and to gain a greater understanding of the associated impacts, follow this link.

If you're looking for a more comprehensive understand of the new standards and want to know what your company can do the prepare in advance, just click the link below.

Warning: this article contains general information about the new lease accounting standards only, and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.