IFRS (International Financial Reporting Standards) are a set of accounting standards that provide a common global framework for how companies prepare and disclose their financial statements. They aim to enhance transparency and comparability across companies and industries internationally.
IFRS 16 Leases is a specific IFRS standard that fundamentally changed how lessees (the party that leases an asset) account for leases. Prior to IFRS 16, a lessee would classify leases as either "finance leases" or "operating leases." Operating leases were kept off the balance sheet, which critics argued masked a company's true financial leverage and liabilities.
Importance of IFRS 16 for Lessees
IFRS 16 is important for lessees because it requires nearly all leases to be capitalized on the balance sheet. This single-model approach eliminates the previous distinction for lessees between operating and finance leases. The standard mandates that a lessee recognize a "right-of-use" (ROU) asset and a corresponding "lease liability" for all leases with a term of more than 12 months, or for leases of high-value assets. This provides a more faithful representation of a company's financial position and obligations.
The impact on financial reporting is significant:
Balance Sheet: Both assets and liabilities increase, leading to a larger balance sheet. This can affect financial ratios like the debt-to-equity ratio and gearing ratio.
Income Statement: The straight-line lease expense from the previous standard (IAS 17) is replaced by a depreciation expense on the ROU asset and an interest expense on the lease liability. This results in a higher total expense in the earlier years of the lease and a lower total expense in later years, which can affect profitability metrics like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
Cash Flow Statement: The cash flow classification changes. Lease payments are no longer classified entirely as an operating cash outflow. Instead, the principal portion of the lease payment is a financing cash outflow and the interest portion can be classified as either an operating or financing cash outflow.
Key IFRS 16 Terminologies
- Lease: A contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
- Lessee: The entity that obtains the right to use the underlying asset.
- Lessor: The entity that provides the right to use the underlying asset.
- Right-of-Use (ROU) Asset: An asset representing the lessee's right to use an underlying asset over the lease term.
- Lease Liability: The lessee's obligation to make lease payments, initially measured at the present value of the future lease payments.
- Lease Term: The non-cancellable period for which a lessee has the right to use the asset, along with any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.
- Incremental Borrowing Rate: The rate of interest a lessee would have to pay to borrow funds to obtain an asset of similar value to the ROU asset in a similar economic environment. This rate is used to discount lease payments if the interest rate implicit in the lease cannot be easily determined.
IFRS 16 Journal Entries and Financial Reporting Impact
IFRS 16 requires specific journal entries to be recorded at the commencement of the lease and throughout its term.
1. Initial Recognition (Lease Commencement)
At the start of the lease, the lessee recognizes the ROU asset and the lease liability.
- Debit: Right-of-Use Asset
- Credit: Lease Liability
The initial value of the ROU asset is the amount of the lease liability, plus any lease payments made at or before the commencement date, initial direct costs, and an estimate of costs for dismantling and restoring the asset. The lease liability is the present value of the future lease payments.
2. Subsequent Measurement (Over the Lease Term)
Each period, two main entries are recorded:
Lease Liability Amortization & Interest Expense:
- Debit: Interest Expense (on the outstanding lease liability)
- Debit: Lease Liability (to reduce the principal)
- Credit: Cash/Bank (for the lease payment made)
ROU Asset Depreciation:
- Debit: Depreciation Expense
- Credit: Accumulated Depreciation - Right-of-Use Asset
The depreciation is typically calculated on a straight-line basis over the shorter of the lease term or the useful life of the underlying asset.
The financial impact is that instead of a simple rent expense, the income statement now shows two distinct expenses: interest expense (a finance cost) and depreciation expense (an operating cost). This increases reported EBITDA and lowers reported EBIT (Earnings Before Interest and Tax) and net income in the early years of the lease, due to the front-loaded nature of the interest expense.
Components Impacting ROU Asset, Lease Liability, Interest, and Depreciation
ROU Asset & Lease Liability
- Lease Payments: This is the primary component. It includes fixed payments, variable payments based on an index or rate, and payments from a purchase option if the lessee is reasonably certain to exercise it.
- Discount Rate: The present value calculation for the lease liability is highly sensitive to the discount rate used. A higher rate results in a lower lease liability and ROU asset, and vice versa.
- Lease Term: A longer lease term increases the number of payments included in the calculation, thus increasing the ROU asset and lease liability.
- Initial Direct Costs: These are costs incurred by the lessee to arrange the lease (e.g., legal fees, commissions). They are added to the ROU asset.
- Lease Incentives: Incentives from the lessor (e.g., rent-free periods) reduce the initial carrying amount of the ROU asset.
- Restoration Costs: Estimated costs the lessee will incur to dismantle or remove the asset are added to the ROU asset.
Example: A company leases office space for 5 years with annual payments of $10,000. The company's incremental borrowing rate is 5%. * Lease Liability: The present value of 5 payments of $10,000 discounted at 5% would be approximately $43,295. * ROU Asset: The initial ROU asset would be the same as the lease liability, $43,295, assuming no initial direct costs or incentives.
Interest Expense
- Lease Liability Balance: Interest expense is calculated on the outstanding balance of the lease liability at the beginning of each period. As the principal is repaid over time, the outstanding balance decreases, and so does the interest expense.
- Discount Rate: A higher discount rate results in a higher interest expense.
Example (continuing from above): * Year 1 Interest Expense: $43,295 (initial liability) * 5% = $2,165. * The first lease payment of $10,000 would be allocated as $2,165 to interest and $7,835 to the principal. The new liability balance for Year 2 would be $43,295 - $7,835 = $35,460. * Year 2 Interest Expense: $35,460 * 5% = $1,773.
Depreciation Expense
- ROU Asset Value: The depreciation expense is calculated on the initial or remeasured value of the ROU asset.
- Depreciation Method: Typically, a straight-line method is used.
- Lease Term: The depreciation period is the shorter of the lease term or the useful life of the underlying asset. A shorter depreciation period results in a higher annual expense.
Example (continuing from above): * Annual Depreciation: $43,295 (ROU asset) / 5 years = $8,659. This amount remains constant each year, unlike the interest expense.
Provisions in Nepal NFRS (Nepal Financial Reporting Standards)
Nepal has adopted its own set of accounting standards, Nepal NFRS (NFRS), which are based on IFRS. The provisions of NFRS 16 Leases in Nepal are largely consistent with IFRS 16. It requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with a term of more than 12 months, unless the underlying asset is of low value.
The key features are: * The elimination of the operating vs. finance lease distinction for lessees. * The capitalization of leased assets on the balance sheet. * The recognition of depreciation and interest expenses in the income statement.
Tax Implications
The tax implications of IFRS 16 can be complex because tax authorities may not follow the new accounting treatment. In many jurisdictions, including Nepal, tax laws still operate on the old accounting model (treating operating leases as a simple deductible expense) and may not recognize the depreciation and interest from the IFRS 16 model.
- Deductibility: For tax purposes, the lease payments are generally treated as an operating expense and are fully deductible as and when incurred.
- Reconciliation: Companies must perform a reconciliation between their financial accounting profit (prepared under IFRS 16) and their taxable profit. This involves reversing the IFRS 16-related entries (depreciation and interest) and instead deducting the actual lease payments made during the period.
- Deferred Tax: The difference between the accounting treatment (ROU asset and lease liability) and the tax treatment (no asset or liability, only expense) creates a temporary difference. This requires the company to recognize a deferred tax asset or deferred tax liability on its balance sheet to account for the future tax consequences of these differences.
