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March 28, 2019

The tricky question of accounting for leases under IFRS 16

I live in a leased townhouse and run my business from a leased office. This is likely to be the story of many people and businesses in this region. Hence a genuine question arises for such businesses that have offices, warehouses, staff accommodation and/or other properties on lease about the implications of IFRS 16 for leases applicable from January 1, 2019 in their accounting.

All entities are required to bring their lease agreements on the balance-sheet as a right-of-use (RoU) asset and a lease liability, barring some exceptions. The related expenses will then hit the income statement under two heads — amortisation of the RoU asset and interest accretion on the lease liability.

This is a sea change from the existing treatment under IAS 17 whereby many of these property leases would have been considered as operating leases and rentals simply expensed as operating expenses in the financial statements.

A bigger concern for some businesses is likely to be the impact it will have on certain balance-sheet ratios. Such an impact could be beneficial or disadvantageous depending on the significance of different matrices to the entity. For example, application of IFRS 16 will result in an increase in earnings before interest, tax, depreciation and amortisation (EBITDA) and operating cash flow, but will likely adversely impact liquidity and debt ratios.

Entities with leased properties and subject to financial covenants may do well to look at these potential implications in advance and renegotiate with the lenders if needed.

Complexities can also arise in the implementation of IFRS 16. One concern relates to the fact that many property leases in the region are annual.

Many such lease agreements are also silent on renewals, though in practice, it is common for most of these arrangements to be renewed for a few more terms. This can then raise the question as to what period of lease should be considered for accounting under IFRS 16.

At one end, it can be argued that there is no valid contract beyond the initial term as technically both parties — the lessor and lessee — can walk away from the lease after the initial term. Thus, the non-cancellable period is the contractual lease term and there is actually no “option” available to the lessee to extend beyond that.

Any extension is thus a modification of the initial contract. However, the argument at the other end is that in substance, the lessee and the lessor are reasonably certain to keep renewing the property lease for at least a few terms and hence, the right-of-use asset should include the period for which such reasonable certainty exists.

How to determine such period will then become a key judgement, one which can impact the balance-sheet size and also potentially result in balance-sheet volatility year-on-year. This is an area where businesses should discuss and agree the appropriate approach upfront with their auditors.

There are a few other relatively “simpler” complications around property leases. The maintenance obligations of the lessor often included in the lease contract is one of them. IFRS 16 allows companies to strip out any non-lease components and only account for the lease component as the RoU asset.

This increases accounting complexity. On the other hand, this has mixed implications on the ratios as stripping out non-lease components reduces the load on the balance-sheet, and also reduces the EBITDA and operating cashflows than otherwise. How to determine the value of these non-lease components if the lease agreement does not explicitly mention it will be a judgemental area.

Many leases also have variable lease payments such as revenue-based lease payments and inflation-linked rentals. The treatments of such items are fairly clear and should not normally result in difficult judgements, though they would definitely add to the time and cost of accounting.

Note: This article was published by Gulf News on March 28, 2019. Here is the link to the Gulf News article.

We can assist you with any accounting issues around IFRS 16 and Topic 842. For our list of services, please visit this link.

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