IFRS 16
1. Replacement
IFRS
16 will replace IAS 17.
2. IAS 17
i.
Finance
lease
IAS 17 required the capitalization of
finance leases. This means that you should record all the assets you leased and
your liability to pay instalments in the SOFP.
This is the double entry that is passed
to capitalize a finance lease
Dr The asset that you leased, e.g. Motor
Car
Cr Lease liability
ii.
Operating
lease
They are not capitalized. That means that
when you read the SOFP of a firm, you will not find it.
iii.
Gearing
Operating leases are not included in the
financial statement. This means that the double entry above will not be made.
When you enter into any lease, you are
liable to pay future instalments. When you add all the future instalments
together, then, you will arrive at your lease liability.
The lease liability for an operating
leases is not added to your liabilities. This will lead to liabilities being
under-estimated.
An under-estimation of liabilities
reduces gearing.
iv.
Classification
Some leases may have features of both
finance lease and operating lease. If you don’t want to increase your gearing,
you will classify the lease as an operating lease. This leads to an opportunity
for creative accounting.
v.
Asset
The conceptual framework defines it as
an economic resource from which future economic benefits are expected to flow. An
asset is anything that you can use to make money in the future or to reduce your
costs in the future.
When you enter into an operating lease,
the asset you lease will be used to either make money/reduce your cost. For example
you acquire a machine on operating lease. This machine will be used to produce
goods that you can sell for cash in the future. So, the machine is an asset.
This means that the asset meets the
Conceptual Framework’s definition, but, IAS 17 said that the operating lease
asset should not be included in the SOFP(i.e.capitalized).
Example
An Machine was leased for 4 years. The machine
had a cash price of N20m. This lease has features of a finance lease and
operating lease features.
Particulars
|
Fin Lease
|
Operating lease
|
Difference
|
N’m
|
N’m
|
N’m
|
|
Machine(Dr)
|
20
|
0
|
-20
|
Liability(Cr)
|
20
|
0
|
-20
|
As you can see, if you recognize the
lease as an operating lease your assets and liabilities will be N20m less than
what they should be.
vi.
Effect
of Understating assets
The effect is that the Return on Capital
Employed will be overestimated. This will lead to an overly-optimistic view
about the company’s performance.
Example
Assuming the net asset before the lease
was N10m and the PBIT for the year was N1m:
ROCE(FinLease)= 1/(10+20)*100= 3.333333%
Op lease= 1/10*100= 10%
So, the company can inflate its ROCE by
treating the lease as an operating lease.
vi.
Completeness
The failure to capitalize an operating
lease means that the SOFP will not show a true picture of the company’s
financial position. This is because operating lease assets and liabilities were
excluded from the SOFP.
If the user/reader of the financial
statement wants to totally understand the financial statement, he/she will have
to adjust the SOFP by including operating lease assets and liabilities. This can
be very tasking. What if the company has 100 operating leases?
To conclude, a true and fair view will
not be shown by the financial statement.
vii.
Other
reasons for replacing IAS 17
IAS 17 was described as “completely useless”
IASB’s Chairman by in 2002. Here are other reasons why IASB chose to replace
it:
a.
Disclosure
The disclosures are not enough. It is
possible for the company to keep quiet about some operating leases, so, they can
hide them from FS readers.
b.
US
GAAP
IASB wanted to make the lease standard
of IFRS to be similar to the lease standards used in US. This is to encourage
US to switch to IFRS. The work US will be need to do to change to IFRS will be
reduced.
Also, there are some big companies that
do business in US and countries that use IFRS. Making the lease standards
similar will make it easier for them to prepare their Consolidated Financial Statements.
c.
Too
Judgemental
A company’s management has to use its
judgement to determine whether a lease is a fin/op lease when it has features
of both.
The more management judgement is used in
the preparation of financial statements, the greater the risk of creative
accounting.
d.
Comparism
It is harder to compare the balance
sheet of companies when companies havr some assets and liabilities are excluded from
the SOFP.
Example
Liabilities shown in
SOFP
|
Excluded op lease
liability
|
Actual liability
|
|
Company A(N’m)
|
10
|
10
|
20
|
Company B(N’m)
|
10
|
0
|
10
|
Comparing A and B based on their SOFP
figures will probably not give you accurate information. Adding excluded
liabilities can be a tedious process.
3. IFRS 16
i.
Published
It was published in January 2016
ii.
Effective
date
It is not compulsory to adopt it until 1st
January of 2019. Any company that chooses to adopt it before this date must
also adopt IFRS15 (Revenue)
iii.
Classification
Leases are no longer classified into
finance lease and operating lease.
iv.
Lessor
Accounting
It didn’t really change. The main thing
is that the required disclosures were increased. The changes below refer to
lessee accounting.
A lessor gives out his asset on a
leases, while, the lessee is the receiver.
v.
Capitalisation
All leases must be capitalized except:
a. A
lease with a period that is not greater than 1 year/12months
b. A
lease with a period that is not reasonably certain to be more than 12 months,
i.e. one is not sure that the lease period will be more than a year
c. A
lease of an asset that has a low value. IASB did not define “Low value”. This will
be based on the mangement’s judgement.
vi.
The
double entry for a capitalizing a lease
Dr Right-of-Use Asset/Lease
Asset(another name for ROU asset)
Or
Dr The account of the leased asset(just
like IAS 17)
Cr Lease liability
vii.
Accounting
It is easier to account for a lease when
it is not capitalized. All you have to do is to debit the lease expense to the
SOP/L.
When a lease is capitalized, you have to
recognize it in the SOFP. In the SOP/L, the lease expense will be split into
a. An
interest expense and
b. Depreciation.
viii.
Services
If a contract includes a lease and
services, you can either:
a.
Split
the contract
The service part will be expensed to the
SOP/L, while, the Lease part will be capitalized.
b.
Do
nothing
If you don’t have time, you can choose
to treat the total contract amount as a lease.
Example
You enter into a contract with ABC
Motors that include a lease of a car with a N1m cash price. You also agreed, in the
contract, to pay N0.1m for the the supplier to maintain the car
Option 1
Treat the N1m as a lease and expense the
N0.1m
Option
2
Treat the entire contract value as a
lease- N1.1m
ix.
Cash
flow
The switch to IFRS 16 will not change
the total Cashflow.
That said, it will increase s from
investing act ivies and reduce CFs from operating activities.
This is because operating lease rentals
are recognized under CF from Operating Activities under IAS 17.
Now, all lease rentals must appear under
CFs from investing activities.
x.
Advantages
of IFRS16
a. It
reduces the scope for creative accounting
b. It
makes financial statements more comparable
c. It
is in line with the Conceptual Framework
d. It
makes financial statements to give truer and fairer views
xi.
Additional
Disclosure requirements
a. Information
about assets, expenses and cashflows- for every lease
b. Maturity
analysis of lease liability i.e. show when leases will end
c. Any
other relevant information
xii.
Application
of IFRS 16
There are two options:
a.
Full
retrospective application
This is done by adjusting the numbers of
the financial statements that were prepared before you ported to IFRS 16.
b.
Partial
retrospective application
This is done by adjusting the opening equity
figures to reflect the switch. It is less complex.
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DOWNLOAD AUDIO LECTURE
Join me at Bespoke Associates where I currently lecture the ICAN Case Study, PSA and MGE.
National Primary School, Abule Ijesha, Yaba.