New Accounting Standard On Leases: IFRS 16 And Its Implications On Reflecting Economic Reality

Issues with the old accounting standard for leases

The IFRS issued a new standard for leases that will oblige lessees to recognize most of the leases in their statements of financial position as lease obligations with equivalent right to use assets. A lease contract is considered to be a contract between two parties, the lessor, and the lessee. According to the lease agreement, a lessor is the lawful owner of the property; the lessee acquires the right to utilize the property in return for rental fees (Warren, 2016). Under present accounting requirements, more that 85% of the leases are labelled as operating leases and they are not reported on the statement of financial position. The new lease accounting model issued by FASB in FY2016 represents one of the biggest and most important reporting adjustments to accounting policies in decades. This principle accounts for a complete overhaul of financial reporting that will basically require corporations that lease assets to realize on the balance sheet the liabilities and assets for the obligation and right formed by those particular leases (Altamuro, Johnston, Pandit, & Zhang, 2014).

Under this particular rule, the lessee will be needed to recognize liabilities and assets for leases with terms of more than twelve months and also requires that both types of leases be realized on the statement of financial position. IFRS 16, stipulates that the new standard becomes effective for public business entities, non-profit making organizations and certain employee’s benefits plans beginning after December 2018 and all other businesses after December 2019. This assignment attempts to explain the reasons why the new accounting principle on leases will help replicate the economic reality.

According to the introductory comments to the European Parliament in Brussels, the IASB chairperson stated that the previous accounting principle did not ponder the economic realism because the former accounting standard for leases required lessors and lessees to categorize their leases as either operating leases or finance leases and report for those two forms of leases seperately (Choubey, 2016). This particular standard was basically criticized for waning to meet the requirements of analysts and investors since it did not continuously offer a realistic representation of renting transactions. Specifically, it did not necessitate lessees to distinguish liabilities and assets that rises from operating leases as they were off-balance sheet leases. Consequently, many analysts investors and adjusted the reported amounts in a lessee’s financial reports so as to reflect the liabilities and assets emanating from off-balance sheet leases, and make other significant changes (Buchman, Harris, & Liu, 2016). Conversely, because of the limited available information, the estimates made were often incorrect. Additionally, several other stakeholders did not make amendments. This aspect created unevenness and inaccuracy of statistics in the market. Therefore, the new standard will offer much-needed transparency on firms lease liabilities and assets which mean implies that off-balance sheet lease financing is no longer hanging in the shadows.

The need for transparency and accuracy

The new leasing principle presents theatrical changes to the lessee’s balance sheets. Lessor accounting is basically rationalized so as to conform to certain variations in the lessee standard and the new standard for recognizing income (Shough, 2011). Regardless of being off-balance sheet, there can be no uncertainty that the operating leases basically creates real obligations because, during the economic crisis, some big retail businesses went bankrupt since they were incapable to bend to the new economic authenticity. In this case, the companies had significant enduring operating lease obligations on their stores and hitherto had a misleadingly lean statement of financial position which was the main reason why under the previous accounting principle, reporting companies off-balance sheet obligations were up to sixty six times bigger than the reported liability on their statements of financial position (Bloomfield, Biondi, Glover, Ohlson, Wilks, & Penman, 2011). Apparently, the accounting does not actually reflect the economic reality.

The reporting company’s off-balance sheet obligations were up than the reported debt on their statements of financial positions because they used to record no assets or liabilities on the financial records, but the paid amount was recorded as incurred. Consequently, a capital lease has been stated as an asset and as a liability on the company financial reports often at the present cost of the rental payments but never greater than the fair assets value of the market value. In order to compensate this aspect of missing information, diverse investors use several techniques that involve adding back operating leases into the balance sheet (Kieso, Weygandt, & Warfield, 2010). Conversely, these particular changes are usually rough calculations that might be way off the spot. Generally, the cost and risks of the new lease standard are quite manageable.

From the introductory comments to the European Parliament in Brussels, the IASB chairperson argued that under the previous accounting principle on leases, no-level playing field exists between some private airline firms because it leads to lack of comparability. An airline company that basically lessees fleet often looks very different from its competitors that borrow funds in order to purchase most of its airlines even when in certainty their financing liabilities might be very comparable. In this particular case, there was no level of playing fields because most of the airlines have been suffering the similar form liability that involves borrowing funds to buy new fleet and companies that lease fleet from leasing companies (Gazzar, Lilien, & Pastena, 2008).

Implications of the new leasing principle

Analysts and investors, however, have long considered the aspect of lease expenses as an essential element for assessing a business financial health because most of them basically do back of the envelope calculations in order to determine the appearance of the company balance sheet if it was forced to own up to lease liabilities. Diverse problems that are often experienced in the former lease standard will be determined in the impending lease standard because all the leases will be acknowledged as either liabilities or assets by the lessees. In this case, the accounting standard will reflect better the fundamental economy by discouraging the aspect of understatement of profits and also the understatement of liabilities in the company financial statements.

Basing on chairperson’s introductory comments, I think that the new accounting principle for leases will not be prevalent with everybody since the standard will result in a substantial change to the balance sheet of diverse companies globally. The IASB believes that it is highly improbable that the enhanced reflectiveness of lease liabilities will basically lead to substantial impacts on the borrowing costs and the debt agreements. The new change in IFRS 16 is projected to affect most of the listed firms as they will not be prevalent with anyone. This is because the new accounting standard will enable the lessee to recognize a right of utilize asset and a lease obligation that is treated same to other nonfinancial assets and depreciated accordingly (Grenier, Pomeroy, & Stern, 2015).

The unpopularity of this new standard is expected to increase because a lessor will basically recognize operating lease debts as revenue on a straight line basis. Implementation of the new IFRS 16 accounting standard will basically not put the leasing business out of trade operations because leases will continue to be highly competitive because it is considered to be a flexible source of financing. According to the chairman, the leasing industry will remain attractive to firms to lease property so that they do not endure the risks of possessing them and thus leading to improved allocation of capital that should be beneficial for the growth of the economy. Changes in accounting are usually contentious and can be encountered with cautions of adverse economic impacts, debt agreement defaults and the changes in system charges which may basically cause unpopularity of this particular standard.

IFRS 16 basically states that the leaser will state a capital lease as a liability and as an asset at the sum that is equivalent to the present cost at the start of the lease period of least lease payment in the lease period agreement (Hales, Venkataraman, & Wilks, 2011). This aspect elucidates why the IASB chairperson said that the new reflectiveness of all leases would basically result to better informed investment assessments by the stakeholders and no more buy decision versus balanced lease by the company management team. This recorded amount shall exclude the section of the payments that represents executor costs like maintenance, taxes, and insurance to be paid by the lessor with the proceeds thereon. Another possible reason is that the recognition of lease accounting in the company balance sheet will enhance the management to have a clear insight of the amount of liabilities the company possesses because the improved allocation of capital will benefit the economic growth (Öztürk, & Serçemeli, 2016). IFRS 16 is also projected to decrease the operating cash outflows by the company with a consistent rise in financing inflows. This is because when using the last leases standards, firms presented cash flows on the past off balance sheet leases as basically operating events.

Changes to lessee’s balance sheets

When utilizing IFRS 16, principal payments on all lease obligations are usually encompassed in financial activities. On the other hand, interest costs can also be comprised either in financing activities or operating activities in accordance with the new lease standards, and this will basically lead to better informed asset decisions by the shareholders (Aiken & Ji, 2013). The new IFRS 16 standard will offer a more central place to the idea of stewardship and make clearer the major aim of financial reporting which is not only to assist the market participants to estimate future cash flows but also help them access the management stewardship of the company resources.

Accounting IFRS standard update will affect firms that lease real vehicles, estate, construction and manufacturing equipment and other assets. The standard basically requires that these particular businesses recognize most of their respective leases on the balance sheets possibly inflating their reported liabilities and assets. The new principal will also obligate lessees to record on their balance sheet liabilities and assets for all agreements with conditions of more than twelve months concerning their categorization (Greuning, Scott, & Terblanche, 2011). In this case, lessees will basically record a right to utilize the property and a consistent burden to pay discounted rent to its present value. The recognition, presentation, and measurements of the cash flows and expenses that arise from a lease by a lessee will remain to rely mainly on its categorization as a capital or operating lease.

For capital leases, the lessees will basically amortize right to use assets differently from the lease obligation interest on the report of comprehensive revenue. They will categorize payments of the principal percentage of the lease charge in funding projects and interest outflows on the lease obligation and variable lease amounts in operating events in cash flow statements (Kaaya, 2015). For operating leases, lessees will basically record a total lease amounts evaluated so that the lease cost is assigned over the lease period on a generally straight line basis. In this case, the company management will categorize all cash outflows in operating events in the cash flow statements.

For diverse firms, leases often play a vital part in their industry operations. However since most lease businesses such as operating leases are off balance sheet presently, leases accounting under the present lease principal usually do not require substantial effort (James, 2016). The new lease standard will necessitate a firm to additional transform its current operating lease engagements footnote revelation to replicate lease liabilities and assets.  IFRS 16 obliges lessees to basically recognize most leases on their statements of financial positions despite the industry that the company operates in. Its execution could lead to modifications to the processes, policies, and controls that sustain accounting for lease and probably lease administration, tax, and procurement (Deegan, 2012). For most of the lessees, the new principal will lead to a gross up of the statements of financial positions that could basically cause a decline of return on assets and debt ratios related with present accounting. Diverse firm’s might also wish to consider the repercussions of its metrics and financial reports as they basically discuss a contract that they are or may enclose leases because these particular events will require participation from diverse units across the firm.

Conclusion

Lessors will see little to their accounting from current IFRS because the new lease standard includes some targeted alterations that are aimed to support lessor accounting with both lessee standard of accounting.  The new standard requires extra disclosures so as to assist users of the financial records better understand the timing, amount, and contingency of cash flows that are related to leases. In this case, lessees will disclose both quantitative and qualitative requirements that comprise of information about variable lease opinions and payments to terminate or renew leases (Kaaya, 2015). These particular changes may also have diverse repercussions for lessees since firms may incur costs to educate its staff on the proper application of the new requirements and financial statements users on the effect of the new requirements.  

Conclusions

The new IFRS 16 accounting standards basically states that the leaser will state a capital lease as a liability and as an asset at the cost that is equivalent to the present cost at the start of the lease period of least lease payment in the lease period agreement. Diverse companies often use leases when investing as they usually lease an asset as a way to cut costs and reduce risks. Companies often agree to rent a property owned by another party so as to reduce costs. This financial arrangement is vital because renting is less capital intensive than purchasing because if a firm has constrained on its capital, then it can develop swiftly by leasing than purchasing diverse properties.

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