With International Financial Reporting Standard (IFRS) 16 coming into effect for accounting periods beginning on or after 1 January 2019, Rebecca Williams and Anna Middlebrook of DLA Piper provide an overview of the changes, and the impact for lessors and lessees.
IFRS 16 was introduced by the International Accounting Standards Board in January 2016.
While there was the ability to ‘go early’, it is now effective for accounting periods beginning on or after 1 January 2019.
IFRS 16 is a major change in the accounting treatment of leases for those who adopt international accounting standards. It eliminates nearly all off-balance-sheet accounting for leases, essentially capitalising assets held under operating leases.
In making this amendment, IFRS 16 has an impact on a number of accounting metrics, such as EBITDA, the weighting of finance costs and depreciation, and the assets and liabilities which are contained on lessee balance sheets.
Under IFRS 16, subject to a few exceptions, all leases will be treated the same – broadly, the way a finance lease is: as an asset (the ‘right to use’ the leased item for the lease term) and a liability (the obligation to pay future rentals).
UK GAAP companies can still continue to apply UK GAAP to the accounting treatment of leases, but IFRS 16 will filter through to UK GAAP companies adopting IFRS/FRS 101 (Reduced Disclosure Framework) rather than FRS 102.
IFRS 16 and Lessors
Under IFRS 16, lessor accounting is substantially unchanged. Lessors continue to classify leases as finance and operating leases. There are, however, new requirements relating to sale-and-leaseback transactions.
For lessees, there is a single accounting model for all leases – bringing operating leases on balance sheet – but with two exemptions: low-value assets, and short-term leases of 12 months or less. Additional guidance has been provided around sublease arrangements.
IFRS 16 may mean lessees have to change policies and processes regarding lease accounting, administration and tax. Lessees may also reassess their needs when negotiating lease terms and payments.
The effect IFRS 16 has on how items such as EBITDA, finance costs and depreciation are reported in the accounts of a lessee can impact, among other things, how financial covenants lessees are tied into in finance agreements.
However, in documentation entered into before 1 January 2019, it is usually agreed that financial covenants and metrics will be tested based on pre-IFRS 16 GAAP, known as Frozen GAAP. This allows financial statements to be delivered and reported on using the same accounting principles, practices and policies utilised when the documentation was entered into.
Frozen GAAP can be implemented by either producing two sets of accounts – one for the purposes of compliance with accounting standards and one for the purposes of compliance with the agreement – or providing a reconciliation statement alongside the company’s latest accounts, such that the accounts are based on IFRS 16, but the reconciliation statement shows the position under pre-IFRS 16 GAAP.
If Frozen GAAP has been deployed, for the purposes of testing financial covenants, IFRS 16 will have little or no effect on the covenant itself. Alternatively, different metrics can be put in place to counteract any adverse accounting impact the change to IFRS 16 may have.
The Finance Act 2019 contains provisions relating to the introduction of IFRS 16 with a view to maintaining the current tax regime after the introduction of IFRS 16 for leased plant and machinery so that corporates are not materially impacted by the introduction of IFRS 16.
In 2011, in anticipation that changes to lease accounting treatment would eventually be made, HMRC introduced Section 53 Finance Act 2011 as a temporary measure to preserve the tax treatment of lessors and lessees irrespective of the changes made to any leasing accounting standard. It was repealed in February 2019 enabling tax, in general terms, to follow the accounts and to leave IFRS lessees and UK GAAP lessees in a similar position.
Lessees are and will be affected by IFRS 16 – in terms of accounting but also in terms of adapting their systems and processes to ensure compliance with IFRS 16.
It is likely that the impact of IFRS 16 on lessors will be more closely related to changing behaviours and requirements from lessees when considering lease terms.
by Rebecca Williams and Anna Middlebrook