The IFRS 16 standard for lease accounting impacts several year-end activities as well as the annual financial statements. This article explores what you need to know, and how to prepare.
This article will look at how IFRS 16 specifically impacts year end, annual reporting and annual financial statements. We will be looking at the profit and loss statement, the balance sheet, the cash flow statement, disclosure requirements, taxes, and preparing for the audit.
Leases are, however, managed throughout the year, and leases impact financial ratios and metrics that do not pertain to year-end closing activities. Over the last few years, we have written extensively on a variety of IFRS 16 themes, including:
- Our thorough A-Z IFRS 16 guide
- A deep dive into IFRS 16: The practicalities of implementation
- The impact of IFRS 16 on 12 financial ratios
- How to use software to automate IFRS 16 compliance
- An academic study quantifying IFRS 16 impacts on financial statements
So, in this article we assume that you already are performing most of the activities necessary to comply with IFRS 16.
In the profit and loss statement: Depreciation and interest expense
The depreciation of these right-of-use (ROU) assets is recorded in the profit and loss statement. Depreciation is calculated over the term of the lease using a systematic method, such as straight-line depreciation.
IFRS 16 uses the concept of lease liabilities, representing the present value of future lease payments. Interest on these lease liabilities is recognized in the profit and loss statement. The interest expense is calculated using the interest rate implicit in the lease or, if that rate cannot be readily determined, the lessee's incremental borrowing rate.
The front-loading nature of depreciation and interest expenses can lead to a significant impact on the reported profit in the initial years of a lease.
In the balance sheet: Recognition of lease assets and liabilities
IFRS 16 requires lessees to recognize right-of-use (ROU) assets on the balance sheet. These assets represent the lessee's right to use the leased asset over the lease term. This increases the total assets reported on the balance sheet. The value of the ROU asset is generally equal to the present value of future lease payments
Simultaneously, lessees are required to recognize lease liabilities on the balance sheet. These liabilities represent the present value of future lease payments to be made over the lease term. This increases the total liabilities reported on the balance sheet. The amount of the liability is determined by discounting future lease payments using the interest rate implicit in the lease.
While the recognition of ROU assets and lease liabilities affects both assets and liabilities, it does not directly impact equity. Similar to the impact on the profit and loss statement, the front-loading nature of lease liabilities can lead to higher reported liabilities in the earlier years of a lease.
Impact on the cash flow statement
Under IFRS 16, a portion of the lease payments is allocated to interest and depreciation, impacting the classification of cash flows from operating activities. Lease payments include principal (repayment of the lease liability) and interest, and they are separated between operating and financing activities in the cash flow statement.
The principal portion of lease payments, representing the repayment of lease liabilities, is classified as cash flows from financing activities. This reflects the reduction of the lease liability over time. The interest portion of lease payments, on the other hand, can be classified either as cash flows from operating activities or financing activities, depending on the accounting policy adopted by the entity.
The recognition of lease liabilities and right-of-use assets leads to changes in the total cash flows reported in the cash flow statement. Cash outflows related to the repayment of lease liabilities are reflected in the financing activities section, affecting the overall cash flow position.
The changes in the classification of lease payments affect the calculation of free cash flow. The front-loading of financing cash flows and adjustments to operating cash flows contribute to variations in free cash flow over the lease term.
IFRS 16 has enhanced disclosure requirements, necessitating more detailed information about leasing activities in the financial statements. This includes information about lease liabilities, right-of-use assets, and the amount of cash paid for leases.
Companies are required to disclose significant judgments and estimates applied in determining lease terms, discount rates, and assessing the impairment of right-of-use assets.
The nature and amount of expenses arising from leases must be disclosed: What is the proportion made up by renting property, machinery, vehicles, etc.? Also, the classification of cash flows related to leases must be disclosed.
Entities adopting IFRS 16 (for the first time) are required to disclose the transition approach chosen. This includes details about practical expedients, such as the use of hindsight in determining the lease term.
While IFRS 16 changes how leases are reported in financial statements, it does not change nationale tax laws. However, the differences in accounting and tax treatment of leases can result in temporary or permanent differences impacting deferred tax calculations.
Get ready for the audit
Annual financial statements are audited, your IFRS 16 compliance included. The auditor is seeking assurance that the figures used in the calculations are correct, and these can be found in the agreement document. Furthermore, the auditor will seek answers on whether you have performed the calculations accurately. If you are using lease accounting software, you can provide the auditor with read access to the agreement documents, making it easy for the auditor to follow the calculations. The auditor will be satisfied, and you (likely) save on the audit fee.