Tutor tip: accounting standard on leases IFRS 16

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By Lecturer, Stephanie Pentland

18 February 2019

From 1 January 2019, the long-awaited accounting standard on leases, IFRS 16, became mandatory and therefore replaced IAS 17.

IFRS 16 was originally issued in January 2016 and has already been covered in TC Financial Accounting and TPS Financial Reporting because early adoption was permitted. However, many companies will only be using this standard for the first time now.

Why the need for change? 

Leases provide an important and flexible source of financing whereby the lessee obtains the use of an asset and incurs a liability when it enters into a lease.

However, IAS 17 made it difficult for investors and other users of financial statements to get an accurate picture of a company’s leased assets and liabilities, particularly for industries such as the airline, retail and transport sectors.

This situation arose because of the distinction in IAS 17 between ‘operating’ and ‘finance’ leases – assets and liabilities were recognised for finance leases but not for operating leases. This gave rise to ‘off-balance sheet finance’ for operating leases.

When IFRS 16 was originally issued, the International Accounting Standards Board (IASB) estimated that listed companies who used IFRS or US GAAP had US$3.3 trillion of lease commitments, of which 85% did not appear on the statement of financial position of these companies.

Does it matter?

Yes – IAS 17 made it difficult for users of financial statements to compare companies. It also meant that investors and other users of the financial statements had to estimate the effects of a company’s off-balance sheet lease obligations, which, in practice, often led to overestimating the liabilities arising from those obligations.

IFRS 16 solves this problem by requiring that all leases (with very limited exceptions) are reported on a company’s statement of financial position as assets and liabilities.

A really useful article by Hans Hoogervorst, IASB chairman, summarises how and why the new standard improves financial reporting.

All TC and TPS students learn IFRS 16 in their studies now. It is a good idea, however, to think about why the former operating leases (IAS 17) gave rise to ‘off balance sheet finance’ and how it potentially distorted the way in which someone would interpret a company’s financial position – these skills will be useful as you move onto TPE.

Those studying for TPE should always have an awareness of developments in accounting standards.

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