IFRS 16 is an International Financial Reporting Standard (IFRS) issued in January this year that sets out standards for lease accounting. It will be effective from 2019 and replaces the earlier leasing standard, IAS 17.

It will affect all types of companies who use leasing arrangements – particularly sectors such as airlines, retail and shipping – and requires that all leases should be reported on the balance sheet. Currently, more than 85 per cent of leases globally are labelled as 'operating leases', so they are not recorded on the balance sheet. Leases are an important form of finance for many businesses and listed companies globally currently have $3.3 trillion-worth of leases.

Real liabilities

“Despite being off-balance sheet, there can be no doubt that operating leases create real liabilities,” writes Hans Hoogervorst, Chairman of the International Accounting Standards Board (IASB) in his article Shining the Light on Leases. 

Companies can have deceptively lean balance sheets despite having significant long-term operating lease commitments and in many cases, accounting does not reflect the real economic situation of the company.

Unwitting investor

While many investors seek to compensate for this by estimating the value of operating leases as if they were on the balance sheet, these calculations are usually inaccurate. Hoogervorst writes: “Moreover, not all investors are able to do this “add-back” and the prevalence of operating leases indicates that companies are aware of that. In some cases companies go to great pains to structure their lease obligations so that they remain off-balance sheet, probably to look better in the eyes of the unwitting investor.”

IFRS 16 to reflect economic reality

He adds that the current system under IAS 17 means that companies with similar financial obligations may look very different from an accounting point of view.

IFRS 16 seeks to address these problems and requires all leases to be recognised as assets and liabilities. This will better reflect the underlying economics.

The IASB believes this change will affect roughly half of all listed companies. Hoogervorst writes: “Accounting changes are often controversial and can be met with warnings of adverse economic effects, defaults on debt covenants, and costs of system changes. The IASB has looked at all these possible risks very carefully and has concluded that the risks and costs are manageable.”

IFRS 16 benefits greatly outweigh costs

IFRS 16 will not change the nature of leases – just their accountancy requirements. That means that leases will still be an attractive and flexible source of finance for companies that don't want to bear the risk of owning equipment/premises/fleets, etc.

While there will be a cost in the implementation of IFRS 16, companies aren't required to put leases worth less than $5,000 or with a duration of less than 12 months on the balance sheet, which will protect smaller companies from some of the expense.

Hoogervorst concludes: “We expect the benefits of IFRS 16 to greatly outweigh its costs. The new visibility of all leases will lead to better informed investment decisions by investors, and to more balanced lease-versus-buy decisions by management. IFRS 16 will lead to improved capital allocation, which should be beneficial for economic growth.”