Question

IFRS16 ‘Leases’ which was effective from 1 January 2019 introduced significant changes from IAS17 which it supersedes.

a) Give a brief overview of those changes and why they were felt to be necessary.

b) Under IFRS 16, the Lucas Company will now be classifying its leases as finance leases rather than operating ones for its year ended 31 December 2019. Explain the impact this will have on the Lucas Company’s key financial statements and on its key ratios. Total: 12 marks Word limit: 250 words

Answer 1

a) The introduction of IFRS 16 “Leases” will profoundly change the lease accounting rules with a potentially significant impact on the financial statements presented in accordance with IFRS. This standard is applicable from the beginning of January 2019 but early application of this standard is possible for entities adopting IFRS 15.

Let us see the changes in standard and its future impact on the financial statements, positioning us lessee side. For the lessor, the consequences are limited.

IAS 17 “Leases” published in 2003 based on a fundamental distinction between finance leases and operating leases. The accounting treatment relies for finance leases on the lease of the property at the balance sheet as Liability and for operating leases by the recognition of rent expense for the period.

In recent years the contractual terms of the contracts were complied to qualify a lease as Finance or Operating lease. This situation was not satisfactory because ultimately the economic reality was not properly translated, in particular the state of financial position (balance sheet) did not reflect the economic assets used by the company or all of the commitment to pay the liability.

For example, you could find truck companies who had no truck in the balance sheet because the entire truck fleet was under leasehold and which was considered operating leases. This required us to perform non-accounting adjustments to integrate leases in the analysis of solvency and profitability ratios.

The objective is to improve transparency and comparability of financial statements by adopting a single treatment which leads to sign the balance sheet of the lessee. All leases. Consequently :

	Balance sheet
Asset		Liabilities
Right to use the underlying asset (amortized over the period of use)		A financial liability under the commitment (repaid by rent payments)
	Income statement
	Amortization of right of use Financial costs
	= Decreasing rental expenses

As a simplification option, companies can continue to register expense for contracts of low value or less than 12 months

b) A lease is an agreement whereby the lessor (the legal owner of an asset) conveys to the lessee (the user of the asset) the right to use an asset for an agreed period of time in exchange for consideration (return for a payment or series of payments). The approach of IAS 17 was to distinguish between two types of lease. Leases that transfer substantially all the risks and rewards of ownership of an asset were classified as finance leases. All other leases were classified as operating leases. The lease classification set out in IAS 17 was subjective and there was a clear incentive for the preparers of lessee’s financial statements to ‘argue’ that leases should be classified as operating rather than finance leases in order to enable leased assets and liabilities to be left out of the financial statements.

The requirements of IFRS 16 will have significant impacts on key accounting ratios of lessees. The greater recognition of leased assets and lease liabilities on the statement of financial position will reduce return on capital employed and increase gearing. Initial measures of profit are likely to be reduced, as in the early years of a lease the combination of depreciation of the right of use asset and the finance charge associated with the lease liability will exceed the lease rentals (normally charged on a straight-line basis