IFRS 16 is the new standard for IFRS reporters that does away with the distinction between operating and finance leases for lessees and brings everything onto the balance sheet. We posted an overview of the changes last year, which you can find here.
This post sets out more detail on the practical accounting and tax implications of implementing the new standard.
Technical update: Implementation of IFRS 16
1 January 2019 saw IFRS 16 come into effect for reporting periods beginning on or after that date. New accounting standards are generally adopted with full retrospective application. However, IFRS 16 gives a choice of full retrospective or one of two modified approaches. In this blog post, we will consider these three options and we will also discuss the tax implications arising from the change of accounting for leases.
Historical operating leases spanning the transition period
For companies that are currently operating leases under IAS 17, there are three possible transition options available. The choice of transition needs to be applied consistently across all leases.
Under the fully retrospective and modified retrospective #1 methods, the difference in the value of the asset and the liability will be taken as a transitional adjustment to equity. All three methods will have differing impacts on future earnings due to the values of depreciation and interest charges, which will appear in the income statement. There are also a number of other transitional options and reliefs to consider. Fully retrospective adoption is significantly costlier and more time consuming than the modified approach, because it requires an assessment of each lease on transition based on the conditions in place as at the inception of the lease. We have provided a summary of the impacts of the different options in the table below.
Modified#1 generally results in a lower asset value than lease liability. The debit to equity reduces net assets at transition but also reduces subsequent depreciation charges and impairment risk.For both Modified#1 and Modified#2 reconciliation of the previously disclosed IAS 17 lease commitments note figures, the new figures recognised on the balance sheet are required, providing a helpful check that nothing has been misplaced along the way.
Modified#2 is the easiest option but distorts post transition comparability of results; until the leases at transition have expired, assets are measured on different bases as new leases commence under the new, normal rules.
It’s hopefully apparent from the above but just to put it in black and white – under the modified approaches the numbers presented for a first year to December 2019 will be calculated under a completely different basis to the comparatives shown for 2018. Notwithstanding this there is a reasonable expectation that the majority of reporters will follow this route, driven by considerations of complexity and practical expediency.
Tax implications of IFRS 16
Due to the change of accounting for leases, specifically from a lessee’s perspective, there will be a need to consider the tax implications. A number of tax rules depend on the classification of leases into operating and finance leases. Under IFRS 16, a business will not need to make a distinction in respect of leases where it is the lessee.
The tax laws on leases are currently in draft form. However, the consultation period has now been completed and the legislation was confirmed at the most recent budget and is now subject to enactment. The government has decided to broadly retain the existing tax treatment for leased plant and machinery, including keeping the capital allowance/long funding lease regime, albeit with some changes.
Current legislation is effectively being extended so that going forward, a tax deduction for rentals for the use of an asset is equal to the accounting values of the finance cost charged on the liability and the depreciation on the right of use asset. In this way, it will spread the tax effect in a similar way to how operating leases are currently accounted for and taxed on an accrual basis.
The implications of the transitional rules are more complex as two of the three options result in a difference between the value of the lease liability and the value of the right-of-use asset. Legislation is to be introduced requiring a lessee to spread any transitional adjustment recognised upon adoption of IFRS 16 over the average remaining length of the leases, which give rise to the transitional adjustment. There is likely to be a difference in the accounting treatment to the tax treatment on this issue and separate records may need to be kept for each.
The choice of transitional adoption could result in an adjustment made within equity resulting in the right-of-use asset and the lease liability being initially recognised at different values. This would give rise to a temporary difference and the need to recognise a deferred tax balance, which would unwind under the spreading provisions set out above.
Murray Harcourt can assist you through this process for a smooth transition for this significant change to lease accounting. If you have any questions, please give us a call on 0113 231 4131 or email firstname.lastname@example.org.