A lease is a contractual arrangement whereby a user (lessee) agrees to pay an owner (lessor) for the use of an asset. A primary principle of IFRS 16 is that all lessee leases should be reported on the balance sheet, although there are exceptions for small items (e.g., under $5000) and for leases with a term of 12 months or less. Under IFRS 16, a lessee is required to recognise an asset for the right to use the leased item and a liability for the present value of its future lease payments.
According to IASB chairman Hans Hoogervorst:
“These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.”
If the lease payments for an asset are $100,000 each year for 5 years, the Net Present Value (NPV) of the payments will be calculated, typically using the borrowing rate as the discount rate (we will cover NPV in a later module. It is a calculation that takes into account the time value of money – money today is worth more than money in the future.)
The discounted value of the lease payment is: $457,971 at a discount rate of 3%.
This is the lease liability and the value of the asset – the balance sheet balances.
IFRS 16 mainly affects operating leases, where the whole of the lease payment used to be deducted from expenses, thus reducing EBITDA. The asset did not appear on the balance sheet.
Now, the asset appears on the balance sheet. On the income statement, the interest and depreciation are deducted – BUT these are after EBITDA is calculated. Therefore, IFRS 16 increases EBITDA and some believe that this undermines the value of EBITDA as key performance indicator as the gap between EBITDA and physical cash flow increases.