IFRS 16 was introduced by the International Accounting Standards Board (IASB) in 2019. The accounting standard has led to significant changes in the way companies must account for their leases.
The biggest change is that the companies that report according to IFRS must now balance most leases, which means accounting for more variables than in IAS 17. In this article, we want to describe the complexity of calculations according to IFRS 16.
Understand the complexity of calculations according to IFRS 16
IFRS 16 replaces the previous accounting standard IAS 17. More and more businesses keep their accounts according to the IFRS rules. Whether it is a listed company or a company that has financial instruments that are obliged to prepare consolidated accounts according to IFRS. Companies can also be owned by foreign owners who require and then must report lease agreements in accordance with IFRS 16.
The accounting standard means that businesses must now balance most leases as a right-of-use asset and lease liability. This will ensure that businesses provide a more accurate presentation of their financial position and ensure better transparency towards investors and other stakeholders.
The implementation of IFRS 16
The implementation of IFRS 16 entails major changes in the accounts. In accordance with IAS 17, operating leases were not recognized in the balance sheet, and rental costs were expensed on a straight-line basis. According to IFRS 16, however, all leases (as long as they do not fall below the threshold for value and duration), including operational leases, are entered in the balance sheet. This means that the companies’ balance sheet values increase for both assets and liabilities, which can have a significant impact on their financial ratios and key indicators.
Calculation according to IFRS 16
When companies have to balance their leasing agreements according to IFRS 16, one must look at whether the implicit interest rate to discount the liability can be determined. This means that the business must find the present value of the rental obligation. The alternative for discounting the obligation, if the implicit interest rate is not known, could be to use the tenant’s marginal lending rate.
The calculation according to IFRS 16 can be complex and time-consuming. This involves identifying all leases, determining the lease period and calculating the present value of the lease payments. Businesses must also assess the impact of variable rent payments, rent incentives and rent changes. The unique thing about calculations according to IFRS 16 is that you must reassess your leases regularly, which can increase the complexity of the calculation.
Discount rate
A central topic in accounting for leases according to IFRS 16 is discounting and discount interest. Discounting is widely used in business and social economic analyses, often to calculate the profitability of a project or investment in the future. To calculate this, one looks at several variables such as future income and/or expenses and then determines the discount rate.
By estimating how much the business will pay in future rental costs for an item or service, you can discount the expenses and get a calculation of the value of the item today (present value). Once the discount rate has been calculated, the implicit interest rates (forward interest) to discount the liability can be determined.
Tenant’s marginal lending rate
If the implicit interest rate cannot be defined, the tenant’s marginal lending rate can be used instead. The tenant’s marginal lending rate means that you look at a similar economic environment and what you would have to pay to borrow over a similar period and with similar security to acquire an asset with the same amount of wood as the right-of-use asset. The marginal loan interest may vary from lease to lease, as they have different lease periods, different leased objects and different geography.
Impact on financial indicators
The increased balance sheet entry of leases under IFRS 16 has led to significant changes in companies’ financial reporting and key figures. By accounting for lease agreements as right-of-use assets and lease liabilities, the company’s total assets and liabilities on the balance sheet increase. This can have a direct impact on the company’s debt ratio, which is the ratio between debt and equity. Since the rental obligation is now shown as debt, the debt ratio could increase, which could give the impression of increased financial risk and leverage ratio for the company.
At the same time, the increased balance sheet entry of lease agreements will also affect the company’s equity. As the rental obligation is now reflected as debt, this may reduce the relative size of the company’s equity in relation to total assets. This in turn can affect the equity ratio, which is the ratio between equity and total assets, and thus affect the company’s financial robustness and ability to withstand losses or unexpected events.
Furthermore, the increased balance sheet entry of lease agreements can affect other important financial indicators, for example interest burden and return on investments. A higher level of debt on the balance sheet can result in increased interest costs, which can affect the company’s profitability and profitability. On the other hand, a more accurate presentation of the company’s financial position can contribute to increased confidence from investors and creditors, and thus potentially affect the company’s credit rating and access to capital.
In sum, the increased accounting for lease agreements under IFRS 16 can have far-reaching consequences for how the business is assessed by stakeholders, including investors, creditors and analysts. It is therefore important for companies to understand these changes and communicate them clearly in their financial reporting to ensure the correct interpretation of their financial situation and performance.
Impact on investors, creditors and other stakeholders
The changes that come with the implementation of IFRS 16 can have significant consequences for how investors, creditors and other stakeholders assess the company in decision-making processes and risk assessments. Some examples are:
- Investors will now get a more comprehensive picture of the company’s financial position and performance, as the lease obligations are entered on the balance sheet and shown as liabilities. This can help to increase transparency and trust in the company’s reporting.
- Creditors, such as lenders and bondholders, will be concerned with how the increased debt ratio affects the company’s ability to service and repay its debt obligations.
- The changes in reporting practices under IFRS 16 may also affect creditors’ assessment of the company’s creditworthiness and loan terms.
Software for handling calculations according to IFRS 16
A dedicated software for handling the accounts according to IFRS 16, such as ShareControl IFRS 16, brings with it a number of significant advantages. The software enables the automation of a wide range of manual processes related to the identification and classification of leases.
Automate calculations of present value and lease payments, which not only saves valuable time and resources, but also reduces the risk of accounting errors. By using an IFRS 16-compliant software, organizations achieve increased accuracy and reliability in their calculations. This is particularly important when dealing with complex financial aspects of lease obligations, as the software ensures that all relevant factors are properly considered and calculated.
Overall, a software for handling the leasing accounts according to IFRS 16, such as ShareControl IFRS 16, provides a holistic and efficient solution that strengthens the organisation’s ability to meet complex accounting challenges. This approach lays the foundation for careful and well-thought-out decisions, optimal utilization of resources and solid compliance with the accounting standard.
