Analysis of IFRS 16 Leases for Ending Off-Balance Sheet Treatment of Operating Leases

This essay analyzes the new accounting standard of IFRS 16 Leases and its impact on ending the off-balance sheet treatment of operating leases. It examines the reasons for off-balance sheet representation, evaluates the effectiveness of IFRS 16, and discusses its limitations.

Financial Reporting

Introduction
The present essay is developed to undertake an analysis of the new accounting standard of
IFRS 16 Leases developed for ending the off-balance sheet treatment of operating leases by lessees. The
essay is presented to examine the extent to which the above statement of establishing new accounting
standard of IFRS 16 is agreeable. The concept of operating lease can be defined as the contract in
which the owner known as lesser allows permission to the lessee, to use an asset for a specified
period of time less than an economic life of an asset without transferring the rights of ownership.
It can be defined as the short-term agreement between the lessee and the lesser to rent an asset
within a time period of less than one year and retaining the ownership right. The IFRS 16 Leases
is issued on January 2016 and will be effective from the annual reporting periods after 1 January
2019. The accounting standards have replaced IAS 17 to change the accounting treatment for
leases. The new standard is developed to eliminate the classification of leases as either operating
or financial leases and need them to be capitalized by their recognition as a liability on the
balance sheet (Smith, 2018).
Explanation of the Reasons of Operating Leases Representation as Off-Balance Sheet Items
The financing method of off-balance sheet can be refereed as an accounting practice
where a company does not represent liability on its balance sheet. The method is used to mainly
influence the debt and liability position of a business entity. The off-balance sheet items can be
regarded as assets or liabilities that do not appear on the balance sheet of a company. These
financial items are not direct obligation of a company but are regarded as its assets and liabilities.
The accounting method of off-balance sheet can be used for shielding the ownership of an asset
and its corresponding liability from a company’s financial statements (Beattie, Edwards and
Goodacre, 1998). A company as such can report less debt during its financial reporting and thus
can make it more desirable for investors and lenders. The examples of off-balance sheet
financing are accounts receivables, joint ventures, research and development activities, operating
leases and other such transaction that enable a company to preserve borrowing capacity. The
companies mainly use such transactions to manage its cash flow and overcome the credit risks.
These items are generally depicted in the notes to the accounts within the financial statements of
a company (Deloitte, 2016).

An operating lease represents a good example of a common off-balance sheet item. This
mainly helps a company to record only the rental expenses of the equipment taken on a lease and
does not requires to mention the ownership of the asset on the balance sheet. This enables the
company to reduce the entire purchase price and results in reducing the liability obligations
within the balance sheet (Giner and Pardo, 2018). Thus, leased assets and its associated liabilities
related to its payment of rent in the future context are not depicted in the balance sheet. It is a
contract that enables the company to use an asset without having its ownership. It mainly impacts
the debt ratio of a company and thus reduces the financial obligations as it does not take into
account the actual price incurred during purchase of an asset. This is because a company can
easily rent or lease a piece of equipment and can buy it at the end of the lease period for a
minimum amount of money (Morales-Díaz and Zamora-Ramírez, 2018).
Critical Evaluation of IFRS 16 Leases for ending or not ending the off-balance sheet
treatment of operating leases
As per the views of Barone, Birt and Moya (2014) the IFRS 16 is mainly introduced to
change the accounting treatment of lessees by eliminating the need of classifying them in the
form of an operating or finance leases. The standard has maintained that all the leases should be
capitalized and depicted in the balance sheet by demonstrating their right of ownership to the
investors. The changes have been introduced within the accounting standard to protect the
interests of investors by depicting them the actual financial position of a company. It has been
depicted by the effects analysis that listed companies around the world have about $3 trillion
worth of future payments for leases. This amount is not depicted in their balance sheet as per the
past accounting standards developed for recognition of leases. As such, the development and
adoption of the accounting standard of IFRS 16 for enhancing the visibility of lease commitment
within the financial reports of business entities. This will help in depicting the actual economic
reality of an entity to its stakeholders and thus facilitating them to take accurate decisions
(Barone, Birt and Moya, 2014).
Giner and Pardo (2018) stated that the accounting standard of IFRS 16 mainly impacts
lessees as they are required to depict the assets from off-balance sheet within the daily
transactions. They will not hold permission to depict only the rental expenses from operating
leases and but should recognize it as a liability and the asset ownership within the balance sheet.

The lessees will however be provided an exemption to account the leases of short time duration
as it can be done similarly in a manner as provided by the previous accounting standard. The
standard has required on the part of business entities using an asset for lease to depict its right of
use and associated liability to promote transparency within its balance sheet (Deloitte, 2016). This
means that business entities are required to depict large amount of assets and liabilities within its
financial reports that were previously not recorded. Thus, it is certainly intended to end the
depiction of assets and liabilities associated with operating leases under the off-balance sheet
(Giner and Pardo, 2018).
However, as stated by Silvia (2019), the accounting standard has also faced some
criticism as it is not able to complete eliminate the off-balance financing of operating leases
when it is difficult to determine whether there is a lease or not. This is mainly because the
standard has defined a lease as a contract that provides the right to use an asset for a specified
time-period in return for a consideration. As such, this is very wide definition of leases
mentioned under the standard and therefore it may fail to identify some leases that are hidden
within the contracts. For example, ABC is Retail Company and has stored its inventories in a
local warehouse. Thus, there may or may not a lease as it depends on whether the contract has
specified the actual place within the warehouse. The specification of a particular place to use
mentioned within the contract depicts that there is lease under IFRS 16 otherwise not. However,
if the right to use a particular pace is not mentioned within the contract then IFRS 16 may fail to
represents’ the right to use an asset and its associated liability on the balance sheet. Thus, the
major drawbacks associated with the use of this accounting standard is that it is required to
determine if there is an identified asset and there is a right to control its use (Silvia, 2019).
As per the views of Smith (2018) it may be quite difficult for business entities to examine
all the possible contracts and not only the lease contract. In addition to this, the determination of
a lease to be depicted in the balance sheet under the IFRS 16 also depends on the time-period of
lease. The standard has exempted the short-period lease and has stated that they will be treated in
a similar manner as stated in the previous accounting standards. Thus, it has been stated by
various accounting professionals that the standard is not able to complete end the off-balance
financing of operating leases. This is because it can involve the judgment of the accounting
professionals to determine whether an operating lease is for short-term or is of low value. This

can result in posing opportunities for business entities to depict the operating leases as short-term
and thus manipulating the asset and liability position within the balance sheet. Also, it has not
specified the measuring of low-value lease and thus is prone to manipulation depending on the
judgment of the accounting professionals. However, the standard will largely help in developing
a single lease model that can be applied for generalizing all type of leases. The liability
associated with the use of a leased asset will be measure at the present value of the lease payment
(Smith, 2018).
Conclusion
Thus, it can be said from the overall discussion held in the essay that the statement
‘companies complying with 1FRS 16 leases should mark the end of the off-balance sheet
treatment; is agreeable as the standard requires companies to recognize the right of use of an
asset and its associated liability on the balance sheet. Thus, businesses having high amount of
operating leases are not allowed to use the financing method of off-balance sheet for their
recognition and reporting during preparation of their financial reports.

References
Barone, E., Birt, J. and Moya, S., 2014. Lease accounting: A review of recent literature. Accounting in
Europe, 11(1), pp.35-54.
Beattie, V., Edwards, K. and Goodacre, A., 1998. The impact of constructive operating lease
capitalisation on key accounting ratios. Accounting and Business Research, 28(4), pp.233-254.
Deloitte, 2016. New IFRS 16 Leases standard The impact on business valuation. [Online]. Available at:
https://www2.deloitte.com/content/dam/Deloitte/nl/Documents/mergers-acquisitions/deloitte-nl-ma-
ifrs16-impactonbusinessvaluation1.pdf [Accessed on: 15 February 2019].
Giner, B. and Pardo, F., 2018. The Value Relevance of Operating Lease Liabilities: Economic Effects of
IFRS 16. Australian Accounting Review, 28(4), pp.496-511.
Morales-Díaz, J. and Zamora-Ramírez, C., 2018. The Impact of IFRS 16 on Key Financial Ratios: A New
Methodological Approach. Accounting in Europe, 15(1), pp.105-133.
Silvia. 2019. Troubles with IFRS 16 Leases. [Online]. Available at: https://www.ifrsbox.com/ifrs-
16-implementation-challenges/ [Accessed on: 15 February 2019].
Smith, H. 2018. Are you ready for the new Lease Standards under IFRS 16? [Online]. Available
at: https://www.lexology.com/library/detail.aspx?g=a1b33812-ce8c-4cad-b265-6ffb45dc7f9d [Accessed
on: 15 February 2019].