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

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.