Impact of IFRS 16 on Lessees: Analysis and Accounting Treatment

This report shows an analysis of the impact of the new accounting standard IFRS 16 leases on the lessee despite no impact on the lessor. The main impact will be on reporting of the leases and the financial performance of the company. Using this standard would provide firms with greater flexibility, transparency, comparability, and consistency as well as high-quality financial reporting. Additionally, this report discusses the impact of IFRS 16 on the financial statements which shows that it would affect the profitability, liquidity, and solvency of companies.

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Business Report
Student’s Name
Institutional Affiliation

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Executive summary
This report shows an analysis of the impact of the new accounting standard AAB 16-
leases on the lessee despite no impact on the lessor. The main impact will be on reporting of the
leases and the financial performance of the company. Using this standard would provide firms
with greater flexibility, transparency, comparability, and consistency as well as high-quality
financial reporting. Additionally, this report discusses the impact of AASB 16 on the financial
statements which shows that it would affect the profitability, liquidity, and solvency of
companies. While the new standard would result into benefits such as greater quality,
comparability, transparency, and consistency, it would result into costs such as training,
information system changes, determination of discounted rate, and separation of the leases from
the services. The company would be recommended to create a specialist team or a special lobby
group since its benefits outweigh the costs and it would help the clients cope with the transition.

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1. Introduction
1.1. Overview and Background
The IASB published a new standard for leases (AASB 16) in January 2016 which was to
take effect in January 2019 (AASB, 2004, n.d.). This standard requires lessees to report all leases
on the balance sheet. The purpose of this report is to compile the current developments in lease
accounting and how firms should respond to the challenges in adopting the new standard.
1.2. Objectives of the Report
The primary objective of this report is to analyze the impact of this new accounting
standard on leases to the clients and the business. Other aims and objectives of this report
include merits and demerits of the new accounting lease standard, how the AASB 16 should be
communicated to the clients, how the staff of the company should be trained with regards to the
new standard, whether the corporation should have a specialist group that would help deal with
these issues on accounting standards matters and a recommendation on whether the organization
should have a separate lobby group that would deal with these changes in accounting standards
and any other current developments on matters related to accounting standards (AASB, 2015,
n.d.).
1.3. Main Impact
According to the new accounting standard on leases (AASB 16), a lessee is supposed to
recognize all his or her leases on the balance sheet. This standard would have a great impact on
the companies that use leasing or rental as a way to acquire assets. According to the previous
standard (AASB 117), the lessee was required to recognize any lease transaction as a finance or
an operating lease (AASB, 2013, n.d.). Additionally, using this new standard, lessees would be
provided with flexibility which would help them address any issues related to the risk in the
residual value of their acquired asset as well as its obsolescence. Furthermore, this new standard
will affect the performance metrics and financial ratios used by companies such as current ratio,

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interest cover, EBIT, net income, ROCE, and so forth. Ideally, this is because as companies
acquire assets through leasing, they would have to take a loan in order to acquire that asset
(Ahmed and Alam, 2012, p.110). As a result, their gearing ratios would increase which would
translate to a decline in capital ratios, thus enabling the balance sheet to grow. For this reason,
corporations need to keep abreast of these current developments in the accounting standard.
1.4. The scope of the Report
This report will cover all matters relating to the transfer of the right of use an asset to
another party at a cost for a specific period of time as prescribed by the standard (AASB 16).
However, this report would not cover any license of intellectual property granted by the lessor,
the rights of licensing agreements such as films, plays, videos, patents, manuscripts and
copyrights, the leases of any biological assets, and the exploration of minerals and other
resources such as natural gas and crude oil (Brown, 2006, p.87).
1.5. Exemptions made if any
Besides these, the lessees of intangible assets such as goodwill are exempted from the
new accounting standard (AASB 16). Other exemptions as per AASB 16 (para 22-49) include
short-term leases and leases whose assets are of low value (CPA Australia, 2016, n.d.).
2. Key Considerations and Definitions
2.1. Defining a Lease
AASB 16 defines a lease as a “contractual agreement where a lessee (buyer) agrees to
pay a certain amount to the lessor (owner of the asset) for the transfer of the right of use of the
asset”. In other words, a lease can be described as a contract between two parties where one
party agrees to pay a specific amount in order to rent the asset of the other party for use within a
specific duration after which it is returned to the owner (Dakis, 2016, p. 99).

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2.2. Characteristics of a Lease Agreement
A lease may have four main characteristics, that is, a lease may be long-term or short-
term depending on the purpose of use of the asset, the lessee has to pay a consideration known as
the lease payment to lessor in order to be granted the right of use of the asset of the lessor, the
lessee is required to pay the consideration for using the asset of the lessor in instalments and not
as a lumpsum and it may constitute a mutually unperformed contract at its inception since during
the inception of the lease, the lessee and the lessor come together in order to make a contractual
agreement that is yet to be performed (Deloitte, 2016, n.d.).
2.3. Meaning and Characteristics of a Lease Term
A lease term may be defined as a fixed term whereby the lessor gives the lessee the right
to use his or her asset for a fixed duration which is non-cancellable until the fixed duration is
over (De Martino, 2011, p.366). Its characteristics, therefore, are that it has a fixed duration, it is
non-cancellable and it is legally binding which means that it is a legal contractual agreement
between the lessor and lessee which must not be broken until the period expires (Georgiou, 2010,
p.104).
3. What is the New Model and how is it different from the old standard?
The AASB 16 has the same elements or treatment of leases like the AASB 117.
However, it contains improved transparency on capital employed and financial leverage (level of
debt) since a lessee is supposed to recognize all his or her leases in the balance sheet.
Additionally, the lease was grouped or classified as either operating or finance lease in the old
AASB 117 standard (Gross et al., 2014, p.760). However, in this new standard (AASB 16), a
lease is just a lease and there is no distinction brought forth.
4. Accounting Treatment

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4.1. Accounting Treatment for Lessors
There is no huge difference for the accounting treatment of lessors between AASB 117
and AASB 16. Ideally, the lessor is still supposed to classify whether the lease is a finance or
operating lease. Here, finance leases should be accounted for by being recognized as a net
investment in the fixed assets section of the balance sheet (Hung and Subramanyam, 2007,
p.624). Specifically, this net investment can be computed by finding the sum of the residual
value to the lessor and the present value of future lease payments. Despite this, there is no
change in the accounting treatment of operating leases by the lessor since the lessor is required to
recognize this lease on the balance sheet and any other income attributable to it as an accrued
income in the current assets segment of the statement of financial position (Joubert et al., 2017,
p.2).
4.2. Accounting Treatment for Lessees
The main difference between the AASB 117 and the AASB 16 standard occurs in the
treatment of leases for the lessees. Here, the lease would be recognized using the right of use
instead of the previous risk and reward recognition by AASB 117 (Kusano et al., 2016, p.74).
There will be two steps of recognizing leases by the AASB 16 standard, that is, the initial
measurement and the subsequent measurements. The initial measurement would include the
initial cost of the lease liability, any lease payments fewer incentives received for engaging in the
lease and the estimated costs that would be incurred for dismantling the leased asset. Here, the
lease liability would be the present value of lease payments which would be discounted using the
interest rate that has been applied on the lease or the borrowing rate of the lessee whichever is
available (Loyeung et al., 2010, n.d.). For the subsequent measurements, the cost model or the
fair value model can be used. Using the cost model, the lessee can determine the amount to
recognize on the balance sheet by taking the cost of the lease minus the depreciation and

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impairment losses. Here, the lease liability would be computed as interest plus the lease
payments. Using the fair value model, on the other hand, the lessee would have to refer to AASB
140 (investment property) or AASB 116 (property, plant and equipment) whichever has been
adopted by the lessor in order to compute the cost of the lease (Loyeung et al., 2011, n.d.). Here,
the lease liability would be calculated as the changes in the lease liability in comparison with the
carrying value of the leased asset.
4.3. Other leasing related topics
Other leasing related topics that have been considered in the new AASB 16 standard
include peppercorn leases and sale and leaseback.
4.3.1. Peppercorn leases
According to AASB 1058 (income for not for profits), an asset should be recognized t
fair value only when the consideration or lease payment for that asset is less than the fair value of
that asset in the market (Mellado and Parte, 2017, p.132). This means any right to use of an asset
which falls under peppercorn leases should be recognized at fair value and this should be
incorporated in the new accounting lease standard (AASB 16). However, if a not for profit
organization enters into a lease agreement where the lease payments are below the market value,
then it should be measured at fair value in accordance with AASB 13 (Fair value measurement),
a lease liability should be recognized in the balance sheet in accordance with AASB 16
(Accounting for Leases) and any difference between the carrying amount of the asset and its
lease liability should be recognized as an income in the statement of financial performance
(AASB 1058 para 10).
4.3.2. Sale-and-leaseback
This arises when a lessee sells the leased asset to another entity, thus leasing it back from
the lessor. Here, the company ought to first assess whether the transfer of the asset is a sale by
incorporating AASB 15 (revenue under contract with customers). If it is a sale, the lessor should

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recognize a disposal of the transfer of rights by measuring the right of use of the asset against its
carrying amount by the lessee (AASB 15 para 100(a)), measuring the lease liability using the
present value of future lease payments any gain or loss of the rights transferred instead of the
gain or loss of the total leased asset as initially recognized by AASB 117 (para 100(a)). The
lessor, on the other hand, shall recognize the asset at fair value. If it is not at fair value, the lessor
must make appropriate adjustments by determining whether the cost of the leased asset is below
or above market (Pawsey, 2008, n.d.). If it is below market, the lease liability would be treated as
prepayments of the lease payments while if it is above market, the lease liability would be treated
as an additional financing provided by the lessor to the lessee.
If the transfer is not a sale, the lessee shall continue recognizing it as an asset and
recognize the lease liability by applying AASB 9 (financial instruments). The lessor, on the other
hand, shall not recognize the transferred asset and shall only recognize the financial asset
equivalent to the lease payments (AASB 9).
5. Transitional Requirements
5.1. Transitional requirements for Lessors
The lessor is not required to make any adjustments to the lease exempt for the peppercorn
leases and sale and leaseback (PWC, 2016, n.d.)
5.2. Transitional requirements for Lessees
Relief is provided to a lessee when he or she is transiting from AASB 117 to AASB 16.
On transition, the lessee may have two options, that is, adopting the AASB 16 in full or partially
only at the implementation date (Tang, 2008, n.d.). If the specialist team that is helping the client
to transit uses the first option, the team is required to adjust the current year using prior year
estimates (AASB 108 para 22) and restate the opening retained earnings using the estimates.
However, if the specialist adopts the second option, the team would be required to adjust the

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current year using AASB 16, to restate the beginning retained earnings and not to restate any
estimates relating to the lease.
6. Impact of the New Standard
The new standard would have certain benefits and costs which would affect the financial
statements as well as the financial performance of the organization (Thornton, 2016, n.d.).
6.1. Benefits and Advantages of the New Standard
Two key benefits would be realized by incorporating the new AASB 16 standard which
includes quality financial reporting and comparability. First, using the AASB 16 would enable
financial analysts and investors to estimate any off-balance sheet leases. As a result, being able
to know the assets that a company controls would enable them to incorporate a faithful
representation of the financial performance and position (Treasury Department of New South
Wales, 2017, n.d.). Additionally, it would create greater transparency of the capital employed as
well as the financial leverage of the firm. Second, using AASB 16 would enable the business to
compare the cost of the leases and the lease liability between the periods.
6.2. Costs and Disadvantages of the new standard
Despite the benefits of the new standard, it would have some disadvantages which
comprise changes to the information system, training, determination of the discount rate to be
used by the company, incorporating the new standard to identify a lease, and the separation of
the lease and the services within the contractual arrangement. First, the company would have to
make some changes to its information system in order to adapt to the new AASB 16 accounting
standard. Second, the staff of the business would have to be trained on how to incorporate the
new AASB 16 standard (Xu et al., 2017, p.35). Third, the company would need to ascertain the
discount rate or the interest rate that they would use on the lease which would help them in the
computation of the annual lease payments. Fourth, using the new standard would require the

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company to identify whether it is a lease or not based on the definition of a lease under AASB 16
(Appendix A). If it is a lease, then it should be recognized accordingly. However, if it is not a
lease, the company should just recognize it under PPE. Lastly, the leased asset and lease service
should be separated where the leased asset should be recognized on the balance sheet.
6.3. Effects on Financial Statements
This new accounting standard AASB 16 would have six effects on the financial
statements which are detailed below.
No. Statement Effect
1 Balance sheet Under AASB 16, if a lease occurs, the company
would realize an increase in lease assets as well as an
increase in financial liabilities which shall be
recognized in the balance sheet.
2 Balance sheet Consequently, when a lease occurs, the lessee would
recognize a decline in equity since the carrying value
of the lease asset is likely to decline more than that of
lease liabilities.
3 Income statement Subsequently, when the lease occurs, the company
would realize an increase in earnings before interest
tax, depreciation and amortisation (EBITDA). This is
because the standard would not be classifying leases
as either operating or financing and thus the operating
lease costs would not be included in the income
statement.
4 Income statement Furthermore, when a lease occurs, the company would

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realize an increase or a decrease in profit before tax
(PBT) depending on the lease portfolio, that is, when
the interest expense is higher in prior years, the firm
would realize an increase in PBT whereas if they are
lower in prior years, the firm would realize a decline
in PBT.
5 Cash flow statement Moreover, a lease under the new accounting standard
AASB 16 would cause an increase in cash flow from
operating activities and a decline in cash flow from
financing activities since the interest from the lease
payments would be considered as cash outflows from
the financing activities.
6 Cash flow statement However, it is expected to cause no change in total
cash flow since an incline in cash flow from operating
activities and a decline in cash flow from financing
activities would have no effect in the long-run.
6.4. Effects on the financial performance of the company
The effect of the new accounting standard on the financial performance of the firm would
be measured using the financial ratios, that is solvency, liquidity, and profitability. First, when a
lease occurs, the lessor would be taking the asset on loan. Therefore, this would cause an
increase in gearing due to an incline in financial liabilities (Wines et al., 2007, p.863). However,
the interest coverage ratio would decline which would cause solvency problems for the company.
Second, a lease would cause a reduction in current ratio due to an increase in current liabilities

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and it would cause no change in net cash flow. Third, a lease would cause a decrease in asset
turnover, a decline in EBIT an increase or decrease in profit or loss and EPS depending on the
features of the lease and the P & L respectively.
7. Recommendations and Suggestions
7.1. Arguments for and against the creation of the specialist team
The accounting firm should create a specialist team since it would help clients transit to
the new accounting standard (AASB 16) from the old one (AASB 117). However, creating a
specialist team would result in an increase in costs to the company since they would have to be
paid (Xu et al., 2017, p.36).
7.2. Arguments for and against the new standard
The new standard is advantageous since it has brought about transparency on capital
employed and financial leverage for the company. However, using this new accounting standard
would make the company change on its information system and train its staff, thus resulting into
additional costs for the firm (Wines et al., 2007, p.864).
7.3. Recommendations for and against the creation of a special lobbying team
to ascertain any changes and developments in the future
The company should create a special lobby team since it would help them keep abreast of
future changes and developments in accounting standards. Besides, it would help them cope or
transit effectively. However, they would have to budget for the salaries of the special lobbying
team, thus more costs to the business (Xu et al., 2017, p.37).
7.4. Recommendations on the training of the staff and managing client
queries
To train staff, I would advise the company to organize seminars and workshops in
relation to the new accounting standard. Additionally, they can manage client queries by setting
up a specialist team within the company despite the increase in costs.

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7.5. Other Recommendations and Suggestions
Other recommendations would be to enhance good project governance within the
company which would enable them to implement this new standard effectively and manage any
resistance to change from AASB 117 to AASB 16.
8. Summary and Conclusions
It can be concluded that the new accounting standard would bring in increased quality,
transparency, comparability and consistency. The above analysis shows that the new accounting
standard would have a significant impact on the lessees. It is expected that companies with off-
balance leases would be the most affected by this new standard.
9. Presentation for the Client
The client would be required to present the leased asset and the lease liability in the
balance sheet, the interest expense on the lease liability and the depreciation charge on the
income statement and the interest expense portion of the lease payments in the cash flow
statement as an operating activity (PWC, 2016).

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