IFRS 16 applies to annual reporting periods that begin on or after January 1, 2019. However, earlier applications are permitted, provided Audit firms in Dubai and other users of financial statements also use IFRS 15.
What is IFRS 16?
IFRS 16’s purpose is to help UAE company audit specialists accurately represent lease-based transactions and support users in assessing cash flows arising out of leases. The standard requires that the lessee recognize assets and liabilities for leases with a tenor of more than 12 months unless the underlying asset has a low value. The lessee must recognize right-of-use support representing its right to use the underlying asset and a lease obligation representing its obligation to pay lease payments.
Lessees measure Right-of-use assets in the same way as other non-financial assets, such as property, equipment, and plant. Lease liabilities are also measured similarly to other financial liabilities. A lessee should depreciate (usually straight-line) the right-of-use asset and charge interest on the lease obligation. According to IAS 7, a lessee’s cash flow statement should be split into principal and interest.
The initial valuation of assets and liabilities arising out of a lease is based on their present value. Measurements should include non-cancellable and inflation-linked lease payments. Audit services may also use optional periods in Dubai if the lessee is certain that they will exercise the option to extend or terminate the lease.
The right to use the underlying assets is called the leased asset. It is included in the financial position as either property, plant, and machinery or as a separate line item. Lessors may continue to categorize their leases as finance or operating leases and account for them differently.
Sectors that are affected by IFRS 16
The new standard will be mandatory for most Dubai and UAE companies by 2019. Most leases were reported in the footnote disclosures to financial statements. Many leases will now be reported on the balance sheet in 2019 as right-of-use assets and lease liabilities. This will significantly impact financial metrics such as the Gearing ratios and EBITDA, and return on assets. UAE companies such as the airlines, transport, and telecommunication industries will feel the impact of IFRS 16. They rely heavily on operating leases for off-balance-sheet financing.
Lessee’s financial statements will be affected by IFRS 16
The most important effect of IFRS 16 requirements is an increase in financial liabilities and lease assets. With significant off-balance sheet leasing agreements, Dubai firms will see a change in vital financial metrics derived from their reported assets and liabilities.
IFRS16 will impact both sides of the balance. The lessee recognizes a new group of assets for the right to use asset and related lease liabilities. Companies in Dubai UAE that previously used an operating lease to balance their books will have to increase their assets and liabilities now.
The carrying amount for leased assets will usually decrease faster than the carrying amount for related lease liabilities. For companies with material off-balance sheet leases, this will reduce reported equity relative to IAS 17. IASB Effect Analysis of IASRS 16.
Statement of profit and loss
Lease expenses were treated as operating expenses under IAS 17. However, IFRS 16 will account for them as interest expense and depreciation. IFRS 16 will therefore recognize them as the depreciation of right-of-use assets, an operating expense, and an interest expense. The depreciation charge on a leased asset is usually even. However, interest expense will decrease over the lease term because lease payments are made directly to the lessor. As each lease matures, this results in a reduction of total expense.
Internal auditors reported operating leases under IAS 17 under operating expenses. However, with IFRS16, these expenses will be classified between deprecation or interest expenses. This will result in higher EBITDA or EBIT. Analysts and valuation experts should be on the lookout for an increase in valuations when multiples of EBITDA or EBITDA are used.
Statement on Cashflow
Accounting requirements are not likely to change the amount of cash transferred between parties to a lease. IFRS 16 will not impact cash flows classifieds from operating and financing activities. IFRS 16 is expected to reduce operating cash outflows and increase financing cash outflows compared to amounts reported under IAS 17. IAS 17 requires companies to report cash outflows from off-balance-sheet leases as operating activities. However, IFRS 16 allows financial auditors to include principal repayments on all lease obligations in financing activities. IFRS 17 provides for interest expenses to be included in financing activities.
IFRS 17 is a simplified way for analysts to adjust amounts on a lessee’s income statement and balance sheet. It also improves comparability between companies that lease assets and those that borrow money to buy assets. It will have an impact on all financial ratios and financial statements.
Theshani is a Senior auditor and has experience of 4+ years in providing audit assurance and advisory services to a wide range of industry clients. She continues to stay on top of ever-changing industry dynamics by continuously learning and developing expertise.