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At a glance
Seven years on from the introduction of game-changing global lease accounting rules, a largely favourable verdict has been delivered.
This follows the post-implementation review of International Financial Reporting Standard (IFRS) 16 Leases to ascertain how the standard has been received by preparers, auditors and users of financial reports.
In 2019, the adoption of the standard required lessees to recognise almost all leases on the balance sheet. The standard — and its Australian equivalent, AASB 16 — is designed to improve transparency and comparability in financial reporting by capturing lease information that had previously been kept off the balance sheet.
Matt Pinnuck, professor of financial accounting at The University of Melbourne, describes IFRS 16 as “one of the few accounting standards that has had a very big impact”. The requirements have, however, broadly been well understood and properly applied across a range of entities.
Pinnuck says that in an Australian context, AASB 16 has resulted in a “very substantial change on the balance sheet” for businesses, many of which have some form of lease agreement in place.
“It has been a big change and definitely a change for the better,” he continues. “And there has been a substantial improvement in transparency around the amount of debt that firms are carrying through their leasing arrangements.”
Overall effectiveness of IFRS 16 and AASB 16
Lease reporting governs how businesses record and report the financial elements and effects of lease arrangements.
Nikole Gyles FCPA, managing director of Greenway Avenue Consulting, says the revamped lease reporting regime has delivered clear benefits, particularly for listed and large private sector entities.
Gyles is one of the authors of the CPA Australia Leases Research Report 1, a review of the standard’s implementation and effectiveness. “Overall, in the private sector, much of the messaging, including the evidence presented in the report, supports the conclusion that the standard has largely achieved its objectives,” she says.
While some preparers initially feared a heavy compliance burden, Gyles says the report’s findings point to a “clear and sustained shift” in transparency since adoption. The proportion of firms recognising lease liabilities increased from about 42 per cent before the standards to about 90 per cent after implementation.
"There has been significant pushback from the public sector. We are very advanced in Australia in public-sector accounting. It is very transparent, very sophisticated, very good quality reporting, but that comes at a cost."
“This suggests preparers have understood and applied the principles effectively,” Gyles says. “It also indicates that the ongoing costs of compliance are manageable and broadly in line with expectations.”
Audit impacts have also been less significant than some anticipated. Leases are identified as a “key audit matter” in only about 4 per cent of audit reports examined in the CPA research.
Ram Subramanian FCPA, financial reporting lead at CPA Australia, agrees that the standard has been particularly effective in addressing issues in capital markets. He points to airlines as the often-quoted classic example.
Historically, many airlines leased all their aircraft, keeping both assets and liabilities off the balance sheet, “so people could not actually see what assets they used to operate the business because they were leasing them all,” Subramanian says.
Public sector and NFP application challenges
Despite broadly positive feedback overall, the application of AASB 16 has been more contentious in Australia’s public sector and within private sector not-for-profit (NFP) entities. Australia is one of only a small number of jurisdictions to apply the standard to public sector and NFP entities.
In its submission to the AASB on the post-implementation review of AASB 16, CPA Australia notes that many public-sector stakeholders argue the requirements do not meet user needs, are costly to implement, and involve complex judgements and systems challenges.
“There has been significant pushback from the public sector,” Subramanian says. “We are very advanced in Australia in public-sector accounting. It is very transparent, very sophisticated, very good quality reporting, but that comes at a cost.”
"It has been a big change and definitely a change for the better. And there has been a substantial improvement in transparency around the amount of debt that firms are carrying through their leasing arrangements."
A key issue, he adds, is that public-sector entities are funded primarily through appropriations — funding from government to run their operations — rather than debt financing. While they may lease assets, those leases are generally not viewed internally as financing transactions.
“The leasing standard doesn’t align well with the way the public sector operates,” Subramanian says. “It doesn’t fit their ethos or business model, so it is often seen quite negatively.”
Ric De Santi FCPA, an experienced director and former deputy auditor-general of Tasmania, says that despite some initial implementation concerns within government agencies, including the impact on net debt measures, AASB 16 adoption has gone quite smoothly. “Agencies here in Tasmania and elsewhere built those changes into their budgets in advance,” he says.
However, De Santi concedes that a lack of funding compared with the private sector has made the rollout more difficult for some public-sector entities. “The public sector has limited resources to invest in and build systems to do such work,” he says, adding that AASB 16 did increase compliance costs for entities with significant leases. “That has always been a challenge.”
Nevertheless, he supports the notion of having public-sector leases on the balance sheet. “In government, it is all about service delivery, and it is important that the balance sheet shows the assets you’re using and the associated cost. So, bringing it onto the balance sheet is useful.
Making it consistent with the private sector is also of use because I believe in what is called ‘sector neutrality’, whereby accounting standards apply equally to the public and private sectors.”
CPA Australia has recommended that the AASB establish a dedicated project to explore simplification options for lease accounting in challenging areas, particularly for NFP private and public-sector entities.
Potential areas of refinement
It is important to remain focused on the broader benefits of improved transparency while refining IFRS 16 (and AASB 16) where necessary, Pinnuck says. “In the long run it lowers the risk of investing, lowers the cost of capital and therefore increases the amount of funds that we are prepared to invest as a society into listed companies.”
The CPA Australia submissions to the IASB and AASB suggest that there is scope for targeted simplification. Areas identified include discount rate determination, long-term property leases and low value leases, where costs and complexity can outweigh any benefits.
Complex lease structures and limited internal resources have also led to differences in interpretation and disclosure. One ongoing challenge relates to how performance metrics — such as return on assets or EBITDA — are presented. Some entities include leased asset information, while others exclude it, creating inconsistencies that complicate benchmarking and stakeholder analysis.
Other areas where stakeholders have called for clearer guidance include lease term assessments, reassessment versus modification, lease definition issues, improving disclosures, the use of implicit versus incremental borrowing rates, lease incentives, and sale and leaseback transactions.
“Sale and leaseback is where a company sells an asset it owns and then leases it back,” Subramanian says. “There are some real accounting complexities around that, and we’ve asked for greater clarity.”
De Santi believes the reviews should consider factors such as substantive substitution rights.
“If they structure their leases, organisations can arrange it so they do not have to bring the lease liability and the asset on the balance sheet by allowing the lessor to substitute the asset.”
The CPA Australia submission raises the same point, noting that there may be inconsistent application of whether a contract constitutes a lease agreement in the context of substantive substitution rights.
For example, when a local council leases garbage removal trucks from a third party and uses them as part of their refuse removal process, there is some inconsistency in the treatment of these contracts. There may be some interpretative challenges around whether the trucks are under leasing arrangements or not.
De Santi says there are also challenges around peppercorn leases — whereby rent is set at a nominal amount to satisfy legal requirements — and whether they should be recognised at cost or fair value, with many favouring the cost approach.
“Just about everyone does it at cost, so why do you need the option? Or should it be at fair value like all other things on the balance sheet? That potential lack of consistency could be fixed,” De Santi says. “The problem with that is that it just adds more complexity for the public sector.”
What comes next?
As IFRS 16 and AASB 16 undergo review, all eyes will be on possible changes.
Given that upfront transaction costs to adopt the new standards have been modest and the benefits so substantial, any changes are likely to be minimal, Pinnuck says. “For such a significant standard, it is kind of remarkable how little pushback there has been. So, the substance is going to stay the same.”
Gyles says there are opportunities for improvement, particularly in the alignment of voluntary performance metrics with the principles of IFRS 16 “where potential consistencies in the treatment of lease liabilities in metrics such as return on invested capital may undermine the comparability and reliability of management commentary”.
“This is an area where further guidance or educational material in relation to management commentary, or in IFRS 18 and related standards, would be beneficial,” Gyles adds.
With the standards now having been applied for years, Subramanian says costs are largely embedded into organisations’ systems and they have information-capturing mechanisms in place to work out lease numbers.
Moving forward, the key is to reduce any complexities and strengthen the reforms through more practical guidance.
