IFRS 16: Can ENRON like scandal be checked?

Anyone related with Enron should get a minor heart-attack hearing off-balance sheet (OBS) financing. That terrifying scandal caused $74 billion financial loss to the investors, thousands of employees and investors lost their retirement accounts and numerous employees lost their job.

Operating leases and partnerships are most common forms of off-balance sheet financing. As per IAS 17 when a lease was determined to be economically similar to purchasing the underlying asset, the lease was classified as a finance lease and reported on a company’s balance sheet. All other leases were classified as operating leases and not reported on a company’s balance sheet (they were ‘off balance sheet leases’).

The problem with operating lease can be exhibited with the following example: a company needs an equipment for its production. It has two options. Either the equipment can be leased and then be bought at the end of the lease period for a minimal amount of money or it can be bought outright. The company will eventually own the equipment or building in both cases. The difference is how the purchase is recorded. In an operating lease, the company records only the rental expense for the equipment. When a company buys it outright, it records the asset (the equipment) and the liability (the purchase price). So by using the operating lease, the company is recording only rental expense, which is significantly lower than booking the entire purchase price, resulting in a cleaner balance sheet.

IASB and FASB worked together to improve the scenario. Enhancing disclosures was not enough to tackle this problem. As a result, IFRS 16 was introduced with effect from 1 January 2019. It will supersede all the previous leases standard and related interpretations.

IFRS 16 is going to change your balance sheet.

There will be no operating lease or finance lease. All leases will be treated in a similar way to finance leases applying IAS 17. As a result the most significant change will be an increase in lease assets and financial liabilities. However, there will be certain exemptions. Short-term leases (i.e., leases of 12 months or less) and leases of low-value assets (for example, a lease of a personal computer) will be exempted from the above requirement.

Your income statement is not exempted from change as well. The nature of expenses related to those leases are going to change. The straight-line operating lease expense will be replaced with a depreciation charge and an interest expense on lease liabilities.

What about cash flow? The amount of cash transferred between the parties to a lease is not going to be changed. However, the presentation of cash flows is going to be changed. Operating cash outflows is going to be reduced with a corresponding increase in financing cash outflows.

All the efforts were made to ensure that investors and analysts can have a complete picture of the financial position of a company, and can properly compare companies that borrow to buy assets with those that lease assets. Hope IFRS 16 will start an era free of Enron scandal.