Your Guide to Understanding the Implementation of IFRS 16 in Hong Kong
Before we dive into the implementation of IFRS 16 and its impact on companies operating in Hong Kong, let us understand the basics of this accounting standard.
IFRS 16 (International Financial Reporting Standard 16) is the latest lease accounting standard developed by the International Accounting Standards Board. This standard was issued in January 2016 and practically went into effect for reporting periods beginning on or after 1st January of 2019. Similarly, this standard has been adopted in more than 90 countries today.
The IFRS 16 works on a new approach to lease accounting, requiring lessees and lessors to provide trustworthy information on lease transactions. If a company is using an asset on rent, this must be stated as a lease in the company’s balance sheets.
Why IFRS 16 Was Introduced
The IFRS 16 standard was introduced in the wake of enormous frauds caused by companies like Enron and WorldCom. This closed the loophole that allowed such companies to hide some of the assets and liabilities from the balance sheet. Basically, companies had to state lease transactions on their balance sheet, reporting them as ‘right-of-use’.
The right-of-use model states that
“A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration’ (IFRS 16, par.9).”
Likewise, auditors could use strict measures to ensure transparency and credibility in the financial statements.
IFRS 16 in Hong Kong
The implementation of IFRS 16 will bring some drastic changes in financial reporting in Hong Kong. First, there might be some shifts in the key financial ratios in periodic reports. Similarly, there will also be a significant impact on the profit and loss, and earnings per share of the lessees. Since rental expenses are likely to increase, we will see a fall in company earnings and profits. Furthermore, there might be a change in the recording of cash flow. Moreover, companies will have to make additional disclosures in their financial statements.
Major Areas of Impact
The implementation of IFRS 16 will affect those industries where lease transactions are more pronounced. Some of them are:
The retail industry will be a major area of impact due to the implementation of IFRS 16. Retailers are one of the largest groups who base their business on leased items. They rely mostly on leased real estate, like offices and shops.
Retailers will have to reconsider renewal options and determine if there is an economic incentive. Similarly, they must employ strategies to determine variable payments. Furthermore, they will have to separate lease and non-lease elements.
The net debt will increase because rental expenses must be included. Similarly, the EBITDA will rise as there will be no operating lease expense included. The EBIT will also increase as the lease cost will transfer to interest expense. Furthermore, the profits will go down because of the higher interest in upfront payments.
Other industries like wholesalers and service industries like healthcare that operate on a similar basis will face similar challenges.
Telecom operators are also one of the major users of leased equipment. The equipment typically consists of network towers, satellites, and cables. The implementation of IFRS 16 will require telecom companies to identify their leases and separate them from non-lease entities.
Shipping and Aviation
Shipping companies or other companies who lease containers and vessels will also face the impacts of the implementation of IFRS 16. Similarly, aviation companies who use aircraft on a lease will also have to adapt to the new standards. The lessees will have to list aircraft and vessels as ‘right-of-use’ assets on their balance sheet.
The implementation of IFRS 16 will pose no drastic changes to some of the lease types. Some of them are:
If the lease period is less than 12 months, it will remain as a short-term lease. However, if it contains a purchase option or the option to extend the lease period, it cannot be classified as a short-term lease.
Low-value leases are also free from the changes imposed by the implementation of IFRS 16. If the value of the lease is less than 5000 US Dollars, it will be classified as a low-value lease. Typically, furniture and computers would fall into this category.
In addition to short-term and low-value leases, there are also some other types that will be exempted from the implementation of IFRS 16. These include:
- Leases non-regenerative resources which typically consists of the exploration of minerals, oil, and natural gas.
- Leases of biological assets, which will be monitored by the IAS – 41.
- Licenses of intellectual property.
- Rights that are held under licensing agreements like films, patents, and copyrights.
The implementation of IFRS 16 has come with a new set of challenges. Some of the major challenges include:
Collection of Lease Data
The implementation of IFRS 16 has changed the definition of a lease somewhat drastically. Therefore, companies are finding it difficult to assess their leased assets and collect sufficient information. Furthermore, large multinational companies with leased real estate over hundreds of locations have not been able to manage proper centralized documentation.
The implementation of IFRS 16 has asked for a diverse set of individuals to work on financial reporting. Accountants only are insufficient to prepare financial reports and require the help of procurement, operations, and IT personnel.
Adaptation and Communication Challenge
Communicating the new accounting standards to investors and stakeholders can be quite challenging because of new definitions. Understanding the financial performance of the companies won’t be straightforward.
From this blog, we have understood the implementation of IFRS 16 in Hong Kong and how it will affect businesses. We have also learned about the industries that will face major impacts. Lastly, we talked about some of the exceptions and the challenges of adapting to this new standard.
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