OPINION: EARLIER this year, on January 13, 2016, the International Accounting Standards Board (IASB) released a new standard for lease accounting: International Financial Reporting Standards (IFRS) 16, Leases.
The new standard won’t take effect until January 1, 2019, but anyone signing long-term leases on commercial property that will include periods beyond 2019 will be affected by the changes, and now’s the time to understand the impact on you and your business.
The intent of regulators is to provide greater transparency by removing the shadow debt created from operating leases. This will have a significant impact on the accounting implications for owners leasing their properties.
Commercial implications for tenants are less clear. The degree to which tenants are affected will depend on the importance the tenant attaches to accounting presentation vs. ‘purer’ commercial consideration, like cash flow.
Ultimately, your financial statements, regardless of whether you’re the tenant or landlord in a leasing arrangement will necessarily be affected, and you need to be familiar with the new standard and its impacts.
IFRS 16 – what’s the impact?
Ultimately, IFRS 16 will supersede the following standards and interpretations:
- AASB 117 Leases
- Interpretation 4 Determining whether an Arrangement contains a Lease
- Interpretation 115 Operating Leases – Incentives
- Interpretation 127 Evaluating the Substance of Transactions Involving the Legal Form of a Lease
The new standard IFRS 16 is effective for annual periods beginning on or after January 1, 2019.Earlier adoption of IFRS 16 will be permitted if IFRS 15 Revenue from Contracts with Customers is applied at or before the date of initial application of IFRS 16.
The new standard creates a single lessee accounting model – meaning a lessee will now account for all leases in the same way. Under the new rules, there is no distinction between operating and finance leases, and all assets and liabilities will be recognised on the balance sheet for all leases.
Broadly, all leases (with some limited exceptions) accounted for in same way as finance leases are currently accounted for. There are no substantial changes to lessor accounting
Preparing your balance sheet
The effect is that all operating leases should be capitalised and the resulting assets and liabilities recognised on the balance sheet. Recognition will be required of the rights (assets) and obligations (liabilities) arising from all lease contracts on the balance sheets of lessees, this will affect commercial leases, retail leases and industrial leases.
Depending on your balance sheet structure and composition, recognising operating lease commitments as liabilities could have a detrimental effect on your gearing and other related ratios, which in turn could have severe consequences for your banking covenants.
Similar to the current accounting for finance leases, the recognition of lease assets and liabilities would also require your company to determine any deferred income tax arising from these operating lease arrangements, further impacting your balance sheet structure and earnings profile.
Preparing your income statement
The current disclose of operating lease expenses in your income statement will be replaced with depreciation/amortisation of lease assets and interest expenses on the unwinding of lease liabilities.
This will improve EBITDA measures, potentially impacting on business valuation methodologies, employee performances measures and banking covenants that are based on EBITDA multiples or hurdles.
Even though there might not be any cumulative net impact over the term of each lease to the net profit under current and proposed models, the timing of the recognition of lease-related expenses in operating profit will change.
Recognising interest expenses on the unwinding of lease liabilities (using the effective interest method), in conjunction with depreciation/amortisation for lease assets, will generally result in a different expenses profile to what you may currently be used to under AASB 117.
Cash flow impacts
Under existing accounting standards, financial lease payments are generally classified as cash outflows from financing activities, whilst operating lease payments are generally classified as cash outflows for operating activities. The implication of the change in nature of the cash flows will need to be considered.
In addition to the financial implications, it is worth considering if your current accounting systems are sufficiently robust to deal with the annual reassessment and re-measurement process. If you have a significant number of leases, you may find it challenging to track and capture changes cause by reassessments and re-measurements of lease assets and liabilities each reporting period. There may also be additional time and costs pressures where these processes are required to be audited.
Another potential issue in measuring your lease obligations is the determination of an appropriate incremental borrowing rate to discount the expected lease payments.
Given the changes to lease accounting that are currently on the horizon, we recommend meeting with your advisor to discuss how you might be affected, and to take steps towards preparing your financial statements with a view to the implementation of AASB 16 in 2019.
By Andrew Clugston, Partner, Pitcher Partners.*
Australian Property Journal
