New approach to accounting for leases long time coming
The International Accounting Standards Board (IASB) issued the long awaited IFRS 16 Leases earlier this year. Rarely does a revision of an Accounting Standard have such great ramifications beyond the realm of financial reporting.
The impact of this new lease standard extends to commercial areas such as the drafting of contracts, gearing or loan covenants, and remuneration schemes.
Most Australian companies have leases in some form, whether they relate to operating premises or the finance of plant and equipment through hire purchase arrangements. The impact of the new standard will be pervasive as there will no longer be a distinction between finance and operating leases.
What are the significant changes?
- Greater guidance on whether a contract contains a lease so there may be more leases identified within a business;
- Lessees must recognise all leases on balance sheet, except for short-term leases and leases of low value assets like telephones, photocopiers and computers. Lessees can continue to apply existing operating lease accounting to such leases by expensing the rental cost on a straight-line basis; and
- For general purpose financial statements, there are enhanced disclosures regarding the nature and future financial impact of additional leases.
While there are no significant differences proposed for lessors under the revised Standard, it does mandate changes to the way leases are recorded:
- Balance sheet: Initially recognises lease assets and liabilities on the balance sheet at the present value of future lease payments. However, lease assets will also include costs directly related to entering into the lease. Rental incentives received prior to lease commencement will be netted off against the asset. The lease asset will be amortised in a similar way to other assets such as property, plant and equipment.
- Profit & Loss statement: Recognises amortisation of lease assets and interest on the liabilities over the lease term. The effect on profit will depend on the type of leases held, however the expectation is that the higher interest charge will reduce profit in the earlier years of the lease. Conversely, the allocation of some of the lease cost to interest and depreciation will allow Earnings before Interest & Tax (“EBIT”) and Earnings before Interest, Tax, Depreciation & Amortisation (“EBITDA”) to increase. This is especially relevant for companies with banking covenants or remuneration schemes linked to performance measures like EBIT or EBITDA.
- Cash flow statement: Currently, operating lease costs are typically included as an operating cash outflow. The new Standard requires the separation of total amount of cash paid into a principal portion (presented within financing activities) and interest (presented within either operating or financing activities).
The new Standard does not apply until reporting periods beginning on or after 1 January 2019, so most companies in the Hunter won’t be affected until the 30 June 2020 financial year. However, planning is critical and it is important that companies understand the impact of this Standard in advance, especially those intending to enter into new long term funding or supply contracts.
Contact our Audit & Assurance specialists to discuss how the new Standard might affect your business – Newcastle (02) 4962 2688 | Sydney (02) 8346 6000.