Leases - to the balance sheet!
The new leasing standard IFRS 16 Leases will introduce a fundamental change to traditional operating lease accounting, requiring lessee’s to capitalise leases on the balance sheet. In years gone by operating leases were disclosed as off balance sheet commitments with only the annual lease expenses recognised.
Effective for annual periods beginning on or after 1 January 2019, IFRS 16 also introduces some other subtle changes and thankfully some exceptions, but in short:
- The concept of ‘operating leases’ (at least for leases greater than 12 months, or for ‘low value items’) is gone;
- Subject to the above, all leases will be capitalised on the balance sheet through the recognition of a ‘right to use’ asset and a lease liability representing the present value of the obligation;
- What was traditionally referred to as ‘rent expense’ disappears – replaced by a depreciation on the right of use asset and an ‘interest expense’ on the lease liability recognised over the lease period;
- To determine the value of the right of use asset and lease liability, non-cancellable lease payments (including inflation-linked payments), as well as payments for option periods which the entity is reasonably certain to exercise, must be included in the present value calculation.
So what does this mean?
For lessees, quite a lot. Especially those with significant volumes of operating lease arrangements, as the new standard will likely boost the balance sheets (with portions of the liabilities likely to be classified as current and non-current liabilities) and change the pattern of income statement expenses and the nature of these, the following key company metrics will likely be impacted:
Net Debt and Gearing – the lease liability will be included in net debt calculations, but the right of use asset will likely be excluded. This will impact debt/equity ratios and for those with other borrowing or financing facilities in place, debt covenants. Will the implementation of this standard under existing covenant calculations result in a breach of covenants? Will these need to be renegotiated?
EBITDA – there may be a favourable overall impact on earnings before interest, tax, depreciation and amortisation (‘EBITDA’) and EBIT as expenses previously classified as ‘rental’ in nature will be replaced by interest, depreciation and amortisation (which will now be excluded from the calculation of EBITDA). Market or shareholder expectations may need to be managed through this process so as not to mislead users of the accounts regarding changes in these metrics. Will this impact on how metrics are presented, share-based payment arrangements based on performance, etc.?
Net Assets – although both a lease liability and right of use asset are recognised under the new standard, the right of use asset will be amortised on a straight-line basis whereas the lease liability will likely unwind on a slower basis in the earlier years. Accordingly it is likely that net assets will reduce. Will this impact on the dividend policy of the company or create any potential thin capitalisation risks?
If you are a lessor, you can breathe a small sigh of relief, as the new standard does not change the current practice of lease accounting for lessors.
Generally, the new requirements must be applied retrospectively by either restating comparatives or showing the cumulative effect of initially applying the standard ad the date of ‘initial application’ as an adjustment to opening retained earnings. This election must be applied consistently to all leases. Depending on your entities’ balance date, this may require an opening position to be calculated as at 1 January 2018 (for December balancers) or 1 July 2018 (for June balancers).
Although the standard will not apply until the year ended 30 June 2020 (or 31 December 2019 for December balancers), as outlined above some of the potential impacts could affect how leases are negotiated, how financing and borrowing arrangements are structured regarding covenants and potentially how remuneration and dividend policies are structured.