At a glance
By Rachael McKinney with David Hardidge and Ram Subramanian
The International Accounting Standards Board (IASB) estimates that more than US$2 trillion in leased assets is left off the balance sheets of listed companies applying International Financial Reporting Standards (IFRS) or US generally accepted accounting principles (GAAP). That’s a lot of company assets and liabilities sitting off-balance sheet, potentially undermining the transparency of those businesses.
That’s all about to change when IFRS 16 Leases (AASB 16 Leases in Australia), the new accounting standard for leases, comes into effect. After more than a decade in development, this new accounting standard – which will operate from 1 January 2019 – will essentially eliminate the accounting distinction between finance and operating leases, bringing previously off-balance sheet arrangements onto the balance sheet.
Under the new standard, future operating lease payments will be capitalised and included on the balance sheet as a right-of-use (ROU) lease asset and a corresponding lease liability. The asset will then be subject to depreciation, while interest will be recognised on the lease liability over the lease term.
A number of practical implementation challenges have been identified with the new standard. For example, variations arising from Consumer Price Index (CPI) increases could require re-measurement of the lease asset/liability in subsequent periods.
Other considerations surround the impact of IFRS 16 on novated lease contracts, and peppercorn leases. Peppercorn leases are where the lease payments do not reflect the fair value of the property being leased, and are not uncommon in the public and not-for-profit sectors.
The balance sheet and the bottom line
Once recognised, the new interest expense and depreciation charge will in fact be higher than the periodic lease rentals at the start of the lease term; it’s a phenomenon known as the financing effect.
“The accounting will affect profit and loss, with depreciation and interest expense instead of lease payments,” says David Hardidge, director – technical and treasury products at the Queensland Audit Office.
The direct effect is that net profit will be lower in the earlier stages of the lease term, thanks to higher interest payable on a larger liability. As the liability is paid, the lease payments remain unchanged but the interest element will start to reduce, as will its impact on the bottom line. The changes will also affect other ratios such as earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA).
“Your profit will be affected by the financing effect, even if your underlying results stay the same,” says Hardidge.
Even though you will have higher accounting expenses at the start of the lease, this does not mean higher tax deductions. The deductibility of lease rentals will be governed by the local tax legislation, which may not change. Differences between accounting and tax treatments will require tax effect accounting adjustments.
The challenge will be working out the interest or discount rate and, therefore, the interest element of the lease rental payment. That may be implicit in the lease, though more likely it will not be able to be determined and you will have to use an incremental borrowing rate.
ROU assets will generally be reported under the applicable property plant and equipment (PPE) class, although there is likely to be a further note to the financial statements that differentiates leased and owned assets.
The revaluation of these new ROU assets for financial reporting purposes is also allowed under IFRS 16, but only if the related class of assets is revalued. On the flip side, if for example you revalue buildings you own, it seems there’s no corresponding need to revalue leased buildings. It’s an added consideration for the financial reporting team.
As with most new accounting standards, there’s an option to apply IFRS 16 retrospectively and include balance sheet comparatives. However, IFRS 16 also offers a modified retrospective approach that doesn’t require restatement of comparatives.
At the time of adopting the standard, any lease liability is simply based on future rentals for the lease term, discounted to reflect its present value. The scope of the modified approach, which allows a choice of how the lease asset is calculated (a decision that will affect future profits), is limited. Entities with a 30 June year-end must recognise assets based on the new rules from 1 July 2019.
Under IFRS 16, ROU assets and liabilities are valued by determining the present value of future lease rental payments. Recalculating the value of those cash flows will only be triggered when there is an actual change in the lease and, therefore, lease payments. The underlying discount rate to bring them to their present value will usually stay the same.
Any change in the value of the discounted cash flows, because of the change to future lease payments, will need to be recognised as an adjustment to the lease liability. The value of the asset will also change, as will the interest and depreciation on the adjusted asset and liability.
For example, an asset held under a 10-year lease with an annual CPI adjustment will be valued as the original ROU asset depreciated over 10 years, with subsequent annual CPI adjustments, each depreciated for the remaining number of years on the lease at the time of the adjustment. It’s a degree of complexity that current asset registers are likely to struggle with.
If the rental payment is contingent on, for example, a variable monthly sales number (as is often the case in retail), then the variable component is accounted for as an operating lease expense in the profit and loss. Only the fixed, known element of the lease payment is accounted for under the terms of IFRS 16.
Electricity and maintenance should be excluded, but if they form part of a fixed rental payment you can elect to estimate their value and exclude them or include them in the capitalised lease rentals, although that will inflate both the value of the asset and liability, and impact on the bottom line.
Software vendors have been quick to recognise the complexity of IFRS 16 compliance and are already promoting new solutions for calculating CPI adjustments and more – but buyer beware, as there are jurisdictional differences, for example, between IFRS 16 and the US version (ASC 842) that will impact on the calculations.
That said, it’s unlikely that current asset registers will be able to cope with the complexity of lease accounting. Those reliant on spreadsheets to keep track of one or a handful of leases will need to look for a more sophisticated solution to track multiple leases with different start dates and different contract terms.
While adopting IFRS 16 should ultimately bring, in the words of the IASB, “transparency, accountability and efficiency”, which can only be a win for the users of financial statements, it also brings a huge practical challenge that businesses need to be addressing now.
Ram Subramanian, policy adviser – reporting, policy and corporate affairs at CPA Australia, says it’s not so much about who wins or who loses, but about who it has more impact on.
“The impact is greater on lessees, on those who obtain lease assets,” he says. “When it comes to those who provide lease assets, the lessors … they pretty much carry on as they always did.
“If one group must be defined as a winner, it’s the people who invest in companies that rely heavily on leased assets to run their operations. Investors will have more information than ever, on which they can base their investment decisions.”
Exceptions to the rule
IFRS 16 Leases applies to all leases except the following:
- Short-term leases – less than 12 months
- Low-value leases – value not specifically defined but guidance is less than US$5000 when new, and likely applied to individual assets rather than the total value of the assets under the lease
- Leases to explore for or use materials, oil, natural gas and similar non-regenerative resources
- Leases of biological assets in scope of IAS 41 Agriculture held by a lessee
- Service concession arrangements in scope of IFRIC 12 Service Concession Arrangements
- Licences of intellectual property granted by a lessor in scope of IFRS 15 Revenue from Contracts with Customers
- Rights held under licensing agreements in scope of IAS 38 Intangible Assets for items such as motion picture films, video recordings, plays, manuscripts, patent and copyrights (for leases of other types of intangible asset a lessee is permitted to apply IFRS 16, but not required to do so)