With IFRS 16 coming into effect from January 1, it will lead to an increase in leased assets and financial liabilities on the balance-sheet of the lessee. The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organisation’s leasing activities.
Accordingly, companies with material off-balance sheet lease commitments will encounter significant changes in their key financial metrics such as the leverage ratio, return on invested capital (Roic) and valuation multiples.
The International Accounting Standards Board (IASB) believes that leasing of assets is of importance to many entities. Leases can be used to provide access to assets without significant upfront costs, and the use of those assets is of value to the entity.
Without entities recognising these leased assets in their financial statements (along with the corresponding liability), users could neither see all the assets the entities are benefiting from nor compare their financial position with entities that have chosen to either buy the asset outright or entered into alternative financing arrangements.
What is the impact for leases?
For many companies, leases play a critical role in business operations. However, because most lease transactions were off-balance sheet, accounting for leases under current lease standards did not require a significant effort. The new standard will require a company to convert its existing operating lease commitments disclosure to reflect lease assets and liabilities.
Its implementation could result in changes to the policies, processes, controls and IT systems that support lease accounting and, possibly, lease procurement, lease administration and tax.
The new standard will affect virtually all commonly used financial performance metrics such as gearing, current ratio, EBITDA, operating profit, net income, asset turnover, interest cover, EPS (earnings per share), RoE (return on equity) and operating cash flows.
These may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes. It may compel many organisations to reassess certain “lease versus buy” decisions.
Balance-sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will be changes to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (acceleration of lease expense relative to the recognition pattern for operating leases).
Entities leasing big-ticket assets — including real estate, manufacturing equipment, aircraft, trains, ships, and technology — are expected to be significantly affected. The impact for entities with numerous small leases, such as tablets and personal computers might be less as the IASB offers an exemption for low value assets. Low value assets meeting this exemption do not have to be recognised on the balance-sheet.
Although the standard became applicable from January, many companies are still getting ready for implementation. Companies should review the new standard and understand the implications, including areas within the company that will experience the greatest impact.
It is also important to stay updated for potential changes in interpretation of the new standard. Not all aspects of current lease accounting are changing under the new standard.
Therefore, companies should assess what lease arrangements exist and the lease procurement, lease administration and lease accounting functions that support these arrangements in comparison with the requirements of the new standard. This will allow them to determine the extent of the changes required and appropriately design and plan the transition.
— Rajesh Tacker is Partner at RSM AE Technology.