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Managing commercial leases – a whole new world!


On 13 January 2016, the International Accounting Standards Board (IASB) issued IFRS 16 Leases, which essentially does away with operating leases and, subject to limited exceptions, requires all leases to be capitalised on the balance sheet rather than leaving them “off balance sheet” – which is general practice.  It will affect most companies that report under IFRS who are involved in leasing of property and high value equipment, and will have a substantial impact on their financial statements. For many other businesses, however, exemptions for short-term leases and leases of low value assets will reduce the impact.
The main implications of the new standard on current practice for lessees include:

  • No more operating leases under IFRS 16 (subject to certain exceptions)
  • All leases (subject to the exceptions) will be capitalised on the balance sheet by recognising a ‘right-of-use’ asset and a lease liability for the present value of the obligation
  • No rental expense! i.e. no more straight-line expenses for operating lease costs. All leases will incur a front-end loaded expense, comprising depreciation on the right-of-use asset, and interest on the lease liability
  • When initially measuring 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.

Lessees of retail premises paying contingent (turnover) rentals, and others required to make significant contingent rental payments, will be relieved to know that these will not be capitalised into the right-of-use asset, but will continue to be expensed in profit or loss.

Summary of Changes:
MAIN CHANGES
Who is affected?· Entities that lease assets as a lessee or a lessor
What’s the impact on lessees?·  All leases will be accounted for ‘on-balance sheet’, other than short-   term and low value asset leases
·   Lease expense will typically be ‘front-loaded’
·   Lease liability will exclude:
   – option periods unless exercise is reasonably certain
   – contingent payments that are linked to sales/usage
·  The new standard will affect virtually all commonly used financial ratios and performance metrics such as gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS< ROCE< ROE and operating cash flows.  These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes.  These impacts 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 also be a change to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (acceleration of lease expenses relative to the recognition pattern for operating leases today).
·  Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships and technology – are expected to be greatly affected.  The impact for entities with numerous small leases, such as tablets and personal computers, small items of office furniture and telephones might be less as the IASB offers an exemption for low value assets (assets with a value of $5,000 or less when new).  Low value assets meeting this exemption do not have to be recognised on the balance sheet.
·  The cost to implement and continue to comply with the new leases standard could be significant for most lessees.  Particularly if they do not already have an in-house lease information system.
What’s the impact on lessors?·  Only minor changes from the current Standard, IAS17 Leases
·  Changed needs and behaviours from customers which impacts their business model and lease products.
Are there other changes?·  A new definition of a lease may result in some arrangements previously classified as leases ceasing to be so, and vice versa
·  New guidance on sale and leaseback accounting
·  New and different disclosures
What does this mean?We expect that IFRS 16 will result in many entities experiencing
·  Higher EBITDA (earnings before interest, depreciation, amortisation and tax) due to ‘operating’ lease costs being allocated to depreciation and interest, rather than to an ‘above the line’ expens
·  Lower net profit in the early years of a lease due to front-end loaded expenses for interest.
·  Higher debt levels.This means that triggers for bank covenants and bonus arrangements will need to be reworked to compensate for these accounting standard changes.Extensive system changes will also be needed for assets previously recorded as operating leases:
·  Creating asset registers to record ‘right-of-use’ assets and calculate amortisation charges
·  Determining interest amortisation on lease liabilities.
When are the changes effective? ·  Annual reporting periods beginning on or after 1 January 2019
·  Various transition reliefs
·  Years to be presented in accordance with IFRS 16 in financial statements if full retrospective method is applied – FY 2018, FY 2019

Changes to definition of Lease:

IFRS 16 largely retains the definition of a lease in IAS 17 but changes the guidance on how to apply it. This refinement was necessary as the removal of ‘off-balance sheet’ operating leases created a greater need for distinguishing a lease and a service contract.
In practice, the changes to the guidance on the definition in IFRS 16 are not expected to affect conclusions about whether contracts contain a lease for the vast majority of contracts.  In addition, the new definition will only apply to new lease contracts and therefore there will be no need for businesses to reassess their existing leases when transitioning to IFRS 16.

Definition of a ‘lease’

 ‘…A contract, or a part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration…’

What to do now?

  • Lessees and lessors may need to consider renegotiating or restructuring existing and future leases.
  • Business and legal structures supporting leases should also be reassessed to evaluate whether these continue to be effective (for example, joint ventures and special p8urpose entities).
  • If you are a lessee or a lessor and have not discussed these changes with your financial and legal advisors, now may be the time to do so.