IFRS 16 – a new lease of life
| 16-02-2018 | Lionel Pavey |
Leasing is a common method used in business to benefit from using an asset. The part owning the asset is called the lessor who agrees to allow the user – the lessee – to use the asset, in return for a rental fee. The lessee also has to agree to certain terms and conditions as to how the asset can be used and by whom. This arrangement allows a business to enjoy the benefits of an asset – normally property or equipment – without having to purchase the asset outright at inception. The contract can also offer flexibility to the lessee with regard to replacing an asset when it is determined to be outdated. On the 1st January 2019, new accounting standards will be implemented meaning that for a lessee all lease contracts will have to be displayed on the balance sheet – with exception of short dated leases (less than 12 months) and with a monetary value of less than USD 5000.
Impact
There will be no more off balance sheet constructions. The balance sheet of a company will grow, as all leases are included. This would lead to a growth in both assets and liabilities. Furthermore, there will be no distinction between an operating lease and a financial lease as happens now. Under the new regulations a lease contract will be split between the right of use of the asset and the service component costs (including interest expenses) that will now appear as an expense on the profit and loss statement. For businesses that have traditionally relied on lease contracts – aircraft, shipping, heavy industry – there will be a noticeable impact.
Consequences for lessee
This will lead to considerable changes in the standard financial ratios and metrics that a business uses – EBITDA, interest coverage ratio, net income, operating profit, earnings per share, return on equity etc. By placing all lease contracts on the balance sheet, a further effect could be felt on borrowing costs, bank covenant compliance and even credit ratings. There will also be more costs and work involved in complying and maintaining the regulations. It will lead to an increase in debt on the balance sheet. The changes could be so large that some businesses will reconsider if an asset should be leased or purchased outright. This could lead to major reviews and renegotiations of existing contracts.
Whilst this is a change that impacts on the accounting side of a business, the knock-on effects will be visible to a treasury department. It will be necessary to collaborate internally and project the impact on existing bank covenants, other lending facilities and the financial metrics that are used.
Cash Management and Treasury Specialist
