Leases are a source of financing that are used by a number of companies.Under current accounting rules only a finance lease ends up on the balance sheet.
Significant numbers of companies will have operating leases, for example a property lease for 5 years, which is only disclosed in the notes to the financial statements.
Some might argue that as a result investors are unable to get an accurate picture of a company’s off balance sheet obligations.
New IFRS16 rules
For accounting periods commencing 1 January 2019, for those lessees who prepare the financial statements under International Financial Reporting Standards (IFRS) there are going to be significant accounting changes with regards to operating leases in that these will be brought onto the balance sheet under IFRS 16 ‘Leases’.
All leases (except small value or very short leases i.e. those with a term of 12 months or less) will be capitalised at the net present value of the future lease payments.
Definition of a lease
A lease is defined as a ‘contract that conveys to the customer (‘lessee’) the right to use an asset for a period of time in exchange for consideration’.
A lease will exist when a customer has the right to control the use of an identified asset for a period of time.It may be challenging to determine whether the contract is a right to use an asset or is instead a contract for service that is providing the use of the asset.
If a supplier can practically substitute another asset and there is a clear economic benefit for the supplier to do so then the contract will not be considered a lease.
Leasing accounting impacts
As a result of this change lessees will recognise a right of use asset but at the same time a financial lease liability on the balance sheet.
In the profit and loss account there will be an increase in depreciation expense on the asset, as well as increase in the interest expense on the interest liability. The interest expense also tends to be higher in the earlier years of a lease than the later years.
As a result of these changes some lessees may need to review any loan covenants for possible breaches of financial ratios for example EBITDA. In addition this could also impact staff bonuses that are linked to performance criteria.
The impact on lessor accounting remains largely unchanged however, they may need to review their business models and lease products as a result.
Some companies may decide to buy more assets rather than lease them. Alternatively they may turn to a contract for services rather than for use of an assets.
Whilst the Financial Reporting Council have not suggested the requirements of IFRS 16 will be reflected in FRS 102 at present, given the significance of the change, it might be something which could affect UK GAAP in the future.
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