IFRS16 – Lease accounting standard is changing, are you ready?

By July 23, 2018Blog

Whether it be the old SSAP21 or the soon to be superseded IAS 17, the accounting treatment for Leases, from a Lessee’s point of view has always been a controversial issue. Keeping assets and liabilities “off balance sheet” where the lessee has, in substance, the right to use an asset and the obligation to make payment in order to enjoy that right is clearly open to some challenge on how true and fair a view is being presented.

About IFSR16

The new International Standard, IFRS 16, will apply for periods on or after 1st January 2019. It represents a fundamental change to Lessee accounting which will result in the recognition of a substantial amount of additional assets and liabilities.

Additionally, as the transitional arrangements are more complex than is usually the case, early planning for the route to be taken towards first time adoption should be considered.

Firstly, there is the issue of does a contract contain a lease.

A contract contains a lease if it conveys ‘the right to control the use of an identified asset for a period of time in exchange for consideration’.

For this to be the case, IFRS 16 says that the contract must give the customer:

  • the right to substantially all the identified asset’s economic benefits, and
  • the right to direct the identified asset’s use.

The right to direct the use of the asset can still exist if the lessor puts restrictions on its use within a contract (such as by capping the maximum mileage of a vehicle or limiting which countries an asset can be used in). These restrictions define the scope of a lessee’s right of use, rather than preventing them from directing use.

IFRS 16 says that a customer does not have the right to use an identified asset if the supplier has the practical ability to substitute the asset for an alternative and if it would be economically beneficial for them to do so.

Secondly, unless either the lease is for 12 months or less, or the asset being leased is deemed to be of “low value”, the lessee shall recognise;

  • A liability, measured at the present value of the lease payments. This will include fixed and variable payments, residual value guarantee payments and if reasonably certain, purchase option payments.
  • A right-of-use asset, measured in line with initial recognition of the liability plus upfront deposits, direct costs and the costs of future obligated dismantling (consistent with IAS 37, Provisions)

Subsequently, interest will be charged on the liability and lease payments will reduce is carrying amount. The right-of-use asset will be depreciated over the shorter of the lease term or the useful life of the asset, unless title is expected to pass, in which case we default to the useful life.

The implications of the new standard on a set of financial statements are quite far reaching. The introduction of more long-term liabilities will see an impact on gearing. The charging of finance cost will impact on interest cover. Lenders’ covenants will need to be reviewed and potentially renegotiated. On the other hand, both operating margins and EBITDA will increase. Performance metrics which affect staff appraisals or bonus schemes may therefore require resetting.

Impact on Key Performance Indicators (KPI’s)

KPI

Measure

Basis

Effect

Gearing Risk Debt / Equity INCREASE
Interest Cover Debt Servicing Operating profit / Finance cost DECREASE
Operating Margin Profitability Operating profit / sales INCREASE
EBITDA Profitability Earnings before interest, tax, depreciation and amortisation INCREASE

There is a choice of first time adoption to the new standard. The traditional, fully retrospective approach with restated comparatives or the modified retrospective option with a cumulative catch applied as an adjustment to opening equity at the beginning of the adoptive period.

There are many things to consider. Understanding the needs of the key stakeholders, consideration of the transitional options and the impact these would have, developing a time line to implementation, and liaising with the auditors.

Murray Harcourt can assist you through this process for a smooth transition for this significant change to lease accounting.  If you have any questions please give me a call on 0113 231 4131 or email david.caseldine@murrayharcourt.com