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Lease accounting: getting ready for a new approach

It is all go in the financial reporting world. With three key new IFRS standards taking effect in 2018/2019, companies need to get in shape to embrace the changes and provide stakeholders with the key information and explanations needed to understand the – sometimes huge – impact they will have on financial statements. Pearson Business School’s Jennifer South writes.

IFRSs 9 and 15 launched in 2018, so we are just now starting to see what effect they have had on companies’ results – and from 2019, companies are required to adopt IFRS 16 on Leases, which for some industries will have by far the biggest effect of the three.

Under the old IAS 17 standard, with the main requirement for recognising an asset and a lease liability being whether the company enjoyed the ‘risks and rewards’ of ownership, there was much scope for keeping liabilities ‘off balance sheet’. In industries such as retail, companies may have had dozens of leases on commercial retail properties, but since these are relatively short term when compared to the life of the property, under the old standard only the annual rental expense would be shown, with future cash commitments on the lease disclosed deep in the notes – despite the fact that some leases could run for 10 years or more in the future.

Given that the fundamental purpose of producing financial statements is to help stakeholders make useful decisions about a company, not including – in some cases quite significant – liabilities left some companies looking in a healthier state than they truly were, and may have swayed directors towards more short-term leases to avoid recognising the debt within the balance sheet. But all this is about to change.

The New Principles

For accounting periods starting from 1 January 2019, nearly all lease contracts that companies enter into – the only exceptions being very low-value assets or very short lease terms – will need to come ‘on balance sheet’, recognising the present value of the future liability and a right-of-use asset to reflect the value the company is getting from the contract.

This asset will subsequently be depreciated; in effect, the part of the original asset’s value the company has a right to use will be included in much the same way as current property, plant and equipment.

The effect on the financial statements of affected companies will be huge. Not only will liabilities increase greatly – analysis by PwC in 2018 suggests the debt shown by retailers will on average double due to the many short-term shop rental agreements they have – but finance costs will also grow, and due to the nature of accounting for leases using amortised cost, there will be greater finance costs hitting profit or loss at the start of the lease term.  

Key Metrics Affected

While there will be a slight reduction in operating expenses as the cash rent expense is replaced by depreciation of the right-of-use asset, overall – despite clearly representing the company’s position more faithfully than before – the effect for the company will be broadly negative. Gearing will increase dramatically, and companies with interest cover covenants will need to be careful to communicate and renegotiate with finance providers to ensure they are not adversely affected by the changes.

Companies operating in industries which have a lot of short-term, high-value rental agreements will be most significantly affected by this change – retailers with shop leases, airlines leasing aircraft and the telecoms industry with the various phone shops, cables and towers being leased spring to mind.

Collaborative Reporting

Going forward, this and the other new standards are clearly going to disrupt the way teams work within the business. 

Until now, the decisions over leasing a new retail outlet, for example, will have been primarily strategic and cash focused; is it in the right place, at the right price? But now, as soon as the contract is signed, significant liabilities will immediately be shown – and remember, the highest finance costs are at the start of the term too – so companies need to be conscious of the effect on gearing and interest cover before entering into any agreement. The accountants need to get involved from the start.

The nitty-gritty details of the contracts will also be important: options to extend the contract or buy the asset at the end of the term will have a knock-on effect on the financials and need to be considered carefully. Longer terms will lead to higher liabilities initially but lower finance costs towards the end of the contract, so the choice of term may be important to keep within the company’s KPIs. 

It is worth remembering, though, that these types of contract were already in progress before the standard changed – fundamentally nothing has intrinsically altered within the company – it is just now that users have a better, fuller picture about the commitments the company has to fulfil in the future.

It will be interesting to analyse and investigate the effect of the standard as companies start to implement it – and to see which manage stakeholders’ expectations well to ensure they understand the rationale of the standard and the reasons behind the movement in position. 

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