From 1 January 2019 a new accounting standard applies for all reporting entities and public companies which will fundamentally change the way they record and report leases. IFRS 16 will have a major impact on these entities’ balance sheet and it is crucial impacted businesses start planning for the changes ahead of its implementation.
It is unlikely small or even medium businesses will be impacted. The definition of a reporting entity applies to businesses with users dependent on financial reports for making decisions who do not ordinarily have access to the information. Where this is unclear there are several guidelines such as the number of owners (the more owners, the more likely a entity is a reporting entity), the economic and political influence of the entity and the size of the entity (value of assets, number of employees). So this change will only impact larger businesses that produce general purpose financial reports that must comply with Australian accounting standards.
The new standard defines a lease as “a contract, or part of a contract, that conveys the right to use an asset for a period of time in exchange for consideration.” So it covers situations where an entity has the right to use an identified asset, obtain all the economic benefits from this use and the right to direct how the asset is used.
The change being implemented by this new standard is that all leases are to be accounted for on the balance sheet. Most businesses would be familiar with this principle for finance leases such as chattel mortgages and hire purchases where the asset purchased is depreciated and the lease liability recognised on the balance sheet. However this standard basically applies a similar treatment to all operating leases. Common examples might be the renting of business premises or short term leases for IT equipment, phone systems and motor vehicles. The standard seeks to achieve uniformity in the accounting treatment between all leases.
Businesses must now recognise these other leases on the balance sheet. The value of the lease is based on the discounted payments required under the lease, taking into account the lease term. This can be a tricky calculation where the lease has optional extension periods as this could increase the term and the value of the lease. The cost must also be split between the lease cost and the cost of any separate service (i.e. an IT system may come with a maintenance agreement – these two items must be separated).
The lease asset is shown as a separate class of fixed assets – “Right to Use Assets” – and a corresponding liability is also shown – “Lease Liability”. Instead of claiming an expense for each payment, the asset is depreciated and the interest component of the lease is recognised. This will result in the same deduction over the life of the lease, but with an accelerated expense claim in the earlier years.
There are two major exclusions for impacted entities – the standard does not apply to leases with a period of less than 12 months (but be wary if an extension or renewal is possible) or for leases involving assets with a value under $5,000.
So what is the issue with this? There are two issues – it will involve more accounting for these types of leases and will increase the time involved with recording these leases. The second hidden issue is the impact on the balance sheet. These changes could significantly alter many ratios such as liquidity and working capital ratios and many banks have lending facilities contingent on a business satisfying certain ratio criteria. So businesses will need to ensure their lender is aware and happy with the changes to the business’ financials otherwise they could be in for troubles with their finance facilities.
If you need further information on this standard and its potential impact to your business, please do not hesitate to contact us.