Unleash the lease on your balance sheet
The new accounting standard relating to leases has now been with us for nearly a year. Of particular interest are the words the International Accounting Standards Board (IASB) chose as a heading to its press release announcing the issuance of IFRS 16 on January 13 this year: “IASB shines light on leases by bringing them on to the balance sheet.” The latter part of the heading is very true; lessees will have to bring all leases on balance sheet as the standard comes into force in reporting periods commencing in 2019. I hold my reservations on ‘shines light on’ as, 11 months down the line, there are still some important questions for which lessees are still seeking answers.
In a nutshell, the two lease classifications – finance lease and operating lease – allowed under the extant standard, will be a thing of the past. Instead, a single lease accounting model will be implemented. Lessees will be recognising a right of use (ROU) asset, denoting the lessee’s right to use a particular asset, and a lease liability representing the obligation to pay future lease payments to the lessor over the lease term.
But I suspect this is no longer news for those who are reading this piece.
Lessees are more preoccupied by the practical implications that the abolition of the operating lease model and the recognition of a new asset and liability on balance sheet will bring. Some still question the measurement of the lease liability. As the lease liability at inception includes the present value of lease rentals over the lease term, the determination of the lease term is key. It includes, of course, the non-cancellable (di fermo) period, but would also consider optional renewals or termination if the lessee is reasonably certain to avail himself of these options – a judgemental determination in itself.
The pattern of expense recognition in profit or loss may also change significantly. While lessees are used to straight line expense recognition in P/L for their operating leases, the total expense that will be recognised for a similar lease under the new standard will be higher in the earlier years, when interest cost on the liability will be at its highest, and lower in later years. EPS will therefore decrease in earlier years.
Certain financial ratios may be impacted significantly. EBITDA will increase due to the new ‘geography’ of lease expenses – ROU amortisation and interest expense below EBITDA, rather than the ‘old’ lease expense on a straight-line basis above. Total assets will increase due to the new ROU asset recognised and gearing increases due to the increase in lease liabilities.
Other ratios are likely to decrease. Net assets will decrease since each individual lease is a net liability for most of its life as the ROU asset decreases faster than the lease liability. Interest cover and asset turnover are expected to decrease as well.
When the impact of the above is significant, lessees are left with no option but to bring the lease-versus-buy decision back to the drawing board.