Major Changes to Lease Accounting Introduced
The International Accounting Standards Board (“IASB”) has introduced fundamental changes to lease accounting with the release of IFRS 16 Leases (“IFRS 16”). These changes will impact on those entities that prepare financial statements under the requirements of New Zealand equivalents to International Financial Reporting Standards (“NZ IFRS”), such as listed companies, building societies and large privately-owned companies.
The primary impact of the new standard will be to eliminate the current distinction between operating and finance leases for those entities that lease assets (lessees), by bringing nearly all leases onto a lessee’s balance sheet.
Key features of the new standard
IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases by both parties to a contract.
IFRS 16 requires a lessee to capitalise nearly all of the leases that it enters into. This is done by recognising the present value of the lease payments and classifying them either as lease assets (right-of-use assets) or together with property, plant and equipment. If lease payments are made over time, a company will also recognise a financial liability representing its obligation to make future lease payments.
This means that, for lessees, there will be an increase in lease assets and financial liabilities. This will impact on key financial metrics derived from the company’s assets and liabilities (such as leverage ratios), which may impact on loan covenants and other agreements based on such metrics.
For lessees with leases currently classified as operating leases, IFRS 16 will also change the nature of expenses related to those leases. The straight line operating lease expense currently recognised will be replaced with a depreciation charge for lease assets (which will be included within operating costs) and an interest expense on lease liabilities (which will be included within finance costs). Although the depreciation charge will typically be even, the interest expense will reduce over the life of the lease as lease payments are made. This will result in a reducing total expense as an individual lease matures. The impact of this change is unlikely to be material for companies that have a portfolio of leases that start and end in different reporting periods.
The only exception to these requirements is that a lessee will not be required to recognise assets and liabilities for short-term leases (i.e. leases of 12 months or less) and leases of low-value assets (such as a personal computer). Such leases will be expensed on a straight line basis over the lease term.
IFRS 16 substantially carries forward existing lessor accounting requirements. Accordingly, under IFRS 16 a lessor will continue to classify its leases as either operating leases or finance leases, and to account for those two types of leases differently. However, lessors will be required to disclose additional information about their leasing activities, and in particular about their exposure to residual value risk.
Internationally, IFRS 16 comes into effect for annual reporting periods beginning on or after 1 January 2019. The standard has not yet been adopted in New Zealand by the New Zealand Accounting Standards Board, but once it is adopted it is likely that New Zealand will have the same effective date.
The IASB has released a short video in which IASB Chairman Hans Hoogervorst provides an overview of the new standard.
BDO will be providing more detailed analysis of IFRS 16 in future editions of Accounting Alert.
Many New Zealand companies that report under NZ IFRS have significant operating lease commitments. The requirement to bring many of these commitments on to the balance sheet will impact key financial statement ratios and any agreements based on those ratios.
Although the effective date of the new standard is 1 January 2019, many companies enter into long-term lease arrangements and the standard is retrospectively applied, which means that companies that report under NZ IFRS will need to start preparing for the changes as soon as possible. In addition, companies entering into new leases that will extend past 1 January 2019 should structure those leases with the requirements of IFRS 16 in mind.
For more on the above, please contact your local BDO representative.