Happy Birthday NZ IFRS 16!
The new leasing standard NZ IFRS 16 Leases turned one in January, having been issued by the International Accounting Standards Board (IASB) in 2016. In light of this anniversary, it is a good time to reflect upon how well prepared you are in respect to this standard. Have you read the standard, attended training on it or performed a diagnostic study in order to identify and understand the impacts on your accounts? As a reminder NZ IFRS 16 is applicable to all Tier 1 and Tier 2 for-profit entities.
What is changing?
NZ IFRS 16 is a significant change from the current leasing standard, particularly for lessees. The distinction between finance and operating leases has been removed, with all leases treated in the same way. For a lessee, a lease arrangement will result in an asset, being the right-of-use asset of the underlying leased asset, and a corresponding lease liability, being recognised on the company’s statement of financial position.
On initial recognition, the lease liability represents the present value of lease payments, and it then builds up to reflect the interest implicit on the lease and is reduced as lease payments are made. The related right-of-use asset is amortised in accordance with NZ IAS 16 Property, Plant and Equipment. For lessees that amortise the right-of-use asset on a straight-line basis, the total of the interest expense and amortisation of the right of use asset are higher in the earlier periods of a lease, and reduce over the term of the lease (front-end loaded).
Instead of recognising rental charges in operating expenses, the payments made by lessees are characterised as asset amortisation and finance charges, which will improve an entity’s reported earnings before interest, tax, depreciation and amortisation (EBITDA).
Contracts linked to EBITDA
For this reason a key implementation issue is to determine what contracts an entity has that are linked to EBITDA. Typically these may include bonus arrangements, employee share plans and banking covenants. In considering this, the following questions arise:
- In the last year, how may contracts have you entered into that refer to EBITDA?
- How many of these contracts were adjusted to take into account the improvements to EBITDA, likely to arise from NZ IFRS 16?
- When do you plan to build NZ IFRS 16 EBITDA into contracts?
- When will you perform a full inventory of contracts linked to EBITDA?
- When will you re-write/renegotiate your contracts to reflect the impact of NZ IFRS 16?
- What are the consequences of not adjusting these contracts for NZ IFRS 16?
Identifying leases within contracts
Understanding what leasing contracts you have is a critical and time-consuming step in the adoption of NZ IFRS 16. A contract does not have to be called a ‘lease’ to be within the scope of the Standard. If you have a contract, or part of a contract, that provides the right to use an asset for a period of time, in exchange for consideration, then you may have a lease. Entities will need to review contracts where goods and services are received to make sure that these contracts do not have any leasing elements that need to be accounted for in accordance with NZ IFRS 16.
Allocation of contract consideration
Allocating contract consideration to lease and non-lease components of contracts requires considerable effort, particularly when there are multiple assets covered by one contract and/or the provision of goods or services within a contract. There is a need to determine the stand-alone selling prices of each component within a contract that contains a lease, which necessitates an understanding of the pricing decisions made, and often requires expertise outside of the internal accounting department.
NZ IFRS 16 is effective from 1 January 2019, but it can be early adopted if NZ IFRS 15 Revenue from Contracts with Customers is also adopted. NZ IFRS 9 Financial Instruments and NZ IFRS 15 apply from 1 January 2018, so there may be an advantage to ‘biting the bullet’ and adopting the three new standards together in one project.
NZ IFRS 16 has a number of transitional options which will need to be considered.
What to focus on
Questions you should ask in respect to NZ IFRS 16 include:
- What leases will be brought onto the statement of financial position?
- How much will the EBITDA improve by?
- Do we have any contracts or bonuses linked to EBITDA? If so, do we need to alter these contracts?
- What implication will applying NZ IFRS 16 have on our gearing/borrowing levels?
- What is our transition plan?
- Do we have the time and resources to adequately deal with this?
It is also timely to consider NZ IFRS 16’s older siblings, NZ IFRS 9 (the completed version issued in July 2014) and NZ IFRS 15 (issued in May 2014), how much attention have you shown them?
For more information, please contact your local BDO representative.