Deloitte’s Alison White and Henri Venter explore the wide-reaching impact of a new lease accounting standard issued by the International Accounting Standards Board (IASB).
The IASB has issued IFRS 16 Leases (the new Standard), introducing a new model requiring lessees to recognise all leases on the balance sheet, except for short-term leases and leases of low-value assets. These changes are also expected to be issued by the Australian Accounting Standards Board (AASB) shortly and are effective for periods beginning on or after 1 January 2019 i.e. 30 June 2020 year-ends for many Australian entities.
The pervasive use of leases means that we expect the changes to impact most entities and especially those with significant operating leases of property, aircraft, manufacturing equipment, mining equipment, and logistics services.
The financial impact
An entity leases a building for five years with annual rentals of $1,000,000. Assume a discount rate of 7.93 per cent. Currently the entity recognises $1,000,000 as an operating cost each year.
Under the new Standard the entity capitalises the obligation to make rental payments at its present value ($4,000,000) and recognises a corresponding asset for the right to use the building.
|Balance sheet ($000)||At inception||Year 1|
The entity computes interest on the lease liability and amortisation on the asset over the lease term. These costs replace the operating cost and result in higher earnings before interest and tax (EBITDA).
|Profit ($000)||Year 1|
|Amortisation of lease asset||(800)|
|Interest expense on lease liability||(317)|
|Profit before tax||(1,117)|
Commercial implicationsAs we can see in the above example, it is likely that profit will be lower in the earlier years of a lease as a result of higher interest accruing on the lease liability in those earlier years (akin to an amortising mortgage), however the overall effect will depend on the portfolio of leases an entity holds. Profit, in aggregate over the life of the lease doesn’t change.
This new Standard is more than an accounting change. Recognition of increased lease liabilities on balance sheet is likely to focus more attention on leases at board and management levels, including consideration of whether leasing is the most efficient means of obtaining access to assets and whether, and which, assets should be bought rather than leased.
Entities also need to consider a number of other commercial implications, including:
- Impact on gearing and loan covenants
- Impact on key ratios and communication with stakeholders
- Impact on remuneration schemes, including bonuses and share-based payments
- Existence of data and systems to calculate the impact and satisfy ongoing reporting requirements.
Many stakeholders both internally and externally will be impacted, including treasury, IT, acquisitions, human resources, legal, tax, investors, analysts and financiers. Stakeholder engagement at the appropriate time will be important to ensure that the impact is fully understood.
Other accounting standard changes
Furthermore, this new Standard is not the only significant change in accounting standards requiring consideration and application. New accounting standards for revenue and financial instruments will be effective a year earlier. These standards will also have wide- reaching commercial implications, especially the revenue requirements, such that a lease implementation project has to be part of a broader integrated financial reporting change programme.
Call to action
Board audit committees have an important role in overseeing the implementation of the new Standard, including understanding the impact, how potential risks are addressed and assisting in setting the tone for an effective implementation.
Although the effective date is three years away, we recommend that entities use this time to analyse the requirements, consider the wider implications of the changes and consequently make any required changes to their systems and processes.
Alison White is a partner in Deloitte’s Assurance & Advisory division and leads the Accounting Technical group. Henri Venter is a director in the Accounting Technical group.
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