17 Jan 2019
The dawn of a new accounting era
With IFRS 16 coming into action early this year, are you ready for the new measures designed to increase transparency?
Are you ready for IFRS 16?
New accounting standards affecting virtually every company that uses rents or leases to gain access to assets came into force on January 1 this year.
IFRS 16, which has been ten years in the making, eliminates almost all off balance sheet accounting for lessees and impacts almost every performance metric from gearing ratio to Ebitda.
“If you lease anything from your office building, to company cars or a machinery, it is vital you speak to your accountants to ensure you are ready to meet the new requirements,” says Andrew Woodward, head of materials handling at Investec. “The new standards could have significant implications for your business.”
Why are these changes being made?
The changes are designed to ensure that companies all return information for leased items in the same way, making their existence more transparent financially. Previously, businesses could hold large financial liabilities via their operating leases but keep them off balance sheets, distorting the appearance of their financial status.
The International Accounting Standards Board, (IASB), which is responsible for the new rules, estimates that there is around $2trn of leased assets not held on balance sheets for listed companies alone.
In 2008, former IASB chair Sir David Tweedie quipped that his greatest ambition was to fly on an aircraft that was actually on the airline’s balance sheet.
Accounting changes at a glance
On 1 January 2019 new accounting standards that came into force have eliminated almost all off balance sheet accounting for leases.
As a result, companies will appear more heavily indebted, with financial ratios and performance metrics from gearing; to asset turnover; interest cover; Ebitda; operating profit and operating cash flows, all feeling the effects.
The new measures are designed to increase transparency by ensuring all businesses return information for leased items in the same way. But they could also impact covenants, credit rating and stakeholder perception.
If you are not yet ready for IFRS 16, it is time to contact your accountant.
Prior to the implementation of IFRS 16, companies accounted for lease transactions as either operating or finance leases. The cost of operating leases were listed as regular outgoing payments on the P&L, alongside other standard expenses. Finance leases were listed on the balance sheet as assets and so were classified as debt.
IFRS 16 will eliminate this dual accounting system. Instead, almost all leased items will now have to be included as an asset in the company books, following the new “right of use” model which says: “A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.”
In addition, the payments made on the lease agreement will have to be reported as a liability on the balance sheet.
Accounting will be further complicated by the new standard because costs for services such as maintenance and cleaning will have to be separated from the main lease payments and reported separately.
Added to this, the depreciation of the asset and interest on the lease liability will have to be shown on the profit and loss accounts.
The new IFRS II standards could have significant implications for your business. It is vital you speak to your accountants to ensure you are ready to meet the new requirements.
What are the implications?
Listing all leases on the balance sheet will make companies appear to become more asset rich but also more heavily indebted.
It will redefine many commonly used financial ratios and performance metrics such as gearing, asset turnover, interest cover, Ebitda, operating profit, net income and operating cash flows.
This will increase comparability, but may also affect covenants, credit ratings, borrowing costs and the perception of stakeholders.
The impact on a lessees’ financial reporting, asset financing, IT, systems, processes and controls may all be substantial.
The cost to implement and continue to comply with the new standard could be significant. Many companies have historically used spreadsheets to manage and account for their leases. The complexity of the new standard means this may no longer be cost-efficient and could lead to errors in reporting. Specialist IT and accounting systems may be required.
Its my greatest ambition to fly on an aircraft that was actually on the airline’s balance sheet.
Are there any exceptions?
Low value leases
IFRS will primarily impact those companies leasing big ticket items such as property,
manufacturing equipment and vehicles. To ease the burden of the regulation, companies leasing smaller items, such as computers, will be offered exemptions. Assets valued at $5000, or less, when new, will be not be subject to the new rules.
Short-term leases that do not extend beyond 12 months in duration and which do not contain any purchase options will also be exempt.
What should you be doing?
1. If you are not already IFRS 16 compliant, contact your accountants as soon as possible to discuss the changes.
2. Balance sheet accounting will require businesses to access significantly more data around their leases including term, rental payable and end-of-term options.
3. Discuss any borrowing costs and covenants that may be affected with your bank
4. Talk to shareholders, investors and other stakeholders to ensure they understand the changes that will occur to your key performance metrics.