The Australian Accounting Standards Board (AASB) issued the AASB 16 Leases standard, leading to potentially broad consequences for the way businesses recognise lease liabilities in their financial accounts.
Under this accounting standard, all leases with a term of more than 12 months, including those previously recognised as operating leases, will be brought onto the balance sheet and recognised as a lease liability, unless the asset is of low value.
To understand what AASB 16 means for Australian businesses, it may be of value to appreciate previous distinctions between two types of leases: operating leases and finance leases.
Prior to AASB 16 being introduced, operating leases were typically not represented on balance sheets; however, finance leases were acknowledged in the company's accounts.
AASB 16 effectively does away with this distinction and requires all major leases to be accounted for on financial statements. According to the AASB 16 standard, "That [previous] model was criticised for failing to meet the needs of users of financial statements because it did not always provide a faithful representation of leasing transactions. In particular, it did not require lessees to recognise assets and liabilities arising from operating leases."
Leased assets
Kinh Luong, Audit and Assurance Partner at accounting firm HLB Mann Judd Sydney, suggests most companies that lease assets should expect the addition of 'right-of-use assets' on their balance sheets as a result of this standard. This will be accompanied by related 'lease liabilities,' which were not previously recognised.
This means leased equipment which may not have previously appeared on balance sheets may appear as both an asset and a liability on the accounts.
“From the lessee's perspective all assets are classified as 'right-of-use assets,' with an exception for those relating to investment property," says Luong. “So any business currently leasing its premises or plant and machinery for more than 12 months will find their balance sheets will change."
Luong explains leases whose terms are for fewer than 12 months, or leases related to low-value items, are not caught under this standard.
“Low-value is not specifically described in AASB 16, but can be defined as the value of the item as new, not the value on its acquisition date," he adds. Examples of items that may be considered low-value include mobile phones, tablets, laptops or small pieces of office furniture.
Widespread significance
One challenge of AASB 16 will be determining the interest rate implicit in the lease where it is not explicit in the lease agreement. Zowie Pateman, Acting Reporting Leader, Chartered Accountants Australia and New Zealand (CA ANZ), says “Under this standard depreciation and interest will appear in the company's income statement. As a result, operating profits are likely to increase for most businesses that lease assets, as will EBITDA.”
According to Pateman, banking covenants and other financial metrics including gearing and interest cover ratios may be affected as a result of this standard. Additionally, she notes staff rewards linked to measures such as EBITDA may need to be reconsidered.
Pateman suggests that while 1 January 2019 is the date from which the standard applies, businesses need to be ready well before 1 January 2018. “Changes to accounting systems and processes will need to be in place before this date to capture the required information for reporting."
CFO action plan
As to what CFOs need to do to ensure they comply with the accounting standard, Luong says as with any new standard, being well prepared can help remove uncertainty and allow sufficient time to manage potential adverse consequences.
Transitioning to AASB 16 may require businesses institute a formal change management process to ensure they are ready. This can include putting in place a project management plan to ensure issues related to the standard are addressed in a systematic way.
According to Luong, any business with substantial operating leases will find that, without their borrowings actually having increased in a real sense, they will have to quickly adjust to managing increased debt levels.
“This year CFOs should review their existing long-term contracts and identify which will fall within the scope of the standard during the period in which it is first applied, being the year ending 31 December 2017," he notes.
CA ANZ's top five tips to transition to AASB 16:
1. Set up a lease register.
CA ANZ suggests that many businesses do not have systems and processes in place to track their equipment leases – some don't even keep copies of lease contracts – so this can be an important first step for all and something to be put in place now.
It doesn't have to be anything too fancy, according to CA ANZ, especially for smaller entities with less-complex leasing arrangements, but it is especially important under this standard for all businesses to be able to capture lease obligations, record judgements made and calculate/track the financial impacts.
2. Consult with a specialist.
Many aspects of AASB 16 may require expert judgements to be made in order to apply to a company's specific circumstances. For instance, CA ANZ suggests firms need to decide which of their arrangements meet the definition of a lease, what the lease terms are and whether the business can take advantage of short-term/low-value exemptions.
Specialist accounting advice may help to understand the financial impacts, set up accounting templates and support decisions made by management and the board.
3. Manage expectations.
Once the financial impacts are understood, CA ANZ says it's important these are communicated to the board, shareholders and other external stakeholders in advance prior to their implementation.
4. Meet with lenders.
The balance sheet and profit and loss changes will impact things like debt/equity ratios and EBIT/EBITDA measures. CA ANZ suggests that if you have external loans, it is important to meet with lenders in advance of applying this standard to consider the impact on any banking covenants.
5. Consider future contracts.
When structuring future lease or financing arrangements, CA ANZ says it is important businesses fully understand and consider the financial impact in light of AASB 16 so they can make informed decisions.
Key Takeaways on AASB 16
- Businesses may have to adjust how they recognise lease liabilities financially.
- All major lease arrangements now to be brought on balance sheet.
- This standard's changes take effect 1 January 2019.