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Will Changes To Lease Accounting Trigger A Change In Business Practices?

Posted by Ryan Hendrie on 15/02/18 10:18

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With the implementation of IFRS 16 accounting changes in January 2019, many people are wondering whether there will be significant changes in business practices as a result of these.

The main change is that companies will have to include all lease commitments on balance sheet, 85% of which, globally, are not currently included. This will inevitably lead to an increase in recorded debt and liabilities, which might be interpreted as a downturn in the company’s performance.

From January 2019, a company that is the lessee must recognise as an asset the right to use a leased item, and also as a liability the item’s present value of future lease payments. Finance leases have always been included on balance sheets.

It is a worldwide phenomenon that many businesses choose to lease office space, equipment, and other assets they need to run their businesses effectively rather than tie up their cash in buying assets outright. Tying up capital in assets could be to the detriment of a business if they should later need to access ready funds.

Although leasing is not restricted to any one sphere of business, it is most often the choice when dealing with assets that depreciate, or need to be replaced on a regular basis, such as computer and office equipment or company cars. Industries traditionally associated with high concentrations of leased assets include transport, telecommunications, retail, real estate and travel/leisure. Many smaller businesses are also not interested in acquiring fixed assets, such as shops or offices, but they do need the use of these assets in order to operate.

The extent to which businesses will be affected by the new leasing changes will depend on several factors, such as the size and nature of the business, the extent to which the business has relied on both operational and financial leasing in the past, and whether what a business has previously defined as a leasing contract, might now be reclassified as a service contract or visa versa.

Immediate Effects On Businesses Of The Implementation Of IFRS 16

  • In most businesses, there will be an increase in their recorded debts and liabilities. This is as a result of operating leases that were previously not included in the balance sheets (only in footnotes), but going forward have to be included. The question is whether shareholders will appreciate that the business’s performance has not deteriorated, and that fundamentally the financial position of a company has not changed, but is now more accurate reflected.

 

  • Greater financial transparency and comparability. The financial statements of a company will now provide a clearer overall picture of its true financial position, and managers will be able to make decisions with regards to the real operating costs of leasing and its viability for the future. Financial comparisons between companies, or within the same company, can also be drawn more easily and more accurately with the help of the detailed information that will now be available.

 

  • Updating/upgrading of accounting systems, controls and governance. The new requirements eliminate nearly all off-balance sheet accounting for lessees, and redefine many commonly used financial metrics, according to PWC. In order to implement IFRS 16 effectively, many businesses will have to upgrade and change their accounting processes, controls, and possibly also retrain existing staff. In large businesses additional staff might need to be taken on. These upgrades, although in many cases a once-off expense, could be expensive, but should be offset by increased insight into risk mitigation as a result of more extensive and accurate financial reporting.

 

The Future Of Leasing 

“IFRS will result in a substantial change to many companies’ balance sheets, and will not be popular with everyone,” accedes IASB Chairman Hans Hoogervorst. But he stresses that the IASB has looked at the risk carefully, and concluded that the risks and costs are manageable, and the benefits greatly outweigh the costs.

There are several areas of concern within the leasing industry and among their clients as a result of the upcoming implementation of IFRS 16. Questions being asked are:

 

Will People Still Choose Leasing As An Option? 

On paper, it would appear that leasing has become more expensive. The actual costs of leasing will not change for the lessee or the lessor. The only change is the way operational leases are recorded. And, says Hoogervorst, “leases will always remain attractive as a flexible source of finance.” There might be costs involved in implementing IFRS 16, but there are benefits to the company as well.

 

Will Companies Re-evaluate Their Decisions To Lease?

In the initial stages, it might seem as if leasing has become more expensive, and this might lead to managers re-evaluating their decision to lease rather than purchase. However, on closer inspection, it would become apparent that only the method of recording costs has changed – leasing costs remain the same.  It is, however, possible that the full costs of leasing may only become apparent now to certain managers, which could lead to a re-evaluation of their original decisions to lease rather than purchase.

 

Will The Costs Of Leasing Increase And Affect The Balance Sheets?

The costs of leasing will remain unchanged by the new regulations, but as the outstanding commitments relating to existing operational leases will now be added to the balance sheets of companies, there will be an increase in recorded debts and liabilities – likewise an increase in recorded assets. “It is highly unlikely that the improved visibility of lease obligations will lead to significant effects in terms of the cost of borrowing and debt covenants,” adds Hoogervorst.

 

Will Shareholders Have A Negative Perception Of The Increased Debts And Liabilites On The Balance Sheet?

Shareholders might find this confusing initially, but all companies subscribing to IASB principles will be affected in the same way. Companies will have to make an effort to explain the changes to those with a stake in the company.

What About The Costs Associated With Compliance?

There definitely will be costs involved in updating systems to implement IFRS 16, but, says Hoogervorst, “the IASB is convinced that the benefits of IFRS 16 will greatly outweigh the costs.”

It’s understandable that you may be concerned about the costs associated with achieving IFRS 16 compliance, however, so you’re doing the right thing getting prepared in advance. In order to make your compliance as smooth as possible, follow our complimentary seven step guide:

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