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It has been 10 years in the making, involved the production of numerous discussion papers, exposure drafts, consultations, hundreds of outreach meetings and public round tables – but the International Accounting Standards Board has finally issued its new reporting standard for lease accounting.

Which companies need to adopt IFRS 16?

The new standard applies to companies which are required to comply with IFRS, as well as to companies which, although not strictly required to, choose to adopt it. IFRS is primarily used by listed companies in the US or other listed companies whose business has a substantial connection with the US.

When does it take effect?

1 January 2019 – However, companies are free to adopt it earlier provided that they also apply IFRS 15 (Revenue from Contracts with Customers).

What does this mean for operating leases?

The new standard treats all leases in the same way in the lessee’s accounts, effectively scrapping the finance lease/operating lease distinction for lessees. As a result, all leases will be capitalised by reference to the present value of the rentals payable and operating leases will be brought on balance sheet. The effects of this will be:

  • to cause a balance sheet increase in lease assets and financial liabilities.
  • to change the financial ratios for many companies, particularly the leverage ratio.
  • (initially at least) to increase compliance costs of switching to the new regime.

There are two exceptions where leases do not need to be brought on balance sheet. They are:

  • short term leases of 12 months or less
  • leases of low value assets (the figure being proposed here is US $5,000)

Treatment in lessor’s accounts

Whilst IFRS 16 will involve major changes to the accounts of lessees, the accounts of lessors will be largely unaffected. This appears to have been a policy decision based on evidence that the cost of implementing equivalent changes for lessors would be significant and outweigh the benefits. As a result, lessors will with a few exceptions continue to classify leases as finance leases or operating leases in much the same way as previously.

What’s the position under UK GAAP?

Initially, there will be no change to UK domestic accounting rules. However the UK Financial Reporting Council has said that it is “pleased that this standard has now been issued and will be fully involved in considering its endorsement in Europe.” So, whilst it won’t happen in the short term, it is likely to be a just a matter of time before similar rules are trickled down into UK GAAP.

What will this mean for companies?

Clearly, companies which currently use off balance sheet leasing will be most affected by the new standard. Evidence suggests that this will have the greatest impact on airlines, retailers, the travel and leisure and transport sectors.

Likely changes for affected companies include:

  • possible switching to debt facilities from leasing – although the tax benefits of leasing will of course remain
  • changes to the cost of funds, particularly for businesses which are rated by the rating agencies
  • potential breaches of financial covenant by companies which use off balance sheet leasing
  • greater use of short term leases

Both lessors and lessees should make the best use of the next 3 years to prepare for the changes. Lessees should look closely at the terms of their bank facility documents, particularly to establish the effect on their financial ratios. Whilst lessors may lose one potential benefit of leasing, it will remain a very flexible and useful finance product. Lessors should focus on marketing its strengths and concentrate on the needs of sectors in which operating leasing is currently popular.

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This blog is intended only as a synopsis of certain recent developments. If any matter referred to in this blog is sought to be relied upon, further advice should be obtained.