As discussed in the previous articles in this series, the new accounting standard for leases – IFRS 16 – requires that companies reporting under IFRS must report all leases on their balance sheets as assets and liabilities. From January 2019, all leases will be treated in a similar way to finance leases (for lessees) and will be ‘capitalised’ by recognising the present value of the lease payments and showing them as lease assets (right-of-use assets). If lease payments are made over time, a company will also recognise a financial liability representing its obligation to make future lease payments.
Based on the above, the question remains as to the relevance of concluding operating leases going forward. Let’s consider the benefits of operating leases:
- Flexible funding structure
- More cost effective compared to cash or traditional funding
- Reduced cash flow due to the residual value investment
- The cost and obligation of ownership, disposal and obsolescence is avoided
- Off balance sheet financing
From the above you will note that only one benefit which relates to off balance sheet (excluding the exceptions) will not be applicable, ALL other benefits remain.
Cognisance also needs to be taken of the fact that the unguaranteed residual value portion will not be included in the right-of-use asset and corresponding liability, and will still remain off balance sheet, thus allowing partial off balance sheet recognition. Entities should therefore ensure that they deal with leasing companies that are residual risk takers to enjoy the benefit of partial recognition.
In addition, leases that meet the requirements of the exceptions to the application of IFRS 16 will be off balance sheet.
‘These changes will no doubt make a significant impact on business from a reporting point of view,’ says Sybrandt Fouché, Chief Financial Officer of RentWorks, ‘but all of the other benefits traditionally associated with operating leases will still apply.’ The International Accounting Standards Board (‘IASB’), which issued IFRS 16: Leases, has carefully considered the potential negative consequences associated with the new standard and has concluded that the risks and costs are manageable.
‘Leases remain a very attractive source of flexible financing for companies not wanting to bear the risks of ownership, and the real business benefits of leasing will not change as a result of the new standard,’ says Fouché.
The International Financial Reporting Standards body is of the opinion that 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. The majority of credit providers and rating agencies already take lease obligations into account when evaluating a company’s ability to pay its bills, even though their calculations may be imprecise as a result of the off balance sheet nature of the reporting.
Fouché says that while there will be costs incurred in updating systems to implement IFRS 16, the exemptions to the standard, as well as the fact that it will not apply to SMEs, will provide some reprieve. In general, the benefits of IFRS 16 should far outweigh its costs. The increased visibility of all leases will lead to better informed investment decisions by investors, and to more balanced lease-versus-buy decisions by management. In addition, IFRS 16 will lead to improved capital allocation, which should be beneficial for economic growth.
The IASB has published an Effects Analysis which accompanies IFRS 16 and outlines the costs and benefits of the standard. (See: http://www.ifrs.org/-/media/project/leases/ifrs/published-documents/ifrs16-effects-analysis.pdf)
Articles in this series have examined:
- Changes in off balance sheet lease reporting;
- The impact IFRS 16 will have on businesses, from an accounting and operational perspective;
- The exceptions to the application of IFRS 16; and
- Whether, in light of IFRS 16, there is still benefit in leasing, as opposed to buying assets.