When IFRS 16 comes into effect in January 2019, it will transform the relationship between businesses and their leases, including those for office spaces and other real estate. Here, award-winning financial journalist Melanie Wright explains what the changes mean and why it’s so important for businesses to ensure they’re prepared.
Many firms lease a wide range of items to support their businesses, such as office space or vehicles. The latest standard from the International Financial Reporting Standards (IFRS), IFRS 16, is due to come into effect in January 2019, changing how businesses must recognise, measure, present and disclose these leases.
1. Prepare to recognise your leases on your balance sheet
When lease accounting, lessees must currently distinguish between a finance lease reported on the balance sheet and an operating lease off the balance sheet, but according to the International Accounting Standards Board, this makes it difficult to get an accurate picture of a company’s lease assets and liabilities. When IFRS 16 rules come into effect, nearly all lease contracts need to be recognised on the balance sheet as assets and liabilities, solving this problem.
2. Assess your contracts carefully
The definition of a lease is broader under IFRS 16 rules than under current International Accounting Standards (IAS) 17 rules, so businesses will need to assess their contracts for potential lease elements to see if they fall under the new guidance. IFRS 16 rules state that a contract 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’ (IFRS 16:9). To determine whether a contract contains a lease, businesses will therefore need to establish whether there is an identified asset, and whether they have the right to obtain all the economic benefits from the use of that asset.
So, for example, if your company rents part of a storage facility to keep goods in, but this area varies depending on how much space is available, then this is not likely to be classified as a lease under IFRS 16 as no specific asset can be identified. If, however, your company rents a specific unit in the storage facility for a set period of time, the asset can be identified and therefore your contract does contain a lease.
3. Review your current leasing decisions
IFRS 16 will affect performance metrics and financial ratios such as asset turnover, gearing, current ratio, interest cover and net income, so it’s important that businesses are ready for these changes. Many lessees will see their operating cash flow increase, as only the part of the lease payments that reflects interest on the lease liability can be presented in financing activities.
Businesses that haven’t included ‘frozen’ generally accepted accounting principles (GAAP) clauses in their financing arrangements could potentially see breaches of loan covenants once the rules come into effect, as their recorded debt levels may rise. Businesses with capital market transactions likely before or after IFRS 16 is implemented will need to think carefully about the impact on their gearing ratios, and may want to review some of their leasing decisions.
4. Seek more flexible lease terms
IFRS 16 allows two exemptions. These are: leases with a lease term of 12 months or less with no purchase option, and leases where the underlying asset has a low value when new. So, for example, if a business rents a workspace for a few months, this does not have to be recognised on the balance sheet. Businesses currently tied into longer leases may therefore consider seeking more flexible lease terms to help manage the impact on their balance sheets.
5. Rethink the type and length of your real estate leases
As real estate leases, including office spaces, will need to be accounted for on balance sheets following the introduction of IFRS 16 rules, companies may opt to move to shorter lease terms or outsource office spaces to serviced providers instead. Under the exemptions outlined above, these would not need to be accounted for on balance sheets, helping to reduce the administrative burden.