Are you involved in a business that leases assets? A recently issued standard in New Zealand has the potential to significantly change what you currently report in your financial statements from 1 January 2019 onwards.
Leases – a new External Reporting Board standard
The standard on leasing was approved in mid-February for issue by the External Reporting Board in New Zealand, and published by the International Accounting Standards Board (IASB).
The key change that’s being made to current practice is that almost every lease obligation (a liability), together with the accompanying “right to use” the leased equipment (an asset) will now end up being reflected in your balance sheet. There are exemptions for short-term leases and leases of low value assets.
In light of this, there are eight “killer questions” that every CFO should consider before entering into future contractual arrangement to lease assets.
If you find yourself answering “yes” to any of the questions noted below, you should seek out a copy of NZ IFRS 16 Leases to learn more about the changes to lease accounting.
1. Are you subject to financial covenants?
If you lease assets, and currently you have tight debt-to-equity ratios, the new requirements will almost certainly make your situation worse. This is because all significant lease commitments will be deemed to be a financial liability, and so will need to be recognised in the balance sheet. There will no longer be a distinction between operating and finance leases for lessees, so leverage and capital ratios will deteriorate when the new standard comes into effect.
2. Do you have a track record of renewing your lease arrangements after the initial term has expired?
If it is reasonably certain that the lease arrangements you enter into will extend into a second or third term, then this fact must be taken into consideration when determining the lease liability that you must reflect in your balance sheet. As one might expect, the longer you lease an asset – the greater the lease liability that will need to be recognised at inception.
3. Does the lease agreement contain any contingent rental conditions or residual value guarantees?
To ensure that the liability (and of course the corresponding “right-to-use” asset) is not understated in the balance sheet, the IASB has introduced some additional elements that need to be taken into consideration. The IASB’s goal in including these factors into the determination of the liability is to reflect the economic substance of the arrangement – taking into account all, not just some, of the cash flows associated with the leasing arrangement. Hence, residual guarantees all now need to be taken explicitly into consideration. Variable payments that depend on an index or rate should also be included in lease liability/asset based on using index/rate at the commencement date. However, care is needed. Other variable payments (e.g. payments linked to sale or usage) are excluded from lease liability/asset.
4. Having entered into a leasing contract are you likely to change the period over which you will lease the asset?
If this is a circumstance likely to happen, NZ IFRS 16 now requires you to recalculate your obligations under the leasing arrangement and adjust the financial statements accordingly. For some this will not be a huge imposition. However, if you are a large and complex organisation, with hundreds of lease contracts, this has the potential to be a time consuming task.
5. Are your leasing arrangements currently being tracked via spreadsheets?
While for some organisations there is still most definitely a place to track leasing commitments through the use of spreadsheets, for others this will probably not be a suitable solution. While it can be argued there is a time and a place for everything, now might be a good time to evaluate the robustness of the controls and systems that support your lease accounting processes because, in many instances, an upgrade may be needed.
6. Do your deferred tax calculations include leasing arrangements?
For the time being it is unlikely that New Zealand legislation surrounding the tax treatment of operating leases will change, so when the lease commitments end up being reflected in company balance sheets, many new temporary differences will be created. Given that temporary differences (as defined in NZ IAS 12 Income Taxes) times the applicable tax rate generates the deferred tax liability or a deferred tax asset that will need to be reflected in the financial statements, preparers of financial statements would do well not to underestimate the amount of work associated with accounting for this component of their financial statements.
7. Are your staff performance incentives based on operating cash flows or EBITDA basis?
There will no longer be straight line recognition of rent expense in income statements (unless the exemptions for short-term leases and low value assets are adopted). Lessees rent expense will end up being front-loaded because of the interaction of effective interest being used to reduce the recognised financial liability coupled with the depreciation of the “right to use” asset. Because interest and depreciation will “replace” rent expense, EBITDA and operating cash flows will increase when the standard comes into effect. While some may conclude that the difference in the expense profile from lease rental expense to depreciation and interest may be insignificant, for many companies holding an evenly distributed portfolio of leases, (being a portfolio with the same number of leases starting and ending in any one period, with the same terms and conditions) taking some time out to assess the impact of these accounting changes is strongly recommended so that remuneration protocols are appropriately aligned with financial reporting expectations.
8. Are you a lessor as well as a lessee?
The good news is that accounting by lessors is not materially changed. Accordingly, in NZ IFRS 16 a lessor continues to classify its leases as operating leases or finance leases, and to account for those two types of leases differently. However one needs to be mindful that there are enhanced disclosures to be provided by lessors that will improve information disclosed about a lessor’s risk exposure, particularly to residual value risk.
The devil is in the detail
Although eight important questions have been noted above, like most financial reporting standards, the devil is in the detail and many more questions could be put up for consideration. If your organisation is a public benefit entity (i.e. in the public sector or is a not-for-profit organisation), the good news is that for the foreseeable future, these changes are unlikely to impact your organisation, because the XRB has not yet signaled it is planning a change to PBE IPSAS 13 Leases.
However, if you are a for-profit enterprise that is required to follow general purpose financial reporting in New Zealand, now is the time to consider the future implications of this new standard because, whether you chose to adopt it early or not, it has the potential to significantly reshape future financial statements.