11 July 2016

Leases are contracts that convey the right to use an asset for a period of time in exchange for consideration. A lessee currently classifies them on the financial statements as either finance or operating leases, depending on the nature of the lease.

A finance lease is “a lease that transfers substantially all the risks and rewards incidental to ownership of an asset1. An operating lease is “a lease other than a finance lease2. It is used to finance the asset for less than its useful life.

The distinction is sometimes put colloquially: a long-term lease, versus a mere rental.

Under current rules a finance lease results in the asset and finance liability being recorded on the lessee’s balance sheet. In the income statement, the payments over the term of the lease are split between depreciation and interest.  This reflects one aim of accounting which is to record substance, rather than form: a long-term lease might encompass so much of the life and value of an asset that, in substance if not form, the arrangement is a purchase and sale. One consequence of this (that often surprises lawyers) is that a balance sheet will include assets to which the entity has no legal title.

Operating leases, on the other hand, are currently not recorded at all on the balance sheet. Lease payments are charged to the income statement on a single line.

However, with effect from 1 January 2019, significant changes are being made to the accounting for leases, superseding the existing IAS 17.

So what is changing?

Recording operating leases off-balance sheet hides information. It is unclear how much of the lease expense is depreciation or interest.

IFRS 16 will require reporting entities to record, on the balance sheet, assets that are the subject of operating leases; and lease expense to be split between depreciation and interest3.

Operating leases relate to  assets that are owned neither legally or in substance. So why record them on the balance sheet?  The answer lies in understanding that the main purpose of financial statements is to assist their uers to make economic decisions. The IASB’s Effects Analysis on the new standard4 explains that “The absence of information about leases on the balance sheet meant that investors and analysts were not able to properly compare companies that borrow to buy assets with those that lease assets, without making adjustments”. The new standard, therefore, focuses more on the liability side of lease arrangements than the asset side: the lease payment obligation should be on the balance sheet; and since there are two sides to every accounting entry, the asset must be recorded too!


How will this affect the balance sheet?

A lessee will be required to recognise assets and liabilities for both operating and finance leases5. The diagram below portrays this change:



Source: http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/IFRS_16_effects_analysis.pdf.
 

How will this affect the income statement?

A lessee will be required to recognise depreciation of lease assets separately from interest on lease liabilities on the income statement6. The diagram below portrays this change:



Source: http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/IFRS_16_effects_analysis.pdf.
 
Instead of a single line for the operating lease expense, IFRS 16 will now require entities to recognise two separate components - a depreciation charge for lease assets and an interest expense on the lease.

However, there are two exceptions – leases of 12 months or less; and leases of low-value assets.


Significance

As shown above, the change will result in an increase in assets and liabilities. This will affect key liquidity ratios (such as debt/equity ratio) which could cause problems with debt covenants.

In the context of valuation, the split of operating leases from a single expense to depreciation and interest expenses separately will result in a higher EBIT and EBITDA, due to the exclusion of the depreciation component of operating expenses for EBIT and both the depreciation and interest component in EBITDA.
It will therefore become important to know that operating leases will be presented differently from 2019, especially when considering historical performance and comparability.  

Endnotes 
1. http://www.aasb.gov.au/admin/file/content105/c9/AASB117_07-04_COMPjun09_01-10.pdf.
2. Ibid.
3. http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/IFRS_16_effects_analysis.pdf.
4. Ibid.
5. Ibid.
6. Ibid.