IFRS 16 Leases comes into force from January 2019
A new lease accounting standard has been formally published covering the future accounting treatment of leased assets. But trade associations say it is unlikely to erode the benefits of leasing.
For the last three or four years, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have been working on a common standard of accounting for all leased assets, including company vehicles.
The new standard, IFRS 16 Leases, becomes mandatory from 1st January, 2019, but as with any other change to accounting standards, companies will need to ensure that they produce a set of comparative accounts for the prior year.
What is the new IFRS lease accounting standard designed to do?
The new standard is intended to bring all leased assets on leases of more than 12 months onto the balance sheet, giving a more complete picture of a business’s financial commitments.
This new approach to lease accounting, called the ‘right of use’ model, differs substantially from the current standard, which does not require operating leases to be reported in company accounts.
Under the new model, a lessee, or leasing company customer, would identify the right to use a leased asset on their balance sheet and incur a corresponding liability for future rental payments.
This is a major change as, under the current standard, the lessee only recognises the leased asset if acquired via a finance lease, with just a note to the accounts for any operating lease liabilities. This only applies to the finance element as any maintenance element is specifically excluded.
The final version of the new standard includes some major simplifications which mean that short term hire vehicles, informal vehicle extensions and ancillary leasing services, such as maintenance, do not have to be reported. It also gives fleet operators the option to report leases on a portfolio level rather than individually.
Hans Hoogervorst, IASB chairman, commented: “These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligations.
“The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off-balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.”
To whom will it apply?
Initially, the new standard will only apply to public sector organisations and firms that report to International Financial Reporting Standards (IFRS). Publicly listed companies already have to make a note to the annual report reflecting any operating lease liabilities.
However, most small and medium-sized enterprises currently report to the UK’s generally accepted accounting principles (GAAP) and will be unaffected until UK standards converge with those of the IASB. There is no deadline for this at present, so for the time being most small and medium sized businesses will be excluded.
There has been considerable industry lobbying over the proposed changes given the importance of leasing to the UK economy. Much of this has focused on the need for the new proposals to be straightforward for small businesses to implement, and the fact that they should not detract from leasing as a simple and cost effective product.
Reaction to the new standard
The BVRLA, the trade association of the UK rental and leasing industry, said it was confident that its members – the majority of the UK’s contract hire, leasing and daily rental companies – would be able to adapt their business processes to help customers with the financial reporting required by the new standard.
Bringing leased vehicles onto the balance sheet would not erode the key benefits of leasing, said BVRLA Chief Executive Gerry Keaney.
“Vehicle leasing continues to grow in popularity and this has very little to do with any balance sheet advantages.
“Its main value comes elsewhere, protecting companies from the risk of fluctuating vehicle values, providing them with extra flexibility and purchasing power and freeing-up precious working capital that would otherwise have been spent buying an asset,” he said.
What might the consequences be?
For companies with material off-balance sheet assets, the new standard could affect key accounting and financial ratios, and, as a result, debt covenants may be affected and may need to be renegotiated.
However, regardless of the new changes, companies are likely to want to continue to lease assets as the majority of the existing benefits from leasing will remain.
Leasing allows companies to benefit from spreading a fixed cost over the lease term, provides 50% VAT recovery on the financing of company cars, offers protection against fluctuations in residual values and provides the opportunity to fully outsource fleet operations and services.
What changes might we see?
IFRS 16 Leases eliminates the distinction between operating and finance leases for leasing companies’ customers.
This may lead the leasing industry to produce new products, such as short term leases, that retain the existing benefits of operating leases. Under the new lease accounting standard, short term leases for a year or less with no renewal option would still qualify for off-balance sheet accounting treatment.
For those businesses sensitive to the changes affecting longer term leases, such shorter term contracts could become more appealing, especially on job-need fleets where vehicle choice is not such an issue.
What might the impact on leasing companies be?
The balance sheet impact for leasing companies is likely to be of less significance than for their customers, although estimating the residual value of assets and accounting for variable lease payments may increase administration and require considerable judgement.
The most significant impact for leasing companies is likely to be the resources required to evaluate existing operating lease contracts, and to develop processes to capture the required information on an on-going basis.
The new proposals may also result in a need for many companies to upgrade or replace their existing accounting systems.
What should companies do next?
The new lease accounting standard will have different implications for different companies depending on a variety of factors such as size, profitability, attitude to risk and ownership of assets and a host of other issues.
The best advice currently is to consult with your accountant and leasing provider to decide on the most appropriate course of action for your business going forward.