How IRFS16 May Impact On Businesses That Lease Vehicles

On 9th November 2017, the European Union published a Commission Regulation endorsing IFRS16, signalling that the new international accounting standard will come into force in the European Union in January 2019.

To discover what this may mean for your business, read on.

Important:  The Maxxia Group of companies do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

What has changed with IFRS16 and why?

IFRS16, paragraph 9 reads: ‘A contract is, or 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.’ 

The objective of IFRS16 is to ensure that companies report information for all of their leased assets in a standardised way.

This doesn’t allow for significant financial liabilities to be held off-balance sheet, as permitted for certain type of leases (operating leases) under the existing rules.

IFRS16 takes a totally new approach to lease accounting, called the ‘right of use’ model. This means that if a company has control over the use of an asset they are renting, it is classified as a lease for accounting purposes and, under the new rules, must be recognised on the company’s balance sheet.

As with other changes to accounting standards, companies will also need to  produce a set of comparative accounts for the prior year.


 

 

Which companies does the change apply to?

Initially, the new standard will only apply to public limited companies and other firms that report to International Financial Reporting Standards (IFRS).

All listed companies are already required to make a note to the annual report reflecting any operating lease liabilities. IFRS16 formalises the way in which leased assets must be treated and brings the underlying asset and related financial obligation onto the balance sheet. Under the previous rules this was only the case for finance leases.

difference between finance lease and operating lease blog

 

 

 

Most small and medium-sized enterprises currently report to the UK’s generally accepted accounting principles (UK GAAP). The changes will only filter through to companies applying UK GAAP if they convert to IFRS/FRS 101 Reduced Disclosure Framework, rather than FRS 102.

The expectation from the FRC is that the earliest UK adoption could be 2022/23, but it will be monitoring and watching the international impact until then.

What does IFRS16 mean for financial reporting?

For companies affected by the changes, this will work in a similar way to the reporting of other non-financial assets (such as property, plant and equipment) and financial liabilities:

  • Balance Sheets – lessees will need to show their ‘right to use’ the asset as an asset and their obligation to make lease payments as a liability.
  • P&L accounts – lessees will show depreciation of the asset as well as interest on the lease liability. The depreciation would usually be on a straight-line basis.

As interest charges are higher in the early years of the lease, the total impact on the P&L account is front-loaded even though rentals remain constant throughout the term of the lease.

Rather than having to account for all leases of similar assets individually, there is scope to combine these into a portfolio. This can only be applied if the company can demonstrate that there would be no financial advantage to them taking this approach.

Affected companies will broadly have to go through three stages to be able to complete their financial reporting:

  1. Identification of all their assets which will be defined as leases under the new regulations (property, equipment, vehicles etc).
  2. Collecting all the information on these leases – term, options at end of lease, rentals payable, interest rate of the lease (if available; for operating leases this will not usually be available) so the lessee will need to think about their incremental borrowing cost (this could be the rate they internally borrow at).
  3. The accounting for their leases – once all the information is assembled the calculation is actually relatively easy – it’s just finding the inputs that could be challenging.

It is expected that step 2 will be the most difficult, and potentially highly time consuming, for organisations with a large number of assets.

Efficient lessors should be able to assist companies with this stage by anticipating needs and communicating proactively.

What are the impacts of IFRS16 for affected companies?

All companies that lease assets for business use will appear to be more asset rich, but also more heavily indebted. The larger the company’s lease portfolio the greater the impact on their balance sheet reporting.

For companies that do have large lease portfolios, the new reporting rules will affect their key accounting and financial ratios. This could potentially impact their ability to raise finance and their overall attractiveness to investors. There will also be impacts for companies with banking covenants in place. These should be reviewed and validated to ensure the new rules do not create funding issues.

Most of the commonly used financial ratios and performance metrics will be affected, some positively and others negatively. How this transition is managed and communicated will be key to minimising the impact on the business.


IFRS 16

What is included and excluded under the IFRS16 definition of a lease?

Many leasing contracts contain elements other than the actual rental of the underlying asset (e.g. services such as maintenance). Under IFRS16 these don’t constitute part of the lease and will need to be split out as a separate charge by the supplier.

For example, a company leases a building and rental payments include fees for maintenance, cleaning or other ancillary services. These should be separated, as only the lease of the asset itself needs to be reported on the balance sheet.

Where a supplier has the right to substitute an asset being used by the customer for an alternative asset, and they have an opportunity to gain a financial benefit from doing this, the contract is not regarded as a lease and does not need to be reported.

Payments regarded as ‘contingent to the use’ of the supplied asset (such as charges for wear and tear during the term of the lease) do not need to be included in financial reporting.

If a company has a formal option within its contract to extend the term of the lease and it takes this option, then it will need to calculate the value of the use of the asset and include this within its reporting. However, informal extensions of leases, for example where a new asset is on order, do not need to be reported.

IFRS16 also has two specific exemptions where leases do not need to be reported on balance sheets:

  • Leases with a term of 12 months or less with no purchase option (such as a car Mini-lease)

  • Leases where the asset has a low value when new (indicative definition of low value is < US$5000).

IFRS16 vehicle leasing specifics

The general rules and exemptions described above have some specific implications for vehicle leasing:

  • IFRS16 effectively removes the distinction between Operational Leasing (of which contract hire is the most common type) and Finance Leasing. The ‘lease’ element of both forms of finance will now appear on-balance sheet.
  • Charges for ancillary vehicle services, such as maintenance, accident management, breakdown cover etc. will need to be broken out of the overall rental for reporting purposes.
  • As with all assets, providing the contract is for less than 12 months, short and medium term hire vehicles do not need to be reported as assets.
  • Informal vehicle extensions at the end of their initial contract do not need to be reported.
  • While no specific guidance has been given on items related to the usage of the vehicle (such as excess mileage or damage charges), costs that are regarded as ‘contingent payments’ based on the use of the asset do not need to be reported.
  • Where a supplier has the right to substitute a vehicle for another during the term of the contract, this is not regarded as a lease and does not need to be reported. In practical terms, this could look like pooling of cars that multiple companies can access.
  • The ability to combine assets at a portfolio level provides fleet operators with the opportunity to simplify their financial reporting.

What are the impacts of IFRS16 for leasing?

While the IFRS reporting changes do fundamentally change the treatment of assets acquired through operational leasing, companies are likely to want to continue to lease assets as the majority of the benefits remain:

    • Spreading a fixed cost over the lease term rather than outlaying capital upfront.
    • Providing 50% VAT recovery on the financing of certain assets (e.g. company cars).
    • Offering protection against fluctuations in residual values and providing the opportunity to outsource operations and services

Interested in exploring off-balance options for company vehicles?

 

Important:  The Maxxia Group of companies do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.