Jackie Russell-Green: New lease accounting changes hit balance sheets

Two British Airways aircrafts, stand on the perimeter of the runway at London Heathrow Airport. Photo / Bloomberg
Two British Airways aircrafts, stand on the perimeter of the runway at London Heathrow Airport. Photo / Bloomberg

The introduction of a new accounting standard isn't usually the sort of thing that gets people excited. To be fair, it often doesn't even get accountants excited.

This time, however, things are different, principally because this new standard will have a significant impact on the balance sheets of some companies.

The new standard in question is the much anticipated standard on leases, International Financial Reporting Standard 16 Leases ("IFRS 16"), which was released a few days ago by the International Accounting Standards Board ("IASB").

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NZ IFRS 16 will affect New Zealand entities (such as listed companies, credit unions and large privately-owned companies) that report under New Zealand equivalents to International Financial Reporting Standards ("NZ IFRS"). It won't impact on small to medium sized privately-owned companies, unless they have elected to report under NZ IFRS.

This new standard on leases has been hotly anticipated for two major reasons - firstly, it's been a long time coming (the IASB first proposed undertaking a project on leases in 2006) and secondly it's always looked likely to introduce major changes to how leases are accounted for.

Despite opposition over the years, that promise of change has certainly been delivered on.

At the moment, leases are classified as either operating leases, which don't appear on the balance sheet, or finance leases, which do.

This has meant people who prepare financial statements have had to make judgements, but by and large more substantial leases such as those of buildings, airplanes and ships, have been kept off the balance sheet.

Under the new standard, this differentiation between operating and finance leases will remain for entities that lease assets to others (lessors). However, companies that lease assets from others (lessees) will now be required to recognise nearly all of their leases on their balance sheets (there are some exceptions for leases of low value items and lease periods of less than one year).

This will mean the recognition of new assets and liabilities, which will potentially impact on balance sheet ratios, such as leverage ratios. This may in turn impact on items based on those ratios, such as loan covenants.

Jackie Russell-Green, technical associate at BDO.
Jackie Russell-Green, technical associate at BDO.

There will be many in the business community who are dismayed by the release of IFRS 16 and the impact that it will have on their financial statements. Many of them will argue that they enter into leases precisely because they don't want the risks associated with asset ownership and that consequently it doesn't make sense to have lease assets and liabilities on their financial statements.

From a commercial perspective I can understand that argument. However, there are two main arguments that counter it - one theoretical and the other pragmatic.

The theoretical argument is that financial statements are required to reflect economic reality. If you have exclusive access to an item, such as equipment or a building, for a defined period of time, that sounds an awful lot like an asset. Similarly, if you have a requirement to make a stream of payments in the future, that sounds a lot like a liability.

Interestingly, it seems that at least some sectors of the market agree, as analysts reviewing the financial performance and position of a company often adjust financial statements with operating leases for the unrecognised assets and liabilities.

The pragmatic argument is that New Zealand made a decision a decade ago to adopt NZ IFRS, which means that we are obliged to implement IFRS 16 in New Zealand.

It's worth remembering that we made this decision for some very good reasons, significant among them being that using international standards would make our financial statements more understandable to overseas investors, thereby encouraging foreign investment in New Zealand.

It's also worth remembering that, by and large, this decision has led to a considerable improvement in the quality of financial reporting in New Zealand.

IFRS 16 doesn't come into effect until annual periods beginning on or after 1 January 2019 (i.e. for most entities, their 31 December 2019, 31 March 2020 or 30 June 2020 balance dates). However, it's important not to be lulled into a false sense of security by the long lead-time. The standard is retrospectively applied (which essentially means you have to go back and adjust your accounts as though it had always been in effect) and, for many companies, leases span multi-year periods - for these reasons, it's important to get started on understanding the impact of the new standard as soon as possible.

- NZ Herald

Jackie Russell-Green is technical associate at BDO.

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