For companies reporting under the International Financial Reporting Standards (IFRS) there could be a significant impact on their financial standards following the introduction of the IFRS16: Leases which is mandatory from 1 January 2019. The retail industry is likely to be one of the most affected industries by the new standard, given the significant use of rented premises for their stores.
What is changing?
The new standard removes the distinction between operating and finance leases, so leases previously regarded as operating leases will now be accounted for in the Statement of Financial Position as a finance lease.
Leases under current IAS 17
| Finance Lease | Operating Lease |
|---|---|
| Property held as a non-current asset on the Statement of Financial Position. | |
| Liability for the lease in current and non-current liabilities on the Statement of Financial Position. | No asset or liability on the Statement of Financial Position. |
| Depreciation and finance costs to the Statement of Profit or Loss. | Rental expense to the Statement of Profit or Loss. |
ALL Leases under new IAS 16
| Property held as a non-current asset on the Statement of Financial Position. |
| Liability for the lease in current and non-current liabilities on the Statement of Financial Position. |
| Depreciation and finance costs to the Statement of Profit or Loss. |
While the depreciation charge will be straight-line, the finance charge will be higher in the earlier years of the lease.
Companies will be reporting higher operating profits than in the past as the interest cost will drop below the line and the EBITDA will look better as it will exclude both interest and depreciation whereas it currently includes the operating lease expense.
Are there any exemptions?
There are limited exemptions for short-term leases with a lease term of 12 months or less, and leases for which the underlying asset is of low value, so this is likely to bring retail company’s retail stores onto the balance sheet.
The ‘right of use’ model
This is referred to as the ‘right of use’ model in the standards which recognises that at the start of the lease, a lessee obtains the right to use the underlying asset for a period of time, and the lessor has provided that right.
What will be the key considerations?
The introduction of this standard will bring with it some accounting difficulties and the following will be key considerations:
- Ensuring that there is a clear understanding of the full portfolio of leases, whether they contain identifiable assets and the terms in place;
- Separating out any service contracts from the leases to which these standards do not apply;
- Determining the discount rate to be applied to individual leases; and
- Ongoing monitoring to incorporate lease modifications such as rent reviews.
What challenges does this bring?
These changes will impact the company’s financial position and could have knock on consequences for the day to day operations that require consideration:
– Will this have an impact on the current key performance indicators that may impact on existing covenants or future financing arrangements?
– Ensuring that the split between distributable and non-distributable reserves is clearly identified so illegal dividends are not declared.
– Will the revised numbers have any impact on bonus or performance related pay schemes?
– There could be potential tax implications for these transactions.
For help or advice on the impact of these changes on your business and how best to respond to them, contact Sarah Hallam via email on shallam@menzies.co.uk or by calling 020 7465 1918.