Impact of Changes to Lease Requirements

In this essay I will describe what the old lease requirement (IAS 17) is and the new lease requirements (NZIAS 16), furthermore, I could also talk about the potential problems with implementing the new lease requirements and how the change in lease implicates the users like lenders and managers, it can be understood as lessor and lessee. In this assignment, the methods of data collection are website analysis and document reviews.

According to the old lease requirements (IAS17), leases can be divided into two categories which are finance leases and operating leases. Firstly, in my understanding, a finance lease can be considered a loan, while operating lease can be seen like renting. The asset of finance lease is being disclosed on the balance sheet and the asset of operating leases disclosed in the notes. (Watkins Meegan, n.d.) Under the operating lease, lessee is not obligated to report the operating leases assets and liabilities on their balance sheet but rather in the footnotes, which will provide financial statement users an inaccurate account of a company’s outstanding expenses, forcing them to estimate the off-balance sheet obligation, which often leads to over estimations (Hendrie, 2016), while the finance operating is the leased assets shall be included in the lessee’s asset and the depreciation should be calculated within the service period. The related assets and liabilities of finance lease have to reflect in the balance sheet. Furthermore, the ownership of the operating lease is with the lessor, while the ownership of financial lease is the lessee, which means the risk and rewards of operation lease is with the lessor, but for financial lease is with the lessee. According to Meegan, most companies like operating leases, because operating leases can increase returns on assets ratios and not decrease the earnings with depreciation expenses, moreover, the value of these lease asset is hard to calculate. (Watkins Meegan, n.d.)

In January 2016 the IASB issued IFRS 16, and the new lease requirement will be effective for periods beginning on after 1^st January 2019. The new lease requirement affects lots of industry, for example, airlines, retail industry and manufactures. The new lease requirement (NZIAS16) defines a lease as contract between two or more parties that creates enforceable rights and obligations. (EY, 2016) The short-team lease like less than 12 months and the low-value asset can use the operation lease, however, the long team leasing and the high-value asset all use the financing lease. IAS16 also request the lessees to recognise their lease asset and liability for the most leases, and the depreciation shall be calculating on the balance sheet, expect the short team leases and low value lease. That is, except for exceptional cases, IFRS16 no longer distinguishes operating lease and financing lease, and adopts the same accounting method- “financing lease”. The IASB think the new standard will allow a more faithful representation of lessee’s assets and liabilities and better transparency of lessees’ financial obligations and leasing activities. (EY, 2016) However, the new lease requirement (IFRS16) has a greatly impact on the lessee’s financial reporting. Because most leases previously accounted for as operating leases, but now, new standard required the lease asset and liability have to recognise, therefore, related financial ratio calculations will be affected. For example, debt to equity will be increase, because the liabilities increase, but the equity no change. EBIT will increase, because the depreciation added is lower than the lease expense eliminated from operating income. EBITDA will also be increase, because lease expense is eliminated from EBITDA. However, the asset turnover will be decrease because lease asset are part of total asset, therefore, sales/asset will be decrease. (Taurae et al., 2016)

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The potential problems with implementing the IFRS16 is the accountants would have no ideas to recognise the standard of the low-value assets. In the standard of low-value assets of IFRS16 is the value greater or equal to $5000 USD, however, if an item is below than $5000 USD, but a company leased many of these items, therefore, what should the accountant manages this case. For example, AUT leased one thousand of a type of new modern printer, which worth $2500 NZD, according to the IFRS16, AUT can use the operating lease, because each printer below $5000 USD, however, AUT leased 1000 of these printers, it worth 2.5 million of NZ dollars, therefore, it can be seen it is a huge value asset. In this case, the AUT accountant will not sure what to do with these assets when she or he begins doing the accounting activities for the year 2019. Secondly, the new lease requirement will also increase the lessee’s operating cost. For example, accountant needs to learn the new accounting systems and processes. accountant in order to obtain the data needed to comply with the new requirements, the system and process may need to make changes, including creating an inventory of all leases at the time of the transition. The complexity involved, the required judgments, and the on-going reassessment requirements may require additional resources and controls to focus on monitoring leasing activities throughout the lease period. Thirdly, when the companies start using the new standard, accountant will greatly increase the workload. For example, at the beginning of applying the new lease requirement, the accountants need to reassess all contracts in accordance with the new standard.

Although the new lease classification process remains essentially unchanged for lessors, the changes made by new standard are still relevant. In particular, the lessors should be aware of the new guidelines on leasing definitions, subleases and the accounting for sale and leaseback transactions. The changes in lessee accounting may also have an impact on lessors because lessee’s needs and behaviours will change and they will negotiate with their customers. (Taurae et al., 2016) we can understand from the information we have obtained that the two most affected users are the lenders and the management of lessees. For the lenders, which like banks, they also need to reassess existing loan contracts and assess whether the lessees still meet the loan conditions based on the lessees’ new financial ratio. For example, in the year 2018, a lessee using the operating lease, hence they do not required to recognise the lease assets and liability and were not showing on balance sheet. But in the year 2019, the company have to use the new lease standard, therefore, their lease assets have to show on the balance sheet and their debt to equity ratio will be increase. If the debt to equity ratio in 2018 is 0.4, which is meet the bank’s loan conditions, however, in 2019, because the new standard, the debt to equity ratio increase to 0.7, that is not meet bank’s loan conditions, and the bank may not continue to lead to this company. Therefore, it will affect bank’s loan business, so the bank needs to re-define these loan conditions after changing the lease requirement, which will increase the workload of banker. However, IFRS16 could decrease the risk of lenders, because lessee needs to put these leased assets and liabilities into the balance sheet, so the lender (bank) can clearly know how much debt the lessee has and more understandable about the borrower’s repayment ability. For example, according to the BHP Annual Report 2018, we can see there are $US 2012 million operating lease, and it should have US$1624 million operating lease remaining in year 2019, which means there are US$1624 million liabilities should be calculated into balance sheet. There is a huge value of liabilities and this could be affecting the bank’s decision of next year’s loan. (BHP, 2018)

The management of lessee is also affected by the IFRS16. The standard introduces new estimates and criteria that will affect the identification, classification and measurement of lease transactions. Due to the need for constant reassessment, the management will be required to make decisions on the lease start date and on each report day. Moreover, the management’s bonus is linked to the company’s financial performance. For example, under IFRS16, expenses will be removed from income statement, and will be record to the balance sheet, therefore, the EBIT and EBITDA will be increase, this is a performance for managers, because it looks like profit have improved. Hence the manager’s bonus will also be improved.

To conclusion, the changed from IAS17 to IFRS16 have a big affection on companies like lessee airlines companies or manufactures, the most signification impact is on their balance sheet and the financial ratio. However, it also can improve a more faithful representation of lessee’s assets and liabilities and better transparency of lessees’ financial obligations and leasing activities, which can reduce the financial risk to lenders or investors. Therefore, I believe this new standard is a positive influence for the accounting and financing profession.

References:

• WATKINS MEEGAN. (n.d.) Retrieved November 16, 2018, from http://govcon360.com/wp-content/uploads/2013/10/Topic-842.pdf
• Hendrie, R. (2016, November 18). The difference between IAS17 and IFRS 16: How lease accounting is changing. Retrieved from http://blog.innervision.co.uk/blog/the-difference-between-ias-17-and-ifrs-16-how-lease-accounting-is-changing
• EYGM Limited. (2016) Applying IFRS: A closer look at the new leases standard. Retrieved from https://www.ey.com/Publication/vwLUAssets/ey-applying-ifrs-a-closer-look-at-the-new-leases-standard-2016/$FILE/ey-applying-ifrs-a-closer-look-at-the-new-leases-standard-2016.pdf
• Taurae. J., Carmichael. D., & Meurer. H. (2016). In depth A look at current financial reporting issues. Retrieved from https://www.pwc.com/gx/en/audit-services/ifrs/publications/financial-instruments-accounting-for-asset-management.pdf
• BHP. (2018). BHP Annual report 2018. Retrieved from https://www.bhp.com/investor-centre/annual-report-2018/annual-report-2018