AASB 16: A critical change to financing growth

November 16, 2016

By David Onto, Head of Intermediary Sales – Australia and New Zealand

AASB 16 is the new accounting standard for leases. It makes significant changes to the way lease arrangements are accounted for, with the greatest impact on the financial statements of lessees and ultimately their Return on Assets (ROA).

The new standard has been developed in response to concerns from investors, analysts and regulators about a lack of transparency regarding lease obligations, according to Ceri-Ann Ross, senior policy advisor – reporting and assurance, Chartered Accountants Australia and New Zealand (CAAANZ).

“The prevalence of off-balance sheet arrangements meant that these stakeholders didn’t always have a complete picture of a company’s financial position and couldn’t easily compare companies that borrow funds to buy assets versus those that lease assets,” explains Ross.

The new standard aims to address this issue by bringing the majority of leases on balance sheet, with AASB 16 applicable to financial years beginning on or after 1 January 2019. This means companies with a June year-end will first apply the new standard in the 30 June 2020 financial statements.

“While this seems like it’s a long way off, it’s important to act now. Applying the changes requires a great deal of judgement and will have a significant impact on financial reports, systems and processes. It could also have a significant impact on things like banking covenants, debt/equity ratios and bonus calculations,” Ross says.

Main changes

The biggest change for lessees is that the distinction between operating leases and finance leases will, in many cases, start to blur. This is largely due to the fact that many traditional operating leases will have to be brought on balance sheet as a “right of use” asset, with a corresponding lease liability. The subsequent accounting will be broadly similar to current finance lease accounting.

Key changes for lessees Old accounting (operating leases) New accounting (all leases)
Classification Operating lease

Finance lease

No distinction
Balance sheet Off-balance sheet –

No asset or liability recognised

On balance sheet –

Recognise right of use (ROU) asset and corresponding lease liability

Profit and loss – expense classification Lease rentals (operating expense) Amortisation of ROU asset (depreciation & amortisation) plus interest charge on lease liability (finance charge)
Profit and loss – expense pattern Straight-line Front-loaded (higher in earlier years, lower in later years)

Source: CAANZ

Preparing for the change

The new requirements are a significant change and shouldn’t be underestimated.

“It’s important for businesses to act now to understand the financial impact, plan changes to systems and processes and make informed business decisions regarding leasing and financing arrangements,” says Ross.

To start preparing for the change, Chartered Accountants Australia and New Zealand (CCANZ) recommends that businesses carry out the following activities:

1.Start tracking your assets. Many businesses don’t have systems and processes in place to track their equipment leases – some don’t even keep copies of lease contracts. This is something that can be addressed now and businesses may find their finance provider can give them access to a system for this purpose

2. Consult a specialist. The devil is in the detail, with many aspects of AASB 16 requiring businesses to make judgements regarding the application of the principles to individual circumstances. For example, firms need to decide which of their arrangements meet the definition of a lease and what the lease term is. Decisions must also be made about the best transition option. Specialist advice may help you understand the financial impacts, set up accounting templates and support decisions made by management and the board.

3. Manage expectations. Once the financial impacts are known, it’s important they are communicated to the board, shareholders and other external stakeholders. The sooner this is achieved, the better.

4. Meet with your financiers. The balance sheet and profit and loss changes will impact items like debt/equity ratios and EBIT/EBITDA measures. If you have external loans, it is important to meet with lenders in advance of applying the new standard to consider the impact on any banking covenants.

5. Consider future equipment contracts. Accounting should not drive transactions. However, when structuring future lease or finance arrangements it is important the businesses fully understand the financial impacts so they can make informed decisions.

Whilst the nature of accounting for leases will change in many cases for the better, there will still exist, for the right situation, and customer an “off balance sheet” solution that meets the AASB 16 definition. Understanding all the options available will be important for business moving beyond 2020, especially around managing the funding of new and existing assets.

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