13 August 2018
A new international accounting standard known as IFRS 16, due to take effect in 2019, is aimed at overhauling the treatment of leases in the financial statements.
From a lessees’ point of view things will change fundamentally. Whilst most UK companies do not report under International Financial Reporting Standards (IFRS), there is an expectation that UK reporting standards will fall in line with IFRS 16 within a few years.
What’s changing?
An example to look at is a motor dealership who occupies a showroom under a lease from a landlord which we would currently refer to as an operating lease. Under the current UK rules, there is no need for the tenants’ future obligations under an operating lease (i.e. future rent payments) to be recognised as a liability on the balance sheet. However, IFRS 16 wants tenants to do just that and at the same time recognise a lease asset representing the right to use the property.
Car dealers that lease a number of major assets, such as their showrooms or storage facilities, will see an increase in the level of both their reported assets and reported liabilities. This will give the appearance of being more asset-rich but also more heavily indebted. A key risk, therefore, is the impact that higher debt may have on current or future debt facilities. For example, a higher gearing ratio may cause an inadvertent breach of financial covenants, or adversely affect credit ratings and borrowing costs, and impinge on the wider ability to raise finance. On the other hand, higher levels of EBITDA may be recognised, as the lease expenditure charge to the profit and loss is removed and replaced by depreciation or interest expenses.
Stakeholders, such as investors, lenders, and suppliers may need to be pre-warned about the changes to financial reporting and it is vital that businesses are able to explain the alterations to their accounts to avoid misunderstandings as to their underlying financial performance and position.
From a commercial standpoint, the impact could also be felt by customers of car dealers, who may currently have considerable amounts of ‘off balance sheet assets’ (car fleets perhaps) which become ‘on balance sheet assets’ under these new rules.
What should you consider at this stage?
Key questions to assess the impact on your company should include the following:
- What contracts do we have currently treated as operating leases?
- What leases are considered to be ‘major’ assets?
- What’s the potential impact on financial covenants and balance sheet ratios?
- Are effective systems in place to record all relevant leases?
Being aware of the impact and considering your implementation plan will be key to preparing adequately for the eventual arrival of these changes.
If you would like to discuss this topic, please contact to your local UHY automotive specialist.
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