IFRS-16 on Leases – Directors be very careful
The advent of IFRS-16 on leases makes some very significant changes to the accounting landscape that could have major impacts on businesses with a requirement to satisfy covenants or where there are capital adequacy or other regulatory requirements.
Currently operating leases, such as rental arrangements for premises, cars and equipment only result in the disclosure of the lease payments made as an expense and a note disclosure on the future lease payment profile. Financing leases, such as hire purchase transactions, were disclosed with the asset being recognised as a fixed asset and the liability also being recognised.
Under the new requirements of IFRS-16, the distinction between operating and finance leases is removed. In broad terms, all leases are to be recognised on balance sheet as an asset and liability at fair value. There is a small administrative exemption for low value assets (valued at less than USD$5,000 or around NZ$7,500).
So where is the issue for directors I hear you ask?
I will focus on what is likely to be the largest issue for most businesses which will be the lease for your premises. This also is the lease that is likely to create the biggest technical issue because of the intangible nature of the future right to use the premises.
The new standard will require a liability to be recognised on the balance sheet for the entire future payments to be made under the lease to the landlord. There will also be a requirement to recognise an asset for the unused future rights to occupy the premises. This parallels the current requirements under a hire purchase arrangement for an asset where both the liability and the asset are recognised.
The amount of the additional liability may be very significant, particularly if the lease extends many years into the future. Long lease terms are common, particularly if premises involved have a significant level of customisation to suit the needs of the lessee.
The issue for directors is that under most bank covenants all liabilities recognised under Generally Accepted Accounting Practice (“GAAP”) are included in the calculations, however intangible assets are often excluded. The future right to occupy a premise is an intangible asset, resulting in a large increase in liabilities without a corresponding increase in assets able to be considered under most covenant calculations.
Clearly, leases of tangible assets such as plant and equipment are less of an issue as both the asset and the liability side of the covenant calculation will be increased by approximately the same amount. Even this may still be an issue if the current compliance with the covenant is close as an equal increase of assets and liabilities in the calculation will still have an adverse impact on the ratio of assets to liabilities.
Impact on the solvency test
Section 4 of the Companies Act deals with the solvency test. The first test is the ability of the company to pay its debts as they fall due in the normal course of business. This should not change as accounting standards don’t impact the ability of a company to pay debts as they fall due.
The second test is that the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.
The new standard will have some limited impact on this test as additional liabilities and assets will be recognised on the balance sheet. There is a requirement to depreciate the assets, or reflect the change in the future use asset created as time passes. There is also a requirement to consider the costs of borrowing or capital when deriving the current fair value of the future lease payments. The value of the asset and liability recognised may therefore not be the same impacting on the net asset position. In most cases this difference between the asset and liability values is not likely to be significant.
In summary, the revised standard is unlikely to have any material impact on the solvency of the company under the Companies Act unless the impact on the new standard causes banking covenant breaches. A breach of a banking covenant could cause a change the ability of the company to pay its’ debts as they fall due.
The key take out for directors is to have a clear understanding of the impact of the revised IFRS-16 on the financial statements of the business well before the standard takes effect. For December balance date companies this will be 1 January 2019. If the standard will have down stream impacts on key covenants, directors need to proactively work with funders and regulators to mitigate these risks. Funders and Regulators need to understand that a new accounting standard does not change the actual underlying risk the covenants were guarding and react appropriately and sensibly to any accounting impacts of IFRS-16.
About McGlinn Consulting Group Limited
Graeme McGlinn is the director of McGlinn Consulting Group Limited. Graeme is a Chartered Director, Chartered Accountant and Certified Fraud Examiner at McGlinn Consulting Group Limited. He has over 35 years’ experience in accounting, auditing, governance, litigation support and risk identification and management in New Zealand and overseas. He can be contacted via his website www.mcglinnconsulting.com or by email at firstname.lastname@example.org