Lessee financial reporting will be significantly affected by a new IFRS lease accounting standard that will be effective from 1 January 2019. The new rules will affect almost all leases of movable and immovable assets save for certain leases such as leases to explore for or use minerals, oil, natural gas or similar non-regenerative resources and leases of biological assets and licenses of intangible assets. A lessee may also elect not to apply certain aspects of the standard to short term leases or leases of assets of low value (such as laptops and office furniture).
Under IFRS a lease may be classified as either an operating lease where the lessor transfers only the right to use the property to the lessee and not ownership or a finance lease where the lessee assumes some of the risks of ownership. Operating leases are currently not required to be reflected on the balance sheet of the lessee while finance leases have to be reflected. In order to paint a more flattering picture of the lessees’ financial commitments lessees often structure leases as operating leases and not finance leases so that the related obligations are not reflected on their balance sheet.
In terms of the new lease accounting standard virtually all qualifying leases which are currently not reflected on the balance sheet of lessees will have to be reflected on the balance sheet.
Criticisms levelled against the new lease accounting standard include the following:
- they will significantly change balance sheet profiles of lessees which could make lessees look more leveraged than they actually are. This could lead to an increase in the cost of borrowing by lessees;
- they will increase the cost and complexity of reporting especially in relation to leases relating to large volumes of small assets; and
- sophisticated lenders already estimate the effect of off-balance sheet leases on leverage when lending to lessees and there is therefore no need to bring these on to the balance sheet.
These arguments are not necessarily valid because:
- the amendments are only a change in accounting and will not change the existing financial commitments of lessees;
- the new rules will ensure that the correct financial state of affairs of lessees will finally be reflected on their balance sheets;
- lenders will be better informed about a lessee’s credit risk and will therefore be equipped to better understand and price the risk of lending to such a lessee;
- in order to limit costs and the administrative burden of the new rules the rules will not apply to leases of 12 months or less and leases of small assets; and
- although some lenders do estimate the effect of off-balance sheet leases, information available to lenders relating to a lessee’s operating leases which are off-balance sheet may be incomplete, not readily understandable and may not fully reflect the obligations associated with operating leases and as such lenders will not be able to make reliable adjustments.
Although the new rules will only kick in 1 January 2019, lessees should start preparing for the changes now so that they are not ill-prepared when they have to implement them by:
- getting up to speed with the new lease accounting standard;
- scoping and gathering information relating to existing post 2019 leases which will need to be reflected on its balance sheet; and
- starting to engage affected stakeholders such as creditors who have loans in place or lessors whose leases will terminate after 2019.