The new IFRS 16 lease accounting rules came into place on 1 January 2019, but there are still a number of questions that are being raised.
First of all, let’s go back to basics. IFRS stands for International Financial Reporting Standard and provides a framework for how companies prepare and disclose information in their financial statements.
The requirement to adopt IFRS applies to companies that are active or direct participants in the public market. It is mandatory for companies listed on stock exchanges to adopt IFRS; it’s voluntary for non-listed companies.
UK GAAP is the accountancy standard set for most UK companies that do not adopt IFRS.
IFRS 16 introduces a single lease accounting model by removing the operating and finance lease distinction for the lessee, which means companies that prepare accounts under IFRS might need to change the way that their lease agreements are recorded.
Previously, leases defined as Operating Leases (typically those where the term of a lease is significantly shorter than the economic life of the asset and the customer has no option to purchase the asset) have not had to be shown on company balance sheets, but this changed on 1 January 2019. It is worth emphasising that only a very small minority of UK companies will be affected by these changes, and for those who do have to adopt the new rules, some of their leasing agreements (e.g. Hire Purchase agreements) will already be ‘on balance sheet’.
Any Operating Lease in place from 1 January 2019 now needs to appear on company balance sheets. A new fixed asset class, ‘Right of use asset’, will show the value of the equipment subject to the lease agreement, and all outstanding rental payments due in respect of the agreement will be shown as liabilities on the balance sheet.
During 2019, companies applying IFRS 16 will need to assess the liability and asset values for leasing agreements that will move ‘on balance sheet’ for the first time. This will become a priority as businesses reach their own financial year ends and accounts are being finalised.
Questions have and will be raised about what information is needed to ensure that accounts are properly prepared and leasing companies can expect to be asked for information not previously disclosed.
Common questions may include:
1 – What is the implicit interest rate applying to the lease agreement?
2 – What was the cash price or the current market value of the asset?
3 – Has a residual value been applied to the asset, and if so what is the figure?
4 – Can a rental payment be broken down between charges for equipment and services?
It is important to note that leasing companies are under no obligation to provide information not already disclosed within the terms and conditions of an agreement and for a number of commercial and legal reasons, answers to the type of questions illustrated above might not be possible.
It must also be pointed out that whilst there are very good reasons why companies might request information about their leasing agreements, they will not normally need answers to prepare their accounts.
The key information involved in lease accounting under IFRS 16 is the rental amount payable, payment frequency and the number of payments outstanding, all of which will be readily available. Using this information a company will need to calculate how a rental payment is split between interest and capital. Whilst knowing the actual interest rate implicit within each individual leasing agreement would provide the information required, businesses will normally find it more convenient to apply a generic interest rate that might be set for a typical commercial loan for the asset class concerned.
For purposes of IFRS 16, a residual value is only relevant when there is an option on the part of a company to buy the equipment subject to a leasing agreement at a pre-agreed price.
Any information relating to the value of an asset (purchase price or market value) can usually be estimated from independent research.
Where a lease agreement involves the provision of services, a lessee would normally wish to remove the service component from gross rental payable so that all accounting calculations are based on equipment rental alone. In cases where no information relating to the allocation of a service inclusive rental payment is available, a company might choose to apply all rental payments to an asset and add under ‘notes to accounts’ that balance sheet entries are inflated by the inclusion of an unspecified charge for services.
All of the guidance above is intended to offer a general introduction to some of the issues facing businesses in the process of adopting IFRS 16, but for any specific advice, a company should always consult an accountant.
Andy is an experienced sales and finance professional with over 25 years’ experience in sales aid leasing. Andy is widely recognised as an expert in business finance and has in recent years focused his attention on developing partner sales teams develop an understanding of how businesses secure project financing. His training programme – Finance Unlocked – is a highly rated customisable course and is offered at no cost to partners.
If you’re interested in helping your sales team overcome finance-related hurdles during the selling cycle, please get in touch with Andy on 07966 114 243 or email here.