A new era of lease accounting

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The current lease standard has been criticised by analysts and investors that important information regarding significant assets and liabilities is omitted from the financial statements for operating leases. The new standard, which was issued by the International Accounting Standards Board (IASB) yesterday, is clear that for lessees all leases, regardless of whether they are operating or financial in nature, will be on balance sheet and accounted for as 'financial leases'.

The good news

The good news is that there is some relief from applying the full requirements of the new guidance. There are some exemptions which could be applied and these relate to leases of 12 months or less (short-term leases), and leases of low-value assets (an amount of $5,000 was mentioned). For such leases, the lease costs will be accounted for in the same way as operating leases are accounted for today.

Lessor accounting remains largely the same and the classification as a finance lease or operating lease is still a consideration. This means that straight-lining of operating leases will remain for lessors.

Helen Wise, PwC accounting technical partner responsible for helping clients implement the new leases standard, has indicated she expects most of the debate to be focused on the assessment of whether a contract meets the new definition of a lease or whether it is a service contract. Where the contract is not considered a lease, there would be no requirement to apply the new standard and it may then require the accounting to be that of a service contract, which may be similar to an operating lease today. Wise said that determining if a contract is a lease may be challenging but that the new standard has many examples to demonstrate how to apply the definition.

There is also new guidance on variable lease payments, assessment of the lease term with options to extend, sale and leaseback accounting and lease modifications. Wise said it probably makes sense to have specialists involved when considering the more complex aspects of the guidance.

Significant changes

It is expected that most entities are lessees and would therefore be impacted by this new standard. The most significant change would be the increase in liabilities and right of use assets on the balance sheet, together with the associated finance costs and depreciation in the income statement. As a result debt covenants may need to be considered to ensure these are not breached. This will typically impact the EBITDA calculations as interest and depreciation related to the leases will be excluded.

The effective date is 1 January 2019. Wise noted that it all seems quite far away but a certain amount of retrospective application would need to be performed to get the numbers right. In order to do this, data would need to be collected on the lease agreements to perform calculations to determine the lease payments, interest costs and impact on the balance sheet.

It will almost certainly also require a change in accounting systems and processes which can take time to design and implement, so it's best to at least understand the accounting impact as soon as possible.