Lease Changes Impacting Financial Statements

Scope

The standard applies to entities preparing financial statements in accordance with Australian Accounting Standards.

The following lease contracts are outside of the scope of the standard:

• Leases of biological assets
• Service concession arrangements
• Licences of intellectual property granted by a lessor
• Rights held by a lessee under licensing agreements
• Leases to explore for or use non-regenerative resources

IDENTIFYING A LEASE

Contracts meeting the definition of a lease should be recorded on the balance sheet: ‘A contract, or part of a contract, that conveys the right to use an asset for a period of time in exchange for consideration’.

In applying the definition of a lease, there are several criteria that must be met, including:

• Is there an identified asset that the customer has the right to use?
• Does the customer have the right to control the use of the asset?
• Does the customer receive substantially all of the economic benefits from the use of the asset?
• Does the customer have the right to direct the use of the asset?

Lease term

The lease term is the non-cancellable period during which the lessee has the right to use the asset. It comprises:

• The non-cancellable period
• Periods covered by an option to extend the lease, if the lessee is reasonably certain to exercise the option
• Periods covered by an option to terminate the lease, if the lessee is reasonably certain to exercise the option

Assessment of whether it is ‘reasonably certain’ that the entity will exercise any such options will need to be carried out by the lessee.

This assessment may include:

• Comparison with market rates
• Significant leasehold improvements made
• Costs relating to the termination of the lease
• The importance of the underlying asset to the lessee’s operations

Recognition and measurement

Exemptions

In addition to the scope exclusions, a lessee can elect not to apply the recognition requirements to:

Short-term leases – defined as ‘leases that, at the commencement date, have a lease term of 12 months or less. A lease that contains a purchase option is not a short-term lease”.

Low value leases – immaterial to the lessee which may include tablets and personal computers, small items of office furniture and telephones. A value of the asset (when new) of $7,000 can be used as a guide.

Example

Company A enters into a lease with the following terms:

• Five annual lease payments of $100,000 in arrears
• Initial direct costs $30,000
• The lessor has provided an incentive of $20,000
• Incremental borrowing rate = 8% (implicit interest rate is not readily determinable)

IMPACT ON FINANCIAL STATEMENTS

Profit or Loss Statement

As the lease liability is unwound over the term of the lease it gives rise to an interest expense. The interest expense is higher at the beginning of the lease and will reduce over time, so the timing of expense recognition is faster compared to the position under the old standard. This means the overall impact on net profit is negative at the beginning of the lease and will improve as the interest expense reduces in later years of the lease.

EBITDA results will increase significantly as all components of the expense, being amortisation of the ROU asset and interest expense, are added back for the purpose of this calculation. Therefore entities may need to revisit any bonus calculations, bank covenant ratios or other earnings driven KPI’s based on this measure.

Balance Sheet

Companies may potentially have large balance sheet changes which will need to be explained to the users of the financial statements.

The ROU asset is amortised on a straight line basis over the term of the lease or the economic life of the underlying asset where appropriate. Hence, the carrying amount of ROU assets will reduce more quickly than the carrying amount of lease liabilities resulting in a reduction of reported equity compared to the position under the old standard.

The ROU asset is a non-current asset whereas the lease liability is split between current and non-current liabilities. This will adversely affect certain balance sheet ratios such as working capital.

Another impact could be that more companies with material off balance sheet leases will now qualify as large proprietary companies with the inclusion of ROU assets on their balance sheet increasing total assets and potentially requiring audited financial statements to be lodged with ASIC.

Transition

Two approaches in adopting the new standard are available:

Full retrospective approach – results in all periods being presented as if the standard had always been applied with comparative figures restated and a third balance sheet included.

Modified retrospective approach – does not require restatement of comparative periods, instead the cumulative impact of applying the standard is adjusted to equity at the date of initial application.

Several practical expedients are available on a lease-by-lease basis for entities applying the modified retrospective approach, such as not recognising leases whose term ends within 12 month of the date of initial application or the use of hindsight when determining the lease term if the contract contains options to extend or terminate the lease.      

HOW CAN WE ASSIST?

Mazars can assist you to manage your transition to AASB 16 effectively and efficiently.

Our service offering includes the following steps in assisting you to implement the new standard:

• Identifying lease contracts
• Assessing accounting impacts
• Evaluating transition methods to achieve desired outcomes
• Calculating lease liabilities and ROU assets applying the appropriate transition method
• Developing a solution for ongoing lease management in future periods
• Assisting with policies and presentation in financial statements as required under Australian Accounting Standards

For more information on the new leasing standard or to understand the specific impact these changes will have on your business speak to your usual Mazars advisory or alternatively contact our Audit and Assurance Specialists:

Please note that this publication is intended to provide a general summary and should not be relied upon as a substitute for personal advice.

Author: Uliana Subbotina