Companies warned about changes to the way commercial leases are accounted for on balance sheets

Listed companies should start preparing for a forthcoming change to the accounting treatment of most leases, according to accounting firm Crowe Horwath Australasia.

The change comes from an updated standard issued by the International Accounting Standards Board, termed IFRS 16 Leases, and will affect companies that prepare and file accounts, including listed firms, management investments, larger private companies and those SMEs that choose to prepare and file accounts.

The change effectively abolishes the concept of operating leases and instead will treat all leases as finance leases.

As a consequence, most leases will be recognised as liabilities on business balance sheets. This differs from a current distinction between operating and capital leases.

The update won’t take effect until January 1, 2019, however, Ralph Martin, audit technical director at Crowe Horwarth, says small businesses should be aware of the potential consequences now.

One of those potential consequences could be forcing small businesses that lease their premises to renegotiate loan agreements with their bank if the updated accounting standard would put them in breach of loan covenants.

This is because the standard could affect calculations for debt-to-equity or interest cover ratios, which can form the basis for loan covenants.

“What was treated in the past as an operating lease will now sit in the balance sheet as a liability,” Martin said in a statement.

“The effect could be to trigger a breach of their loan covenants that could give the bank the right to demand repayment of the loan in full.”

While Martin says not all small businesses will be affected equally. Those in sectors such as retail, distribution, agribusiness, logistics and haulage are expected to be most affected.

He told SmartCompany this morning, the change is likely to have a significant impact on the balance sheet of retailers, whose full liabilities are not necessarily reflected in the company’s balance sheet.

“There are companies with big liabilities out there but they are hidden liabilities,” he says.

There are some exceptions to the new standard.

“Exceptions to this significant standard will be short-term leases (less than one year) and low-value assets such as office equipment and computers, but clearly won’t exclude long-term property leases,” Martin said in the statement.  

Martin described the changes as complex but said the update has come about because the previous standard, IAS 17 Leases, was considered ambiguous.

“The previous distinction between finance leases, which were recognised on balance sheets, and operating leases, which were not, was often arbitrary, and resulted in substantial lease obligations being visible to investors only in the notes to the financial statements,” he said.

“Under this standard the nature of the expense recognised in the income statement will change.

“Instead of being shown as rent, or as leasing costs, it will be recognised as depreciation on the leased asset, and an interest charge on the lease liability.

“The interest charge will be calculated using the effective interest method, which will result in the gradual reduction of interest cost over the life of the lease.

“One effect of the new standard is that sale-and-leaseback arrangements can no longer be used as a method to keep debt off the balance sheet.”

Martin says the main thing for companies to consider is their balance sheets are going to look “quite different” and they will need to understand the impact of that ahead of the change.