Accounting Standard Update Part I: AASB 16 – Leases

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Commencement Date: Reporting Periods commencing on or after 1st January 2019

AASB 16 is applicable to the following businesses:

  • Entities subject to an audit or review.
  • Entities that lodge financial statements with a regulator (e.g. ASIC, ACNC or Consumer Affairs).
  • Where the bank requires financial statements prepared in accordance with Australian Accounting Standards (refer to finance agreements).
  • Where a shareholder requests financial statements prepared in accordance with Australian Accounting Standards.
  • Where the deed or constitution of the entity requires financial statements to be prepared in accordance with Australian Accounting Standards.

Purpose of the standard

To better reflect an entity’s leasing obligations and ‘right-to-use’ assets by including all lease arrangements on the balance sheet.

AASB 16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases (excluding those that are exempt). For certain business, this change is likely to significantly affect financial statements.

Exemptions

AASB 16 provides exemptions for:

  • Short-term leases – a lease that, at the commencement date, has a lease term of no more than 12 months. This includes extension options, so long as it is reasonably expected they will be exercised.
  • Low-value items – items which, when new, have a low monetary value. Examples include laptops, tablets, computers, as well as certain furnishings and equipment. Generally, there is no need to apply AASB 16 for items that cost less than $10,000.

What AASB 16 means for lessees:

  • No more operating leases under AASB 16.
  • All leases (subject to exemptions) must be capitalised on the balance sheet by recognising:
  • a ‘right-of-use’ asset; and
  • a lease liability for the present value of the obligation.
  • Rental expense will be replaced by depreciation on the ‘right-of-use’ asset, and interest expense on the lease liability, recognised in the profit and loss statement.
  • When initially measuring the ‘right-of-use’ asset and lease liability, non-cancellable lease payments (including inflation-linked payments), as well as payments for option periods (whereby the entity is reasonably certain to exercise), must be included in the present value calculation.

Financial impact on the lessee

The impact of the new lease requirements may impact the profitability of an entity. This is because, at the start of the lease period, depreciation and interest will be higher than the rent expense. In comparison, depreciation and interest will be lower than the rent expense when the lease is nearing the end of its term.

Also, assuming all else remains equal, Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) will increase. The reason being that depreciation and interest – both of which are excluded from EBITDA – are recognised instead of rent, which is included in EBITDA.

Impact (or lack thereof) on the lessor

A lessor will continue classifying leases as operating leases or finance leases; each of which is accounted for differently.

Industries and assets most impacted by AASB 16 

The entities most impacted by AASB 16 are those with the propensity to obtain high-value operating leases, such as:

  • Retailers – shops or mall space (these leases often include several renewal options).
  • Manufacturers, mining, and mining services companies – obtaining operating leases to use expensive equipment.
  • Airlines – obtaining operating leases to use aircrafts.
  • Cruise ship operators – same as above, but for cruise ships instead of aircrafts.
  • Service Businesses – renting of commercial premises.

 What is a lease asset? 

Lessee accounting

 Recognition

When AASB 16 (Leases) comes into effect, a lessee shall henceforth recognise a ‘right-of-use’ asset and a lease liability.

Measurement  

Initial measurement of the ‘right-of-use’ asset

When the new leasing standard becomes applicable, a lessee shall measure the ‘right-of-use’ asset at cost. The cost of the ‘right-of-use’ asset shall comprise:

  • the amount of the initial measurement of the lease liability (present value of lease payments over the lease term, discounted using the interest rate implicit in the lease if it can be readily determined, otherwise at the lessee’s incremental borrowing rate);
  • any lease payments made at (or before) the commencement date, less any lease incentives received;
  • any initial direct costs incurred by the lessee; and
  • an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site.

Initial measurement of the lease liability

At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date.

The lease payments included in the measurement of the lease liability comprise;

  • Fixed payments, less any lease incentives receivable (including option periods, expected to be exercised)
  • Variable lease payments that depend on an index or rate, initially measured using the index or rate at commencement date
  • Amounts expected to be paid under residual value guarantees
  • Exercise price of purchase options if reasonably certain to exercise
  • Penalties for terminating the lease early if the lease is expected to be terminated early

Subsequent measurement

After initial recognition, the lessee generally measures ‘right-of-use’ assets classified as property, plant and equipment (PPE) or investment property using the depreciated cost model or the revaluation model.

Transition to the New Standard

We recommend that businesses adjust retained earnings for leases not previously recognised when the new standard first applies rather than restating comparatives.

Presentation in the Financial Report

Statement of financial position

  • ‘Right-of-use’ assets should be disclosed separately from other assets (or on the same basis as if it was owned)
  • Lease liabilities should be included with finance lease liabilities.

However, ‘right-of-use’ assets that meet the definition of ‘investment property’ must be disclosed as part of investment property.

Income statements

  • Interest expense – included under ‘Finance Costs’.
  • Depreciation – for the ‘right-of-use’ asset (classification will depend on whether the income statement is presented by nature or function).

Cash flow statement

  • Financing activities – payments of principal.
  • Operating activities – interest paid on leases, as well as payment for short-term leases and/or low-value items expensed in the profit or loss statement.

Areas of business AASB 16 will likely impact 

  • EBITDA and profitability.
  • Compliance with debt covenants (we advise discussing these changes with your bank).
  • Dividend policy.
  • Remuneration packages (those linked to profit and/or EBITDA thresholds).

Actions required 

  • Understand how AASB 16 will affect your financial reports moving forward.
  • Establish systems to model the impact of AASB 16.
  • Update budgets to account for the predicted effect of AASB 16.
  • Address any adverse implications AASB 16 may bring to your business.

Ashfords can advise you on how this new leasing standard will directly and indirectly impact your business’ financial statements. We are also able to provide you with the resources necessary to help you ensure your business complies with AASB 16.

Contact Ashfords on (03) 9551 2822 to arrange a meeting to discuss what AASB 16 means for your business.

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