For many businesses, the impact of the new leasing standards has affected areas far outside the accounting function. Both IFRS16 and AASB16 leases are far more than just technical accounting challenges and have reportedly significantly affected the financial performance of organisations across the board.
Generally speaking, the effects have typically been seen in the growth of balance sheets, the increase of gearing ratios, and the fall of return on capital employed (ROCE). There is no doubt that these leasing standards present more extensive challenges.
Below we explore the unexpected impacts that these leasing standards may have on your business.
1. Mergers and Acquisitions have become more challenging.
Another difficulty presented by new leasing standards has been the impact on key metrics used to assess merger and acquisition transactions. Many organisations reporting cashflows have needed to be present these differently, with previous operating leases now being treated as an operating expense. This has also meant the cash outflow will now be split between the repayment of principal, which would be within investment cashflows and interest on the lease liability, as included within the financing.
As well, these new standards expect that expenses should be 'front-loaded' towards the earlier part of a lease, rather than to recognise them on a straight-line basis. For some businesses, this could affect the application of earn-out or profit-share clauses in business sale agreements. Likewise, this effect could be further compounded by the impact of the new accounting standard on revenue. The new standards expect that financial statements may be prepared on a 'modified retrospective' basis, which does not require a restatement of comparative periods. This may mean, for example, that the financial statements for the years ended 30 June 2018, 2019 and 2020 are prepared on three different bases, making it harder to track performance meaningfully across multiple years.
Ultimately, this could potentially increase the difficulty for a potential acquirer to assess the performance and cash-generation of any possible organisation.
2. Increasing difficulty of compliance with Banking Guidelines.
Commonly, banks lending agreements include covenants requiring the borrower to comply with particular financial ratios. Many of these lending agreements use covenants requiring the borrower to comply with respective financial ratios. The compliance with new leasing standards may significantly affect the calculations of these financial ratios, especially gearing, which is likely to increase in situations where significant lease liabilities are identified on the balance sheet.
Likewise, costs that were previously recognised in operating expenses as rental payments will now be recognised as an interest expense, which may materially reduce interest coverage. As a result, organisations that are affected will need to calculate the potential impact and enter into negotiations with banks or other lenders before introducing new leasing standards to ensure that there is no unexpected breach of any lending covenant. In some situations, it may be necessary to prepare calculations on both the old and the new bases for a transitional period.
3. The effect on EBITDA may be significant.
New leasing standards will see that rent/leasing is removed as an operating expense and will instead be recognised below the line as interest and depreciation. Due to this, lessees will instead be required to identify a depreciation expense on their ‘right-to-use’ assets and an interest expense on their lease liability. In turn, this will impact and likely increase EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and other similar metrics, with costs previously considered an operating expense being pushed back into interest and depreciation reporting.
This may seem initially appealing to some entities, as an increased EBITDA might seem to suggest a better performance. However, there may be an unintended impact where EBITDA has been used as a key performance indicator.
4. Changes to managing systems and data.
Lastly, one of the tremendous effects these new leasing standards are having on businesses is the reflection of how data is managed and arranged across the organisation. Often, companies manage their leases in a decentralised way, with no central repository or register for different departments to keep track of their leasing arrangements. Even if such a register does exist, it may not hold all of the information necessary to apply the requirements of AASB 16 or IFRS 16 Leases. It is not uncommon for many departments to enter leasing arrangements without the consultation of the finance team prior. As a result, they may not realise the accounting impact of different leasing structures.
Moreover, another piece of the challenging puzzle is the reality that many older leasing agreements, particularly those entered into many years ago, may not be held in electronic form. These original paper documents may be challenging to locate, and again, this is an added hindrance in calculating the one-off impact at the point of the first-time adoption.
As a result, organisations will need to look at restructuring their processes and systems to manage leasing arrangements better, to make compliance reporting as straightforward and seamless as possible.
While the compliance of IFRS 16 and AASB 16 will be challenging, this will offer a new opportunity for entities to streamline and centralise their management of leases, and to ensure that all relevant data is captured. This may assist not only with financial statement preparation but also with more effective lease management and oversight in day-to-day operations.
At Quadrent, we provide our clients with software solutions designed to manage and report on leased assets. We work to deliver long-term cost-savings across your organisation and assist with all facets of equipment finance needs, from providing operating leases to asset management, IFRS 16 compliance and reporting. Our world-leading LOIS solution is designed to assist in creating a robust process that effortlessly guides you in accounting for all leases to maintain compliance with IFRS 16 and uncover hidden ROI savings within Leasing.
Discover how leasing can be a cost-effective and efficient way to access and manage the assets your business relies on.