Significant changes have been made to how you must account for operating leases. A new accounting standard — IFRS 16 — came into effect on 1 January 2019, and Australian businesses must take heed.
Under the changes, operating leases must now be included alongside financial leases on your balance sheet.
Companies traditionally held operating leases off the balance sheet to reduce their liabilities. This was a popular method accountants used to improve a company’s liquidity ratios in order to make the business more appealing to lenders.
What’s the difference between a finance lease and an operating lease?
Under a finance lease, the lessee has the option to buy the equipment at the end of the lease, usually with a balloon payment. However, under an operating lease, the lessee may return the equipment to the lessor when the terms of the lease expire, with no further financial obligations.
This allows businesses to keep operating leases off the balance sheet, while finance leases are listed on the balance sheet as a depreciating asset.
What is changing?
The operating lease changes now prevent this.
As of 1 January 2019, equipment on an operating lease must be treated as an asset on your balance sheet, and depreciation and interest expenses need to be recorded separately on your income statement.
What leases are exempt?
There are some important exceptions to note under the new standard. Short leases with a term less than 12 months and with no option to buy the equipment at the end of the lease do not have to be recorded on your balance sheet.
Likewise, operating leases for low value equipment, where the average value is less than AUD$10,000 can also be held off the balance sheet. Such as a lease of laptops, where there may be several pieces of equipment with a total value over the threshold.
What is the financial impact?
What does all this mean for your bottom line? Essentially, the changes mean you’ll see an increase in both assets and liabilities on your balance sheet.
Listing depreciation and interest on operating leases as two separate expenses will also likely increase your EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation and amortisation).
This could affect your liquidity ratios, which are used to assess your company’s ability to pay off its short-term debts. Lenders will tend to favour companies with higher liquidity ratios, and if your company’s liquidity ratios dip too low, it may become difficult to secure financing.
What’s the take-home message?
While IFRS 16 may impact your liquidity ratios in the short term, banks are expecting this and have adjusted banking covenants accordingly. The good news is that many low value assets such as IT equipment are still off balance sheet. The changes will lead to better visibility in the long term. This will help drive better decision-making based on more accurate financial reports. And that can only be good for your business in the long run.