AASB 16 Leases, a new accounting standard, now requires leasees (eg tenants) to recognise most rental contracts on their balance sheets as assets and liabilities. Under the previous AASB 17 standard, leases were treated as expenses only and recognised off-balance sheet. The change most affects business leases for rental of offices, premises and property.
The new standard came into effect for reporting periods beginning on or after 1 January 2019, so many businesses should already be catering for the change. Importantly, businesses with reporting periods beginning 1 July 2019 will now need to ensure their accounting processes are adjusted to comply with AASB 16.
Note that for lessors (eg landlords), there have been no significant changes to the accounting requirements for leases.
AASB 16 business implications
Business directors and stakeholders need to be aware that bringing lease expenses onto the balance sheet will result in increased levels of reported assets and liabilities.
Depending on the composition and structure of your balance sheet, recognition of operating lease commitments as liabilities could result in higher EBITDA earnings or have a detrimental effect on gearing, financial ratios and performance metrics. In turn, this may have adverse consequences for:
- Loan & debt covenants, due to the change in debt-to-equity ratios
- Employee incentive and bonus schemes based on profit figures
- Net profit in the early years of a lease due to front-end loaded expenses for interest
Businesses may need to rework these arrangements to compensate for the AASB16 Leases accounting changes.
AASB 16 exceptions
AASB 16 permits two optional exceptions for:
- Short-term leases – that have a term of less than 12 months
- Low-value assets – roughly defined as having a new value under $5,000, this will typically cover items such as computers and office equipment
If these exemptions are used, lease payments can be expensed in a straight line over the lease term.
Nearly all other leases will need changes to your accounting so that they are valued and accounted for in compliance with the new legislation.
Accounting changes for AASB 16 leases
1. Initial lease liability measurement
When first entering into a lease (at the commencement date), the lessee needs to value a ‘right-of-use asset’ and a ‘lease liability’.
To determine the value of the right-of-use asset for initial recognition, calculate the value of the lease liability by taking the present value of lease payments over the lease term, discounted using either:
- The interest rate implicit in the lease or;
- The interest rate at the lessee’s incremental borrowing rate
A common proxy for the latter is to use the entity’s regular borrowing rate through their financial institution which approximates the rate at which they could borrow to purchase a similar leased asset.
In certain circumstances, other items may be added to this calculation. You also need to account for any changes (eg annual increases) to your rent when calculating your opening lease liability.
2. Journal changes for subsequent measurement
After initial recognition, monthly journals are required.
To measure the lease liability, allocate rental lease repayments between interest and the reduction in the lease liability.
To measure right-of-use assets, use the appropriate method for the type of asset – either the depreciated cost model, the revaluation model or the fair value model. Lessees that measure investment property at fair value should also measure leased investment property at fair value.
3. Tax effect implications – Take up of DTAs & DTLs
Balance sheet recognition of lease assets and liabilities may also require you to recognise deferred income tax balances arising from these arrangements. The Deferred Tax Asset (DTA) or Deferred Tax Liability (DTL) is to the difference between the right-of-use-asset and lease liability multiplied by tax rate (usually 30%). For example, if the lease liability exceeded the carrying value of the right-of-use-asset by $1,000, a deferred tax entry of $300 will be required.
Actual lease repayments to the lessor are tax-deductible, but interest and depreciation associated with the lease are non-deductible.
How Accru helps with AASB 16 leases transition
As the application of AASB 16 leases can be complex and time-consuming for finance teams, Accru Felsers in Sydney is assisting many clients with the transition.
We can provide advice on how you may be affected and a summary of the implications of AASB 16 specifically for your business. We can also streamline the process for your finance team by preparing a lease schedule or generating journals for the life of your affected lease.
Please contact your local Accru advisor to find out more about how we can assist.