New Rules Increase Transparency in Lease Reporting, Level the Playing Field
The International Accounting Standards Board (IASB) has implemented a new international financial reporting standard (IFRS), changing how leases are recognized and presented in a company's business and cash-flow statements. The goal of the revised standard is to bring the reporting of all leases onto the company balance sheet, thereby enhancing comparability between companies that lease assets and companies that borrow to buy assets. Bringing leases onto the balance sheet may change how companies do business, especially those with many leases. This revised standard could impact a wide range of industries with equipment leases, from large manufacturers to small professional practices.
- New accounting rules bring all leases onto the balance sheet, increasing transparency about debt obligations for public companies and comparability between companies.
- Leases must now separately identify service costs and leasing costs, which may require detailed analysis of existing equipment lease agreements.
- While little or no Canadian tax implications are expected as a result of the rule change, companies with foreign operations – where accounting rules differ – may face changing tax obligations.
Changes Mean Operating Leases Are Brought onto the Balance Sheet
Under the old rules (IAS 17), companies reported their lease contracts as either finance or operating leases. When leasing an asset was economically similar to buying it, the lease was reported on the balance sheet and categorized as a finance lease. Operating leases, in contrast, were not included on the balance sheet – meaning they were "off-balance sheet leases."
The new rules (IFRS 16) treat all leases the same way: the present value of the lease payment is capitalized as an asset and recorded on the balance sheet. In addition, if a company makes lease payments over time, the financial liability for those payments is also reported on the balance sheet.
Companies with Significant Off-balance Sheet Leases Most Affected, but Demand for Assets Not Expected to Change
Companies with off-balance sheet leases who are subject to the new standard, which came into effect on January 1, 2019, will show an increase in both lease assets and corresponding financial liabilities. This will mean, in turn, changes to key financial metrics derived from the company's reported assets and liabilities, such as leverage ratios. The new standard doesn't require changes for leases that are short term (12 months or less) or for low-value assets (such as personal computers and office furniture). The rule changes are also not expected to affect smaller, private companies.
Under the new standard, the demand for assets is expected to remain unchanged. The IASB reports it does not expect that companies will alter their behavior as a result of the new standard – by systematically borrowing to buy assets rather than leasing them, for example.
Equipment Leases with Service Components May Require Accounting Changes
Where a company has a lease with a service component, IFRS 16 requires that this component be separately identified. For example, where an equipment lease includes a service contract, such as for monthly maintenance, the service cost must be recorded separately from the remainder of the monthly payment, which will be recognized as the lease obligation for the equipment.
Understanding IFRS 16 Will Be Crucial for Affected Companies
The magnitude of off-balance sheet leases is substantial. In 2016, listed companies using IFRS or GAAP disclosed nearly US$3 trillion in off balance sheet lease commitments. Some industry sectors will be more affected than others. According to IASB estimates, the travel and leisure, retailers, and transport sectors will see the greatest increase in profit margin percentage before interest and tax as a result of the changes. Companies with substantial numbers of leases will be the most significantly affected, regardless of sector.
CPA Canada notes that “the implications of the new standard are not just limited to accounting procedures." Instead, processes will change in many departments. The “organization-wide, labor-intensive" effort to gather lease information may also create opportunities for companies, according to CPA Canada, by allowing them to gain access to data that could “provide valuable insight into leasing decisions."
Tax Implications for Companies with Foreign Operations
While the Income Tax Act (Canada) does not specify that financial statements must be prepared following any particular type of accounting principles or standards to determine profit, the Canadian Accounting Standards Board mandates the use of IFRS in the preparation of all interim and annual financial statements by public companies – meaning IFRS 16 has become the new standard.
Companies with significant off-balance (operating) leases may now report higher lease expenses in the early years of the lease, as lease expenses are now “frontloaded." As actual lease payments may not change, however, Canadian tax payable in the current period will likely not be impacted.
Outside of Canada, some countries assess tax payable differently, using accounting net income, for example. Canadian companies with foreign operations may face changes in tax owing as a result of the implementation of IFRS 16, and should seek tax advice in those countries.
A company's decisions about how the assets and equipment it requires to operate are acquired – via lease or leveraged purchase, for example – go beyond how those assets are reported on the balance sheet. While IFRS 16 implements accounting changes for asset leases, asset decisions will still require a long-term, strategic view.
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