AASB 16 Leases Are you prepared for the secondary implications

The new accounting standard for leases (AASB 16) is rapidly approaching, effective 1 January 2019. Have you considered the following implications of the new leasing standard?

Most Boards and senior management are aware that this standard will result in all operating leases (which were previously being expensed through the profit or loss) are now being recorded on the balance sheet. This will effectively gross up both assets and liabilities. There are however a number of secondary impacts this standard may have that Boards and senior management will need to assess and take appropriate action prior to the implementation of the standard.

Loan Covenants

Common covenants within commercial loan agreements include Debt to Equity and Interest Cover Ratios. AASB 16 is likely to result in an increase in Debt to Equity Ratios and a reduction in Interest Cover Ratios.

Failure to assess the potential changes to these ratios may result in breaches to covenants subsequent to the implementation of the standard. You may need to renegotiate loans prior to the adoption of the standard.

Earnings Profile:

The expense profile of your organisation may significantly change. Previously, operating lease payments were fully expensed and would reduce NPAT, EBIT and EBITDA equally. Under AASB 16, the associated expense is recorded as interest and depreciation, resulting in changes to the calculation of NPAT, EBIT and EBITDA.

This may also impact the following arrangements:

  • Staff remuneration/bonus plans that are linked to an earnings measure such as EBIT or EBITDA or profit-sharing arrangements.
  • Any contingent or variable considerations included within contracts that utilise earnings hurdles (i.e. business acquisitions which include a contingent consideration component based on earnings).
  • Business valuations that are utilising an earnings multiple (i.e. for business acquisitions).

It should also be noted that the expense profile over the life of the lease will change as it will be a front-loaded expense under AASB 16 rather than straight-line.

Capital Ratios

APRA Regulated Financial Institutions have stringent capital ratios. These ratios require a specific amount of capital to be held based on the value of risk-weighted assets held. Bringing all operating leases onto the balance sheet will increase assets held and increase the capital requirements for these institutions.

Audit Requirements:

The Corporations Act considers a company to be a large proprietary company and hence requiring an audit if they meet two out of three requirements, which include a revenue test, an employee numbers test and an asset test.

The asset test is met if consolidated gross assets of the company and any entities it controls is $12.5 million or more. As AASB 16 requires the recognition of ‘right-to-use’ assets on the balance sheet, this may result in a company’s consolidated assets reaching over $12.5 million and may trigger the change of classification to a large proprietary company for the first time, thus requiring preparation, audit and lodgement of financial statements with ASIC.

If you are unsure where to start or if you would like assistance considering the implications of AASB 16 on your business , we are here to help. At Crowe Horwath, we have a specialist team working through the requirements and training staff to assist clients with the new standards.  Additionally, we have business specialists who can assist with renegotiating banking arrangements, business valuations and assist with implementation of staff remuneration plans.

Our annual Financial Reporting Update is also a great way to get you and your staff up-to-date with the new accounting standards, or we can provide specialised advice to your organisation.

If you’re interested in receiving additional information regarding the new accounting standards, please click here, or contact your financial adviser to discuss further.

Christine Webb – IFRS Technical Manager