The End of Operating Leases – What does it mean for the contract?

For most entities, the transition to the new accounting standard for leases, IFRS 16, is still a few years away. But new lease contracts that are currently being negotiated, in most cases, will still be in force when the new standard becomes mandatorily effective from 2019. This means that both parties to any lease agreement should be adequately informed about the impact of the new lease accounting standard before they put pen to paper.

The new standard essentially abolishes the concept of operating leases for lessees. The result is that virtually all leases will be capitalised on the balance sheet as ‘right of use’ assets, along with a related liability.

The new standard doesn’t alter the accounting for operating leases by lessors, which means the accounting for leases by lessees and lessors will no longer be symmetrical.

This approach is designed as such because the standard setters believe it is important that the practice of having material leases “off balance sheet” should be eliminated. Consequently, the new standard is written as an anti-avoidance standard to prevent contracts from being structured in such a way as to keep those leases off balance sheets.

In many ways, attempting to achieve an “off balance sheet” outcome could be a futile exercise and lessees (and their legal professionals) will be well advised to spend their time designing an arrangement that more closely aligns the contract with the desired operational and risk objectives of the business. For example:

  • There is a new definition of a lease that introduces added complexity when distinguishing between a lease and a service contract. Some of the features of the contract that impact this determination are whether the underlying asset is specified in the contract, for example by a serial number, or whether the supplier has substantive rights embedded in the agreement to substitute the asset.
  • Often, several contracts with the same counterparty are entered into at or near the same time. The new standard requires an entity to combine contracts entered into at or near the same time with the same counterparty in certain circumstances, such as when the consideration in one contract depends on factors in the other contract.
  • The new standard allows a lessee the option of not applying the new lessee accounting requirements for low value items of around USD $5,000 or less and to short term leases with a lease term of 12 months or less. The lessee cannot take advantage of the latter exemption if the lease is structured in such a way that the agreement contains an option to extend beyond the 12 months and the terms and conditions create a situation whereby the lessee has little choice but to exercise the option, for example, to avoid lease termination costs.

The widespread nature of the operating lease means that most entities will likely be affected by the new standard to some degree. The impact will be particularly strong on industries which make extensive use of leases as a form of financing, or who have a large portfolio of rented assets.

Beyond the requirement to adjust the financial statements, lessees are advised to ensure that any new lease agreements are thoroughly assessed before they are signed to ensure the intended (or unintended) accounting impacts align with the expectations of the business.

If you seek any further clarity or guidance around these changes and what they mean for you, we encourage you to contact your local Findex adviser for more information.