Accounting for finance and operating leases – a simpler way forward
The difference in treatment between finance leases and operating leases has, for years, stood out as an inconsistent fillip of established accounting practice. Now the International Accounting Standard Board has developed a regime that will allow all leases to be treated the same way, and has published new rules (in IFRS 16) to that effect, with an effective date of 1 January 2019. The new rules will have knock on effects for reporting under both IFRS and UK GAAP standards.
The proposed rules are still filled with caveats and exemptions (leases with less than a year left to run or leases of low-value assets, for example). Without going into the detail of the rules (which, effectively, record leases on balance sheet as assets and liabilities and then allow the asset to depreciate in a straight line over time whilst accounting for interest costs repaid over time), it is clear that the rules will have some impact on the figures companies report.
A welcome development is the simplification of auditing and reporting for companies that are operating lease-heavy. For most corporate borrowers, this should take welcome effect after a transition period, as most loan agreements have particular rules regarding any change in accounting principles that involve a certain amount of comparison and side-by-side reporting in order to enable lenders to draw accurate conclusions when comparing to financial statements from before the change took effect.
During the initial consultation period, the International Accounting Standard Board identified that the changes might have an impact on how financial covenants are calculated. In particular, EBITDA looks set to increase for companies that have a number of leases that currently fall on the operating lease side of the division. However, depending on how leases (and, particularly, off-balance-sheet leases) are treated, parties may need to re-negotiate certain defined terms in their financial covenants in advance of the accounting practices being changed, in order to avoid potential breaches.
If you require further information about how these changes will impact the calculation of your financial covenants, please contact the author or your usual Fieldfisher contact.