Prior to January 2019, operating leases were treated as expenses and were not shown on companies’ balance sheets. The new global accounting standard IFRS/AASB 16 required companies to calculate their leases as Right Of Use (ROU) assets and liabilities on their balance sheets, bringing transparency to financial reporting and fundamentally changing the way businesses have to treat operating lease contracts.
Welcome to LeaseInfo’s weekly blog. In this article we will be breaking down how to implement AASB 16 correctly and address common mistakes and misconceptions regarding this new accounting standard.
What is AASB 16?
AASB 16 came into effect on 1 January 2019, and was created in response to a lack of business transparency regarding operating lease contracts and obligations.
The accounting standard requires capitalization of lease contracts as asset and liability so that they can be clearly shown on a balance sheet. For example, many airlines rent most of their aircraft and the rents on these planes can add up billions of dollars.
However, pre AASB 16, these rents were not put on the airline’s balance sheet and were instead labeled as “Operation Expenses” meaning that the liabilities the companies represented on their balance sheets were actually a fraction of their real liabilities.
How does AASB 16 affect businesses?
Putting rents on the balance sheet mainly affects companies in two ways:
More Accurate Balance Sheets
When banks lend money, they look at liabilities as a percentage of total debt which is known as debt covenants. AASB 16 gives a clear picture to financiers and investors of the true borrowing capacity of these companies.
Ongoing Management of the Company
Implementing and maintaining AASB 16 is a complex process and effects EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization).
What Issues Companies Face Implementing AASB 16
AASB 16 is a complex change in accounting regulations, and we have identified 5 key areas that our clients have encountered during implementation and on a BAU (business as usual) basis:
Interpreting lease files accurately and entering data accordingly
Data is primarily entered manually by importing excel spreadsheets and then exporting the data into a lease management system. Manual data entry is subject to human error and even small mistakes can cause major complications down the line. It also makes auditing very difficult as there is no recourse back to source documentation.
For example, a common date entry mistake is incorrect escalations of rent such as a particular CPI Index not being captured correctly. Another data entry error is treating an extension of a lease as an option or vice versa.
In this situation the lease should be treated as a new lease when it is mistakenly treated as a continuation of the old lease. This can have major financial implications and can disrupt rent forecasting and calculations.
Data sequencing errors
During COVID-19 the accounting rules became extremely complicated as there was a combination f rent abatements, rent extensions, waivers and periods where rent increases were prohibited under the Australian Federal Government under the Mandatory Code of Conduct for Commercial Leasing.
If the data is not sequenced and entered in the correct order, the results will not reflect the correct treatment of the deal. This can heavily impact future calculations especially in relation to CPI adjustment.
Take the following examples:
o Rent Concession Start Date: 01-Apr-2020
o Lease Extension Adjustment Date: 01-May-2020
❖ Data Entry Sequence: Add Rent Concession details prior to Lease Extension details.
o Rent Concession Start Date: 01-Apr-2020
o Lease Extension Adjustment Date: 01-Apr-2020
❖ Data Entry Sequence: Add Lease Extension details prior to Rent Concession details.
o Rent Concession 1: April – June 2020 (50% waiver)
o Rent Concession 2: July – October 2020 (100 % waiver)
❖ Data Entry Sequence: Rent Concession 1 data needs to be entered first
Making the correct assumptions prior to AASB 16 implementation
To speed up the process of AASB16 implementation, clients are required to apply accounting “judgements” which provide a model on how to handle large amounts of complex data. Many of these assumptions have to be based on a judgement call including but not limited to:
- The reasonable certainty of exercising options
- The provision for make good allowances
- The treatment of incentives such as contribution to fitout
- The provision of redecoration/ refurbishment
All these factors greatly affect your lease liability calculations and right of use asset.
Determining the correct “Incremental Borrowing Rates” (IBR)
When transitioning your portfolio to AASB 16, Incremental Borrowing Rates must be applied to adjust the Right of Use Assets under AASB 16. Consulting your auditors is very important when choosing a borrowing rate as they are affected by the longevity of your lease and overall business risk. Your chosen discount rate can be set at a:
- Lease level and Asset Level (Property/ Vehicle etc)
- Portfolio level
- Country level
With so many ways to structure your transition, taking the time to model each method and talk to professional auditors is crucial. Furthermore, the system must continually update the IBR as it changes over time.
Security access, backdating and lock periods
Many lease management systems (or an excel spreadsheet) cannot control who or how the data can be modified. This means that companies can end up with multiple, outdated copies of the same files or have many people working on a document at once and are unable to see the changes their colleagues have made. Ensuring that your system can manage multiple users is a simple yet critical way to stop your company over-riding critical data.
Additionally, by not implementing lock protocols, the system could backdate into closed periods, significantly impacting opening and closing balances.
In summary, IFRS/ AASB 16 accounting standard has introduced a huge level of complexity into lease accounting and management. The careful selection and implementation of a comprehensive lease management and lease accounting system is critical to your ongoing business success.
This post was authored by Simon Fonteyn. Simon is one of Australia’s leading experts in retail, childcare and medical leasing and rental valuations. He holds a Degree in Accounting & Finance, a Diploma of Valuation, a Masters of Management and is an Associate of the Australian Property Institute. With over 25 years experience in the commercial property industry, Simon founded LeaseInfo® as a way to provide more transparency to the industry.