As we venture into 2020, some companies with December year ends will be to get to grips with a new International Financial Accounting Standard, IRFS 2016 on leases which came into effect for periods beginning on or after 1 January 2019.
It is important to note that this new standard only effects companies adopting either IFRS or FRS 101 and not those in the UK adopting the more common FRS 102. That said, FRS 102 has its roots in IFRS and so whether we see this adopted in the UK in due course is to be seen.
Prior to IFRS 16, leases were categorised either as a
- Finance lease, where the present value of the lease repayments are recognised as a liability and corresponding asset on the balance sheet, with subsequent depreciation and interest charged to profit and loss.
- Operating lease, where the rental payments are charges to the profit and loss account when incurred.
IFRS 16 removes the operating lease treatment, requiring virtually all leases to be capitalised on the balance sheet.
To put this into an example, let’s take a 10 year office lease with monthly lease payments of £2,500 and a cost of borrowing of 5%. Under the old rules an annual rental expense of £30,000 would be recognised each year. However, under IFRS 16 an asset and corresponding liability equal to £237,000 would initially be recognised on the balance sheet.
Depreciation of £23,700 and interest of £11,200 would be charged to the profit and loss account in year one, an increase of £4,900 over the old treatment. At the end of that first year the asset will be held at £213,300 and the liability £218,200, reducing net assets by £4,900.
While the net effect over the full lease will be the same, the new rules will result in front weighting charges to profit and loss. It also has an impact on gearing ratios, audit thresholds and will likely suppress net assets. Companies with bank covenants linked to these may need to take extra care.
This article originally appeared in Wiltshire Business.