Ralph Martin
Small business owners such as retailers or distributors who lease their premises could find themselves being forced to renegotiate the terms of their bank loans in the wake of a change in the accounting treatment of most leases according to leading accountancy firm, Crowe Horwath.
The International Accounting Standards Board (IASB) has just issued IFRS 16 Leases that effectively abolish the concept of the operating lease and treat all leases as finance leases. The end result is that almost all leases will be recognised as liabilities on the balance sheet rather than the current distinction between operating and capital leases.
Ralph Martin, Crowe Horwath’s Audit Technical Director, says one of the unintended consequences of the standard could be to force small business owners who lease their premises to renegotiate their loan agreements with their banks if this change in accounting standards puts them in breach of their loan covenants.
“Many loan agreements contain covenants based on ratios such as debt-to-equity or interest cover. The new standard could significantly affect those calculations.
“What was treated in the past as an operating lease will now sit in the balance sheet as a liability. The effect could be to trigger a breach of their loan covenants that could give the bank the right to demand repayment of the loan in full.
“Exceptions to this significant standard will be short-term leases (less than one year) and low-value assets such as office equipment and computers, but clearly won’t exclude long-term property leases.”
The saving grace for small businesses is that the standard doesn’t take effect until 1 January 2019, but Martin says it’s essential they begin to prepare now for this important change in accounting standards.
“It’s easy to think that 2019 is nearly three years away, but our advice to small businesses is to start preparing for the change now.”
“The new requirements can be complex, so it’s important to seek appropriate professional advice. Not all businesses will be affected equally. We expect the sectors to be most affected to include retailers and distributors, agribusiness, and the logistics and haulage industries.”
The decision to issue IFRS 16 Leases reflects a long-standing view among global standard setters of accounting standards that the previous standard, IAS 17 Leases, was too ambiguous.
Martin says: “The previous distinction between finance leases, which were recognised on balance sheets, and operating leases, which were not, was often arbitrary, and resulted in substantial lease obligations being visible to investors only in the notes to the financial statements.
“Under this standard the nature of the expense recognised in the income statement will change.
Instead of being shown as rent, or as leasing costs, it will be recognised as depreciation on the leased asset, and an interest charge on the lease liability. The interest charge will be calculated using the effective interest method, which will result in a gradual reduction of interest cost over the life of the lease.”
“One effect of the new standard is that sale-and-leaseback arrangements can no longer be used as a method to keep debt off the balance sheet.”
Aside from potential breaches of loan covenants, Martin says there are three other possible consequences:
- It may require some entities to adjust their accounting systems in order to capture the data required for implementation.
- Many loan covenants, business acquisition arrangements, and other contracts make use of EBITDA-based metrics. Payments that were previously classified as “rent” may now be treated as a mix of “depreciation” and “interest.” This may particularly impact earn-out arrangements based on EBITDA multiples.
- The replacement of today’s straight-line expense approach of operating leases with the front-loaded recognition of the interest expense may affect the timing of earnings associated with major projects or asset groups.
