Changes in accounting for leases

At present, leases are classified as either ‘finance leases’ or ‘operating leases’. If the lease transfers substantially all the risks and rewards incidental to ownership then it is a finance lease, if not, it is an operating lease.

Indicators of a finance lease include:

• the lease transfers ownership of the asset to the lessee by the end of the lease
• the lessee has an option to purchase the asset at a lower than fair value during the lease term
• the leased assets are of such a specialised nature that only the lessee can use them, without major modification.
• the lease term is for the major part of the economic life of the asset (even if title is not transferred); or
• at the inception of the lease the present value of the minimum lease payments amounts to substantially all the fair value of the leased asset.

Operating leases

If a lease meets the definition of an operating lease (i.e. where the company leases an asset for a short period of time with no indicators of a finance lease as outlined above) then the lease payments are recognised as an expense, on a straight line basis over the lease term, on the profit and loss account.

An example of an operating lease could be rent paid to a landlord where a lease is 5-10 years, which is significantly less than the life of the building and the lessee has no ownership rights to the property. The rental expense is currently recognised as a cost to the company, as an expense on the profit and loss account.

Finance leases

If a lease meets the definition of a finance lease, the rights and obligations are brought onto the lessor’s balance sheet. The asset being leased will be recognised as a fixed asset of the company and depreciated over its useful life (to the lessee) with the depreciation charge being released as an expense on the profit and loss account.

The lease commitment will be recognised as a liability of the lessee company, increasing with interest, and reducing by payments made to the lessor.

A lessee company will no longer need to distinguish between finance leases and operating leases and most leases will now need to be recognised on the balance sheet, with two exceptions for leases of assets of particularly low value and short-term leases (less than 12 months).

The balance sheet

If the exceptions are not met, as above, the lessee company will recognise a new asset on the balance sheet, within fixed assets, as ‘right-of-use assets’. This will be depreciated over the term of the lease.

A lease liability will also be recognised on the balance sheet, reflecting the company’s obligation to make lease payments over the term of the lease. The liability recognised will be the present value of the future lease payments with lease payments reducing the liability and unwinding with interest payments.

The profit & loss account

The current operating lease expense (rent) will no longer be recognised. Instead, the depreciation charge on the new ‘right-of-use asset’ will be recognised in the profit and loss account as an expense. The interest calculated on the liability will also be recognised in the Profit & Loss Account as a finance cost.

Over the length of the lease the amount charged to the profit and loss account will still total the total cost of the lease payments. However, the timing of the cost will change with a significantly higher cost, due to the finance costs, being recognised in earlier years of the lease.

Finance and depreciation costs will be higher, particularly in earlier years of the lease. This could impact lending covenants with third party lenders, such as banks.

EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation), commonly used by lenders to monitor business performance, will increase as operating lease expenses are removed. Some companies base staff bonuses on EBITDA so larger bonuses may now appear due, this policy may need revisiting to check it remains appropriate.

If a company has entered into significant leases, gross assets on the balance sheet could significantly increase as a result of the changes. If a company is close to the audit thresholds (see article here for further details: Major change to company size thresholds and audit requirements | Old Mill) then they may now breach the asset threshold and an audit may now be required.

Net current assets on the balance sheet will decrease due to the lease liability.

Gearing ratios, used by investors calculating the capital/equity to funds borrowed by the company will likely increase, suggesting an increase in financial risk.

As always, planning is key. It is vital that you identify all your leases and understand the key terms of each lease agreement.

If these terms do not meet the definition of the ‘low value’ or ‘short-term lease’ then we recommend that you assess the implications of each of the leases and ascertain how it will impact your financial result, closely focusing on KPI’s, covenants and audit thresholds, as relevant.

If you think there could be a breach of covenants or KPI’s used by third parties will have significantly impact then start having the conversations with the third parties now- it may be that covenants can be renegotiated accordingly, well before they are ‘breached’.

If you believe that the company (or any group in which it sits) will breach audit thresholds then talk to us. It is important to plan ahead for an audit to ensure the auditor is appointed at the right time. If appointed too late then the auditor may not be able to gain sufficient assurance over certain items, e.g. stock held at the balance sheet date, and a ‘qualified audit report’ may be needed. This can suggest to third parties that the auditor cannot gain sufficient evidence or that there may be an issue, which can be concerning to third parties.

As always, it is good advice for businesses to stay informed about regulatory changes and consult with their advisers. For further details and assistance, feel free to reach out to Old Mill. We can talk about the implications of the change and help you decide what is best for you and your business.

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