Wake up and smell the coffee: IFRS 16 is a major change

Councils who think they won’t be subject to new accounting rules on leases are in for a rude awakening, says David Green.

One of the first things anyone analysing financial statements does is look for the disclosure note on future operating lease payments and convert this into an estimated amount of debt.

After all, an operating lease is still a contract giving the right to use an asset alongside a liability to make payments, just like a loan.

The International Accounting Standards Board has finally addressed this anomaly with its new IFRS 16 accounting standard by making the preparers of the accounts calculate this adjustment instead of the readers.

Now, a finance manager at a large unitary authority told me recently that implementing IFRS 16 will be no problem for them, because they have no leases.

Reading their latest statement of accounts appeared to confirm this.

In for a shock

But does anyone really believe that an organisation with several thousand staff is not a party to a single contract that allows the council the use of someone else’s asset?

Or that the council hasn’t let anyone use any of its assets?

I’ve spoken to other people who believe the new standard only applies to vehicle and equipment leases that have been formally procured by corporate finance in conjunction with a leasing advisor.

They are in for a shock too, because IFRS 16 is a big change, especially for those authorities with plenty of maintained schools.

Renting a room, a car or a photocopier? That’s a lease.

And so is a long-term year contract to design, build, finance and operate some infrastructure, even if you call it a PFI.

IFRS 16 will bring most leases onto the lessee’s balance sheet.

There are exemptions for low value leases, such as laptops and mobile phones, and for short-term leases.

But don’t be fooled into thinking a lease is short-term just because you can terminate it within 12 months – the lease term is now defined as the period that you expect to use the asset i.e. including periods covered by options to extend and options to cancel where you are likely to continue with the contract.

And even if leases do remain off balance sheet, there are still disclosure notes to be made, so information on payments is required.

Increased debt

Once on balance sheet, leases are measured at the present value of the lease payments, rather than the value of the leased asset as now.

And the lease payments include optional payments that are likely to be made, plus indexed payments based on the current value of the index, such as inflation.

Lease terms, lease payments and inflation rates will all vary, requiring most leases to be remeasured annually.

Recognising more lease liabilities and remeasuring existing ones for longer lease terms and indexed payments will substantially increase the recorded debt of most local authorities.

In the private sector this has led to worries over breaching loan covenants on gearing; councils will be more at risk of breaching their authorised borrowing limit and other prudential indicators.

At first glance, the accounting by lessors – owners of assets who let others use them – is relatively unchanged as it retains the split into operating and finance leases.

But the new definitions of lease term and lease payments apply and hence lease receivables will also need to be remeasured on transition in April 2020 and every year thereafter.

The asymmetric accounting will also cause issues for group accounts, not to mention Whole of Government Accounts, where there are intra-group leases with assets on both entities’ balance sheets.

Yes, the first accounts under the new standard don’t need to be with the auditor until May 2021, thanks to a one-year implementation delay in the public sector, but local authorities should use the intervening period to prepare.

In particular, corporate finance needs to start a dialogue with service managers and headteachers to gather the necessary data.

Waiting until after you’ve had your 2019/20 accounts audited is going to be too late.

David Green is strategic director at Arlingclose Limited