Even as some companies are still reeling from the adoption of FRS 115, the next big standard to affect the accounting landscape is FRS 116. This will be a major accounting standard to adopt for lessees.
In a nutshell with this new standard, there is no more distinction between operating and finance lease accounting for lessees. What this means is that leased assets and liabilities that were off balance sheet under FRS 17 (the previous standard) will now have to be recognised.
Needless to say, the impact on the financial statements as a result of this change could be potentially huge, especially if the company has lots of operating leases.
Impact on Statement of Financial Position
The company’s assets and liabilities will increase and this would affect ratios like current ratio and gearing ratio negatively.
In all likelihood, the current ratio will decrease as the lease liability recognise would affect both current and non-current liabilities but the lease asset recognised will only affect the non-current asset section.
Gearing ratio would also increase as financial liabilities is increased and equity is decreased due to increased expenses recognised (depreciation and lease interest).
Companies relying on these ratios to determine or maintain debt covenants would do well to pre-empt these changes and negotiate with their bankers now to avoid breaching their debt covenants.
Impact on Income Statement
As mentioned above, ceteris paribus, a company’s overall profits would decrease upon adoption of FRS 116. This is due to increase in depreciation and interest expense, which would likely outweigh the effect of the absence of the now disallowed rental expense.
An interesting consequence, however, is that EBIT and EBITDA would increase as the additional depreciation expense should be lesser than the disallowed rental expense.
Companies that use these ratios for staff incentive programs would need to take note of these impact and revise their KPIs accordingly. Similarly, companies who report these ratios to their investors should also inform them of these impacts and decide if their current benchmark needs to be revised.
Impact on Cash Flow Statement
The impact on operating cash flow would be positive as the rental expense amount is no longer in this section and the newly included interest payment would be much smaller in comparison. This is because the bulk of the cash outflow is now the principal payment and that would belongs to the financing section.
Companies may wish to educate their investors that the increase in operating cash flows does not really indicate any vast improvement in the business as the net cash flow is unaffected.
Even though the effective date for this Standard is 1 January 2019, companies that have heavy operating lease commitments should start assessing the impact now rather than in 2019., In particular, companies in the co-working and service office industry like WeWork and Regus could be very much affected by this standard, especially if they don't own the properties they operate in.
For companies with debt covenants tied to gearing ratios, they should start negotiating with their financial institutions to avoid situations where those covenants would be breached.
Companies who are using the affected ratios for benchmarking should also assess the impact of these changes and make their own revisions accordingly.
If you need assistance in assessing the impact of adopting this Standard on your Company, we can help!
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