FINSights: Emerging trends in FS

New lease rules to shift liabilities to balance sheetNew lease accounting standards will result in billions of dollars in lease liabilities coming onto the balance sheet of companies with extensive property or equipment leases.Issued earlier this year by the Australian Accounting Standards Board, new Accounting Standard AASB 16 Leases (AASB 16) will come into effect from 1 January 2019. Its main effect is that a lessee will need to include most leases on its balance sheet. This includes operating leases, (which are not required to be included on a balance sheet under the current rules). This means that as a general rule, operating leases will have the same treatment as finance leases.

Subject to certain exemptions and transitional rules, AASB 16 will apply for annual reporting periods beginning on or after 1 January 2019, with earlier application permitted in certain instances.

This will bring Australia into line with global accounting rules (issued by the International Accounting Standards Board). Globally, it is expected that the new rules will result in the transfer of about $4 trillion worth of off-balance sheet liabilities onto companies' books, with the sectors hardest hit to be mining, aerospace and retail.

Spring 2016

Key impacts

Gross up of the balance sheet

Leases (including operating leases) will be represented on the balance sheet as a ‘right of use’ asset and a corresponding ‘lease’ liability.

Note: Since the lessee is not responsible for residual value in an operating lease, the amount of liability recorded on the balance sheet for an operating lease will not include the residual value.

Lease payments characterisation

There will be a change in the profile and amount of the lease expense. Rather than the whole lease payment being characterised as an expense of the lessee, as is currently the case, there will be an interest expense and an amortisation amount.

Consequential changes to financial metrics and debt covenants

Application of AASB 16 to a company with operating leases is likely to result in: increase in leverage (liabilities/equity) decreased asset turnover (sales/asset) increased EBITDA.

James MokPARTNER

T: +61 2 9921 8612M: +61 418 243 121E: james.mok@minterellison.com

Key considerations

While operating leases will continue to remain attractive from the perspective of managing and minimising residual risk liability, such leases will no longer have the advantage of receiving off-balance sheet treatment. Lessees wishing to obtain off-balance sheet treatment of their arrangements, may need to consider a service arrangement as an alternative structure. Service arrangements will not be shown on the balance sheet, and service payments will be recorded as expenses on the profit and loss statement.In addition, the changes may also lead some lessees to consider some of the following approaches: entering into more short-term leases (less than 12 months) where commercially

and operationally viable (as such leases can be accounted for as a straight-line expense and remain off-balance sheet)

shorter term operating leases with larger residual values to minimise impact on the lessee's balance sheet; and

arrangements involving payments which vary based on usage or sales each period (which will be reported above EBITDA as an expense) and minimising the payments that are fixed or tied to an index or a rate (which will be considered contingent rentals and form part of lease liability).

Parties to financing transactions will need to consider the impact of these changes on financial covenants in existing transactions and in particular, whether any amendments are required to the covenants and the timing required for any such amendments.

Shirley WongASSOCIATE

T: +61 2 9921 4859M: +61 433 065 713

E: shirley.wong@minterellison.com