NZ IFRS 16 – Leases: Are you prepared for the secondary implications?
The new accounting standard for accounting for leases (International Financial Reporting Standards – NZ IFRS 16) is effective from 1 January 2019. Whilst everyone is largely aware of the general concept of NZ IFRS 16, bringing all leases onto the balance sheet, most boards and senior management are yet to consider the unexpected impacts this new standard may have on funding arrangements, financial ratios and remuneration structures.
Whilst most boards and senior management are aware that this standard will result in all operating leases, which were previously being expensed through the profit or loss, being recorded on the balance sheet, effectively grossing up both assets and liabilities; there are many secondary impacts this standard will have that boards and senior management will need to assess and take appropriate action on prior to the implementation of the standard.
Have you considered the following implications of the new leasing standard?
Common covenants included in commercial loan agreements include debt to equity and interest cover ratios. NZ IFRS 16 is likely to result in an increase in debt to equity ratios and a reduction in interest cover ratios. Failure to assess the potential changes to these ratios may result in breaches to covenants after the implementation of the standard. You may need to renegotiate loans prior to the adoption of the standard.
The expense profile of your organisation may significantly change. Previously, operating lease payments were fully expensed and would reduce Net Profit After Tax (NPAT), Earnings Before Interest and Taxes (EBIT) and Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) equally. Under NZ IFRS 16, the associated expense is recorded as interest and depreciation, resulting in changes to the calculation of NPAT, EBIT and EBITDA. This may also impact the following arrangements:
Staff remuneration/bonus plans that are linked to an earnings measure such as EBIT or EBITDA or profit-sharing arrangements.
Any contingent or variable considerations included within contracts that utilise earnings hurdles (i.e. business acquisitions which include a contingent consideration component based on earnings).
Business valuations that are utilising an earnings multiple (i.e. for business acquisitions).
It should also be noted that the expense profile over the life of the lease will change as it will be a front-loaded expense under NZ IFRS 16 rather than straight line.
Reserve Bank of New Zealand regulated financial institutions have stringent capital ratios. These ratios require a specific amount of capital to be retained based on the value of assets held. Bringing all operating leases onto the balance sheet will increase assets held and the capital requirements for these institutions.
Audit and financial reporting requirements
Various legislation including the Companies Act 1993, Partnership Act 1908, Limited Partnership Act 2003 and Te Ture Whenua Māori Act 1993 have differing definitions of ‘large’ based on either a revenue or asset threshold. If this threshold is met, those entities will be required to prepare general purpose financial statements in accordance with NZ IFRS, and in some cases, will require an audit.
In determining whether the asset test is met, an entity considers its consolidated gross assets and those of any entities it controls in accordance with NZ IFRS, not the entity’s current accounting policies (if different). As NZ IFRS 16 requires the recognition of “right-to-use” assets on the balance sheet, this may result in an entity’s consolidated assets going above the relevant large threshold.
If you are unsure where to start, or if you would like assistance considering the implications of NZ IFRS 16 on your business, we are here to help. At Findex, we have a specialist team working through the requirements and training staff to assist clients with the new standards. Additionally, we have business specialists who can assist with renegotiating banking arrangements, business valuations and the implementation of staff remuneration plans.