In the past, the accounting treatment of operating and capital leases was very different. In short, operating leases were off-balance sheet and the lease payment was reflected as an expense in the income statement. An operating lease is a contract that confers the right of use but with no prospect of future ownership. You can think of it as being almost like a rental.
A capital lease, on the other hand, was capitalized on the balance sheet. Due to the fact that at some point in time in the future you could become the owner of the asset, ownership rights were accelerated which meant you could depreciate the asset on your balance sheet. In addition, that same depreciation would reflect as an expense in your income statement and reduce your taxable income.
In South Africa, we make use of the accounting standard known as IFRS (International Financial Reporting Standards). From 1 January 2019, IFRS 16 came into effect which says that all leases should be brought ONTO the balance sheet.
So why is this a big deal?
Prior to this, it is estimated that US$2 trillion of operating leases were off-balance sheet. You may be asking, who the hell cares whether they are on or off-balance sheet? The answer is quite simple – the shareholders of these companies, and especially when the companies are listed. A lease is an important financial obligation. It locks you into a contract for a fixed length of time and the lessor expects you to honor those obligations until the contract ends. By not showing these lease agreements on their balance sheets, companies were understating their financial obligations. This meant that investors who were relying on the company’s financial statements in order to make investment decisions were not seeing the full picture.
Under IFRS 16, your operating lease will no longer be left off the balance sheet. You will now need to capitalize future operating lease payments on your balance sheet under an asset known as a right-of-use (ROU) lease asset. The contra entry is the lease liability. The lease asset needs to be depreciated, while interest will need to be recognized on the lease liability.
So what is the impact on your bottom line?
The combination of the lease liability interest expense and right-of-use lease asset depreciation will typically be higher than the lease rental expense at the start of the lease. Consequently, net profit will be relatively lower at the beginning of the agreement. As the lease progresses, the interest component of the lease payment declines which means that net profit will be relatively higher. This is known as the “financing effect”. Notice the declining interest payments on the image below:
Are there any exemptions?
There are exemptions from the new accounting for those leases defined as short-term (less than 12 months) and those with low value. A low-value exemption threshold is not specifically defined in the standard. It is given in the guidance (USD $5000 or approx. R80,000) as an indicator and not intended to be a hard and fast rule, but you can use this as a ballpark number.
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