On January 1st, 2019 a new lease accounting standard, IFRS 16, came into effect for all companies that report under the International Financial Reporting Standard. Under IFRS 16, virtually all leases must be shown on a company’s balance sheet. This can have an important impact on large technology purchases and to technology vendors who hope to make it easy for customers to buy. Let’s explain why.
In general, leases have been of two types: finance leases and operating leases.
- Finance leases have always been shown on the balance sheet and therefore little will change with the introduction of IFRS 16.
- Operating leases, on the other hand, have traditionally not been shown on the balance sheet. These tend to be for terms shorter than the economic life of the asset and involve a leasing company applying a resale value to the asset–an array of backup appliances, for instance–which is recovered when the lease expires. By accounting for resale value when a leasing company calculates rental payments, the total cost of an operating lease for a customer can be less than the cost of purchasing the asset. Now under IFRS 16, companies have to bring these leases on balance sheet using a common methodology.
- There are two major exemptions, however: short term leases (less than 12 months), and the lease of low value items–laptops, mobile phones and tablets have been specifically identified as being exempt.
Why make the change? The short answer is transparency. The organizations that set international accounting rules are keen to ensure that companies improve the understanding of their ongoing financial commitments. Operating leases had a reputation for hiding significant future liabilities and presented difficulties for analysts when assessing the true financial strength of a company.
And the introduction of IFRS 16 changes some of the accounting ratios and key performance indicators used within financial analysis. Companies with outstanding operating leases will appear to be more asset-rich, but also more heavily indebted; total lease expense will be front-loaded even when cash rentals are constant, et cetera.
Why does this matter to technology vendors? Because operating leases have been used as a mechanism for frequent technology refresh and a way of accounting for the technology assets as an expense. This will no longer be an option for listed companies, at least for large purchases. Now the assets involved in the technology purchase, and the full liability of future rental payment obligations will be visible on a balance sheet, rather than simply as notes to accounts.
Large corporations will still demand flexible payment solutions and accounting guidance from technology vendors. Working with financial sales experts like Technology Finance Partners to explore options becomes even more important in this new world. For instance, in certain circumstances service agreements that include the provision of non-identified assets might not be classified as leases under IFRS 16 if there is a high level of asset substitution during an agreement, driven by the service provider.