Fatp Research Assigment

Title: AASB 16 Effect Analysis

Prepared by: Yeo Shan Yuan, 21155759

Prepared for: CEO & CFO of XYZ Ltd

Date: 18th May 2016
Word Count: 1496 words

1. Outline the main differences between the old and new leasing standard relevant to XYZ Ltd’s accounting statements. (3 marks)

There are several critical changes that was made to the old leasing standards in order to correct the manipulation of lease contracts through the abuse of operating leases. The key impacts to lessees would be that all leases other than short term leases low value leases will now be required to be capitalized on the balance sheet. There will also be no more operating leases under AASB 16 or any form of rental expense. A good example would be that there will be no more straight line expense for operating lease costs. There will be minimal accounting changes for lessors in the new AASB 16 Leases.

Under the new AASB 16, there will no longer be a distinction between finance and operating leases. Lessees will thus be required to recognize a lease liability for the obligation to make lease payments and a “right of use” assets. “Right of use” assets refers to the underlying asset that the lessor grants the lessee the right to use. The lease payments which are included in the measurement of the lease liability mainly includes the following types of payment, fixed payments less any lease incentives receivable, variable lease payments which would be measure at commencement date, amounts expected to be payable by the lessee under residual value guarantees and payment of penalties for terminating the lease. (Holland, 2016).

Furthermore, a lessee is now not required to estimate future variable lease payments linked to future performance or use of the asset, or a future index or rate. Rather, at each respective reporting period, the lease liability and “right of use” asset is premeasured and adjusted for any changes to future variable lease payments. (Olde, 2016). All leases will incur a front-end loaded expense, comprising depreciation on the “right of use asset” and interest on the least liability. (Mucking, 2016) The “right of use” asset is initially measured at the amount of the lease liability plus the lessee’s initial direct costs and an estimate of restoration, removal and dismantling costs.

However it is also important to note that lessees can choose not to apply the AASB 16 requirements to short team leases and low value items. Short term leases refer to leases for a period of 12 months or less from commencement date. Low value items refer to new items which have a value of less than US$5,000 (Basis for Conclusions to IFRS 16, BC100).

Simply, AASB 16 would result in higher debt levels and interest costs, especially in the earlier years of a lease. This will impact entities that operate in industries that currently have many operating lease of high value that are material to their balance sheets.  (Mucking, 2016)

1. Outline the key effects of XYZ Ltd implementing the new leasing standard on the income statement, balance sheet, statement of cash flows and key financial ratios. (4 marks)

For companies that have material off balance sheet leases, AASB 16 is expected to result in an increase in lease assets and financial liabilities.  This is mainly due to the new regulations that requires the company to report on the balance sheet lease assets and lease liabilities for all leases. The carrying amount of lease assets will typically reduce more quickly than the carrying amount of lease liabilities, this will thus result in a reduction in equity. It is due to the fact that in each period of the lease, the lease asset is typically depreciated on a straight line basis and the lease liability would be reduced by the amount of lease payments made and increased by the interest reducing over the life of the lease.  The actual effect of a company’s reported equity will depend on the company’s financial leverage, the terms of its leases and the ratio of lease liabilities to equity. (IFRS, 2016)

The key effect of the AASB 16 on the income statement would include an increase in higher profit before interest resulting in a higher EBITDA. This is because though applying AASB 16, a company presents the implicit interest in lease payments for former off balance sheet leases as part of finance costs. In contrast, applying AASB 117, the entire expense related to leases not included in balance sheets would be added to part of operating expenses. EBITDA would be higher because applying AASB 16 does not include expense related to leases whereas EBITDA applying AASB 117 would have included the whole expense related to leases not on the balance sheet. (IFRS, 2016)

Changes in accounting requirements do not cause a difference in the amount of cash transferred between the parties to a lease so there would not be any effect on the total amount of cash flows reported. However, AASB 16 would reduce operating cash outflows and increase financing cash outflows.  This is because previously, companies presented cash outflow of leases as operating activities. However, applying AASB 16, principal repayments on all lease liabilities are included within financing activities.