Leases - Changing of New Standard

Executive Summary

This business report provides a researched assessment of the impact the new lease standard will have on the recognition of leases in regards to the Woolworths Group. The report includes a description of how the Woolworths Group currently recognises its lease agreements under AASB 117, a comparison of the two standards and the impact on Woolworths financial reports. The report also details recommendations in relation to the treatment of old and new lease agreements.

The report finds that Woolworths financial statements will be materially impacted by the implementation of AASB 16, and it is in its best interests to notify its stakeholders of the changes in its classification of leases. Given the nature of Woolworths business activities, it can’t readily alter its high lease commitments, and the costs associated with buying its leased items outright are likely too high for Woolworths to alter how it finances its assets in the future, so this change will likely permanently restructure how Woolworths presents its assets and equities.

A lease is, in theory, a simple concept. A lessor gives the right to use an asset to a lessee in return for compensation in the form of a payment or more often, a series of payments. For Australian businesses, AASB 117 has prescribed for both lessees and lessors how to account for and disclose lease agreements in a fair and representative manner. To this end, AASB provides 2 lease classifications, financial and operating leases. The distinction is whether the lease “transfers substantially all the risks and rewards incidental to ownership” (AASB 117, 2015) with these financial leases appearing on the balance sheet. It is common practice and common sense for a lessee to prefer operating leases, as they don’t appear on the balance sheet, in effect, hiding their debt. AASB 117s flawed criteria used to establish when a lease was capital in nature allowed creative lessees to not recognise leases that had the substance of a finance lease by avoiding certain stipulations and benchmarks (Paretta, 2017). This corporate culture can be seen in financial reports of the Woolworths Group, who reported 2.4 million in finance leases against 13,039.7 million in total liabilities, while also being burdened with operating lease commitments of 24,438.8 million (Woolworths Group, 2017) left tucked away in the notes of their financial reports. This enormous off-balance sheet debt is far from an outlier in public companies, and also within the parameters laid out in AASB 117. Woolworths notes that it primarily leases premises and warehousing facilities for periods of up to 40 years. With these leases being non-cancellable, as well as having the Group be responsible for insurance, maintenance and other costs associated with the leased properties, it is safe to say that they are not being appropriately recognised as intended by the AASB. Although the requirements for these leases to be classified as operating leases have been met, the underlying substance of these leases are capital in nature, and it is for this reason that a new standard had to be drafted to better reflect a more faithful representation of the firms leasing and debt activities.

Initially, based on AASB 117, at the initiation of the lease term, lessees and lessors can classify leases as either operating or finance leases. The operating leases are acknowledged as an expense on a straight-line basis over the lease period unless another systematic basis is more typical of the time order of the user’s benefit. In contrast, finance leases shall be identified at amounts equal to the fair value of the leased property or the present value of the minimum lease payments (Australian Accounting Standards Board, 2015). On the other hand, the new standard under AASB 16 introduces a lease accounting model that eliminates the categorization between operating and finance leases. The introduction of this new standard obligates lessees to recognize all leases as finance leases with exception of leases with a span less than 12 months and leases that has a low value of underlying assets for the responsibility to make lease payments and a right-of-use asset. (CPA Australia, 2016)

The conversion of operating leases into finance leases will increase both assets and liabilities. As results, the leverage ratio and asset turnover of the company will be affected. The leverage will increase as the amount of debt rise while an increase in total asset will decrease the asset turnover. The change of the standard will also put into effect on EBIT, EBITDA, debt ratio, return on assets and other related ratios. As a subsequent effect, Dakis (2016) assert that the debt covenants will be largely affected and may impact the company in a negative way.

One of the key differences between the old and new standard is the measurement of asset and liability of finance leases. Under AASB 117, the measurement of both assets and liabilities are the same which is measured at amounts equal to the fair value of the property that is leased or, if lower, the present value of the minimum lease payments (NSW Treasury, 2017). On the other hand, the new standard measured asset and liability separately. Xu, Davidson, and Cheong (2017) mention that Assets are capitalised with right-of-use asset method which comprise of the amount of the initial measurement of the lease liability, any lease payments made at or before the commencement date, any initial direct costs incurred by the lessee, and an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories (Chartered Accountants, 2016). The assets then will be amortized over time with the similar method as PPE. The measurement of lease liability of finance lease under IFRS 16 is the same as AASB 117.

The accounting treatment for lessors under the new standard is heavily unchanged from current standard (Australian Accounting Standards Board, 2016). Lessors classify all leases with the same classification standard as in AASB 117 and differentiate between two classes of leases: operating and finance leases. Lessors still persist to recognise the underlying asset for operating leases. For finance leases, lessors derecognise the underlying asset and acknowledge a net investment in the lease identical to current stipulations. Any selling profit or loss is recognised at the commencement of the lease.

In addition, the classification of cash flow in the statement of cash flow will change as AASB 16 adopted. Initially, most of cash flows activities regarding leases transaction are concentrated on operating activities since most companies preferably recognized leases as operating leases. As the IFRS 16 adopted, the classification will change into financing activities since companies need to change almost all of its operating leases into finance leases. However, the changing of cash flow classification will not have any effect on the change in cash and cash equivalent in overall. Sale and leaseback arrangements have been one of the normally used financing structures. Under IFRS 16, the sale and leaseback requirement is changing as it demands the companies to analyze and assess if in a transaction there has been a sale in accordance with the new revenue standard. Several sale and leaseback transactions involving assets other than property that would have qualified previously for sale and leaseback accounting will not qualify under the new standard.

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