A lease is an agreement through which a company or individual pays for the rights to use an asset such as a car, a construction crane or time on a supercomputer. While simple in theory, accounting for leases can be complicated.

“The new standard removes the distinction between operating and finance leases for a lessee, which were previously off-balance sheet and on-balance respectively. Instead, it requires a lessee to recognise all leases on-balance sheet with a few exceptions,” said Cecilia Kwei, technical director at Deloitte China.

Shelly So, a partner at the assurance practice at Accounting Consulting Services at PwC Hong Kong, highlighted some of the changes.

“In the past, if you rented a shop or leased equipment, you only recorded the monthly rental expenses in the income statement based on the amount paid. Usually nothing was recorded on the balance sheet,” So said.

“With the new leasing standard, the shop rented and equipment leased will be recorded as ‘right of use asset’ (ROU) either separately or together with fixed assets on the balance sheet. The size of the ROU depends on the rental/lease amount and contract period. Also, you will no longer see ‘rental expenses’ (except when the lease period is shorter than 12 months) in the income statement as it now becomes ‘depreciation’ and ‘interest expenses’. The amount would usually be higher or lower than actual rental paid due to the front-loading impact of how the accounting works,” she explained.

The changes are likely to affect some financial ratios that are widely used, such as the debt-equity ratio; earnings before interest, taxes, depreciation and amortisation (Ebitda); and interest coverage, Kwei said. “As regards the accounting for lessors, it remains largely unchanged from the old standard,” she noted.

Simon Riley, a director and head of financial reporting advisory at accounting firm BDO, agreed that the most significant change is that there is no longer a distinction between operating and finance leases.

“This shift in the way operating leases are accounted for has the potential to fundamentally change the balance sheet and income statement for many companies,” Riley said.

Companies that have significant property and equipment leases are mostly impacted by the new standard, said Catherine Yuen, an associate partner at the Assurance Professional Practice at EY.

Yuen said that is because some of the leases will now be brought to the balance sheet.

“Retails, airlines, shipping companies and basically any companies with leases of properties and vessels that involve substantial value are hardest hit by the new standard,” she noted.

In the past, some investors have said that the accounting treatment of operating leases under the previous HKAS 17, could give a misleading interpretation about the leverage and leased assets used by companies.

“This means that investors had to estimate the effects of a company’s off balance sheet lease obligations, which in practice often led to overestimating the liabilities arising from those obligations,” Riley said.

The new standard could provide a potential fix for this problem and provide more transparency as all major leases a company holds are now reflected on the balance sheet.

However, investors should remain alert and find out how HKFRS 16 changes other key financial metrics of a company. PwC cautioned that financial statements could look “very different” because of the new standard, as assets and liabilities could increase significantly and that would affect the gearing ratio.

Other than debt-related ratios, profitability ratios may also be impacted. Riley explained that under the new standard, there will be two elements determinant – the depreciation of the leased asset, and the interest charge.

“The depreciation component will be accounted for using the straight line method but the interest charge will be weighted towards the earlier part of the lease. Although the total lease charge will be the same over the leasing period, it will be more front-loaded, with higher charges in the earlier years and lower charges in the later years. However, the overall impact on profit will depend on the portfolio of leases an entity holds,” Riley said.

The new standard will also have a positive effect on Ebitda. Rental expenses were previously classified as “above the line” as operating costs under the previous HKAS 17, but are now excluded from the Ebitda measure as depreciation and interest expenses.

Yuen from EY agreed that accounting for profitability and some ratios will be affected.

“For example, the return on asset ratio could be lower under HKFRS16 because while profits would remain the same, assets could be higher due to a different accounting treatment. As a result, the ratio would appear to be lower. Investors should note that the lower ratio is not because the companies are earning less money,” she said.

The new rules might present some challenges to companies in Hong Kong.

“Companies may have to change their internal processes and IT systems to cope with the changes,” said So from PwC.

“In China, there are companies with millions of lease contracts. Therefore, implementing the new standard could mean significant investments … In addition, companies need to consider how to communicate the impact to the investors as the financial statements could look very different as stated above.”

Kwei from Deloitte China believes companies in Hong Kong are well prepared for the changes, as their implementation project including system and process changes would have started a few years ago.