Technical / Finance teams should prepare for changes to lease accounting

It isn’t up there with the big NHS financial challenges – deficits, sustainability and transformation. But it does need to be on financial accounting teams’ radars.

The impact – uncertain in many respects – could be wide-ranging, leading to an increased workload for finance teams, changes to key metrics, different phasing of reported leasing costs and a possible influence on how much investment the NHS can make in capital assets.

The new accounting standard – IFRS 16: leases – is not due to apply in the public sector until at least April 2019 (and hoops must still be jumped through in terms of European and Treasury adoption). So you could be forgiven for thinking that you don’t have to even think about it yet.

But NHS bodies cannot afford to wait until everything is certain and the new requirements are built into the 2019/20 Financial reporting manual. In simple terms, the new accounting standard (replacing IAS 17) will end the distinction between finance leases and operating leases for lessees. Under IAS17, if a lease was judged to be similar to purchasing the asset being leased, it was a finance lease. As such, it was reported on a company’s balance sheet at the net present value of future lease payments and the asset would be depreciated in the revenue account. But operating leases were treated in the same way as service contracts – off-balance sheet and only reported as revenue costs.

In future, leases will require a slightly different treatment. ‘So what?’ many people might wonder. Well, the new approach is likely to be more time-consuming and burdensome for finance teams, at least initially. This is simply because all leases will need to be identified and the accounting entries worked out for the new approach. It is also likely to change how the costs of leasing hit an organisation over time. The total costs won’t change, the same amount will be paid to the lessor, but costs will be higher in earlier years – depreciation may be on a straight-line basis but interest will start high and reduce. 

An early briefing from the HFMA last year demonstrated this in a simple worked example. That may not be a deal-breaker, but organisations need to be aware of the change in phasing of costs, both for existing leases and any new ones being considered.

Metrics will change too. Earnings before interest, depreciation and amortisation (EBITDA) is the most obvious example. Lease payments made under traditional operating cost leases are currently recorded above the line, but once on balance sheet, their depreciation and interest costs will move below it. EBITDA will increase.

Costs and performance won’t change, but managers and regulators will need to view such metrics in light of the new accounting treatment.

Perhaps the greatest uncertainty is around how this might impact on capital funding in the NHS. Moving all leased assets on balance sheet will mean they count against the capital departmental expenditure limit – already under significant pressure, facing huge demands to support sustainability and transformation plans and being tapped to support current revenue overspending.  

It is such a big issue that the Office of National Statistics is leading a project on the impact of IFRS 16 on the national accounts.  

This is being run in parallel with the Treasury’s work on how this standard will affect its Financial reporting manual. The national accounts, which are used to measure performance against the CDEL, are prepared using the European system of accounts 10 (ESA 10), which retains the finance/operating lease distinction. One solution to this problem could be dual accounting – where the accounts are prepared under IFRS but then the ESA10 information is also maintained and submitted to consolidating bodies.  This currently works for private finance initiative schemes. But is it practical for the many hundreds if not thousands of lease agreements NHS bodies are party to?

The HFMA’s Accounting and Standards Committee is starting work on a briefing setting out the practical steps NHS bodies should take now.  It will also include questions on NHS bodies’ preparedness for the new standard in its year-end survey of all NHS bodies in early June.