IFRS 16 and Capital Departmental Expenditure Limit (CDEL): Key Consideration Points

Introduction

IFRS 16 and Capital Departmental Expenditure Limit (CDEL) are two complex concepts that have significant implications for public sector accounting and budgeting, particularly in the public sector context.

Understanding how these concepts interact is essential for departments managing leases, other occupancy agreements and capital expenditure within the constraints of public sector budgeting frameworks.

This article is intended to explore the basic principles of IFRS 16 by answering a number of pertinent questions, explaining how it affects lease accounting, and its relationship with the Capital Departmental Expenditure Limit.

I work predominantly within the Health sector, and IFRS 16 is still something of an unknown to some property managers, yet can have a significant impact if not carefully considered prior to the acquisition by the Trust / organisation of any third party occupancy agreement.

What is IFRS 16?

IFRS 16 is an international accounting standard introduced by the International Accounting Standards Board (IASB) that became effective on 1 January 2019. It fundamentally changed how (for the purpose of this article) leases and other occupancy agreements are accounted for, especially by lessees (i.e. those taking space from a third party (also described as Tenant, but essentially the beneficiary of an occupancy agreement, typically a lease)), by requiring most leases and agreements to be recognised on the balance sheet.

What are the Key Features of IFRS 16?

? On-Balance Sheet Accounting: Under IFRS 16, lessees must recognise almost all lease assets and liabilities on their balance sheets. This includes a "right-of-use asset" (reflecting the lessee’s right to use the leased asset) and a lease liability (representing the obligation to make future lease payments).

? Single Accounting Model: IFRS 16 eliminates the previous distinction between operating leases (off-balance sheet) and finance leases (on-balance sheet) for lessees. Now, all leases (except for certain short-term leases or leases of low-value assets) are treated similarly to finance leases as used to be applied under the previous standard.

? Impact on Income Statement: Lease payments are now split into two components: depreciation of the right-of-use asset and interest on the lease liability, replacing the straight-line lease expense under the old standard (IAS 17).

What is the Impact of IFRS 16 on Public Sector Organisations?

Public sector organisations follow the Government Financial Reporting Manual (FReM), which adopts IFRS 16 as the standard for lease accounting. This means that public sector bodies, like government departments, agencies, and NHS trusts, need to account for leases in accordance with IFRS 16 rules.

The adoption of IFRS 16 has two significant impacts:

? Recognition of Leased Assets: Public Sector organisations must now recognise leased assets and liabilities, increasing the size of the balance sheet. This also includes buildings, vehicles, equipment, and other leased assets.

? Changes to Budgeting and Expenditure Limits: The shift to on-balance sheet accounting under IFRS 16 impacts how leases and agreements are treated for budgeting purposes, particularly with respect to CDEL.

What is Capital Departmental Expenditure Limit (CDEL)?

CDEL is a key component of the UK government’s system of controlling departmental expenditure. It represents the limit on capital spending that public sector bodies are allowed to incur in a given financial year.

Key Features of CDEL:

? Capital Expenditure: CDEL covers capital expenditure, which includes investments in physical assets such as buildings, infrastructure, and equipment. It does not include day-to-day operating costs, which fall under the Resource Departmental Expenditure Limit (RDEL).

? Spending Limit: Each body /department is allocated a CDEL, which it must not exceed. This ensures that public sector capital spending remains within the limits set by the government’s fiscal framework.

CDEL is a critical budgeting tool for controlling capital investments and preventing overspending by public sector bodies. This is the primary reason why, in my opinion, the potential impact of IFRS 16 on CDEL MUST be an active consideration within ANY potential leasehold (or other property related) acquisition.

How does IFRS 16 affect CDEL?

The introduction of IFRS 16 has a direct impact on how leases are classified under CDEL. Previously, operating leases were treated as an expense in the Resource Departmental Expenditure Limit (RDEL) since they were off-balance sheet and accounted for as operating costs. However, under IFRS 16, most leases are now treated as capital investments, meaning they fall under CDEL rather than RDEL.

Key Impacts on CDEL:

? Shift from RDEL to CDEL: With leases now recognised on the balance sheet, the right-of-use assets created by these leases are considered capital assets. As a result, lease liabilities and the cost of the right-of-use assets now count toward a department’s CDEL. This can put pressure on departments’ capital budgets, as these lease assets reduce the amount of CDEL available for other capital projects.

? Potential for Increased CDEL Usage: Departments may find that more of their expenditure is classified as capital, increasing their reported use of CDEL and potentially limiting their ability to invest in other capital projects unless additional budgetary allocations are made.

Mitigating the Impact of IFRS 16 on CDEL

To manage the effects of IFRS 16 on CDEL, Public Sector organisations may need to take several steps:

a) Careful Lease / Agreement Management

Departments should carefully evaluate their third party occupancy arrangements and consider whether leasing still provides the best value for money under the new accounting rules. Some departments may opt to purchase assets outright, rather than leasing them, to avoid the impact on CDEL.

b) Budget Planning

Public sector bodies need to plan their budgets carefully to account for the inclusion of lease-related capital assets in their CDEL limits. This may involve working with HM Treasury to secure additional CDEL allocations or adjusting capital spending plans to accommodate new lease liabilities.

c) Reviewing Lease Terms

Departments should review the terms of existing and future leases to understand how they will be treated under IFRS 16. For example, short-term leases or low-value leases may still qualify for off-balance sheet treatment, which could help reduce the impact on CDEL. Any lease terms must be genuine and representative of the wishes of the parties e.g a lease of 364 days with a knowledge that a new lease will definitely be entered into on the 365th day to carry a Term forward would likely be challenged on audit.

d) Sound Prior Planning

Departments should continuously horizon scan to identify future agreements which would fall within IFRS 16, and plan the expenditure when allocating Capital

What are the Challenges and Opportunities for departments?

a) Challenges for Departments

The key challenge posed by IFRS 16 for departments is the potential reduction in available CDEL for other capital investments. With leases now recognised as capital, departments may find themselves constrained in their ability to fund other projects.

Additionally, IFRS 16 may increase the complexity of financial reporting and require significant adjustments to accounting systems and processes to ensure compliance.

b) Opportunities for Improved Financial Planning

On the other hand, it is argued that IFRS 16 offers the opportunity for greater transparency and a more accurate reflection of the government’s leasing commitments. By recognising leases on the balance sheet, departments can gain a clearer understanding of their long-term financial obligations, leading to improved financial planning and decision-making.

Conclusion

The adoption of IFRS 16 has introduced significant changes to lease accounting for Public Sector bodies, particularly in relation to how leases (and other agreements conferring a right of use for an asset) are treated within the Capital Departmental Expenditure Limit (CDEL).

While IFRS 16 ensures greater transparency and consistency in lease reporting, it also presents significant challenges for departments in managing their capital budgets.

To navigate the complexities of IFRS 16 and its impact on CDEL, departments must carefully manage their leasing arrangements, review lease terms, and plan their budgets with a clear understanding of how leases affect their capital expenditure limits.

I hope this article has been of some use, but as ever, should you require any support or guidance, please feel free to drop me a message and I will happily help wherever I am able (www.efmconsulting.co.uk). I have provided some useful resources below for those managing premises.

If in any doubt as to whether an occupancy agreement falls within the realms of IFRS 16, assume it does, and seek advice from finance colleagues prior to entering into the agreement. Ensure that the IFRS 16 impact has been factored into any Business Case or Financial model pertinent to your proposed acquisition.

USEFUL RESOURCES

Official IFRS Foundation Website

? IFRS 16 Overview: IFRS 16 on IFRS.org

? This provides the official text, basis for conclusions, and interpretations of IFRS 16.

IFRSbox (Independent Resource)

? IFRS 16 Explained: IFRSbox.com

? Provides simple, easy-to-understand explanations, training courses, and examples for IFRS 16.

IFRS 16 Practical Guides

? BDO IFRS 16 Publication: IFRS in Practice 2023/20240 - IFRS 16 Leases

? A thorough guide with practical examples and implications for various industries.