The new lease accounting rule of IFRS16 will lead to a significant change in company balance sheets both on transition as well as on an ongoing basis. A fundamental reason for the change in rules was to allow for greater comparability between companies, and remove the discrepancies between the accounting for finance and operating leases. However, it seems likely, that due to the complexity of application, a degree of subjectivity in terms of key inputs, as well as the choices over how to initially adopt the new Standard, comparability between companies may actually become harder in the short to medium term. Stakeholders will need time to adapt to the new reporting environment and gain a clearer understanding of the impacts on financial performance.
In previous articles we have focused on the Standard itself and its potential implications in term of company behaviour. Here we look at some of the key areas that may lead to problems with comparability both in terms of relative performance against previous years, as well as across industry peers. Finally, we briefly consider how companies may seek to address these issues in terms of how they communicate performance to the market.
Lease accounting rules are complex and require significant use of judgment
The calculations required to determine the liability relating to lease is complex and requires significant amounts of judgment. Companies may have hundreds, or even thousands of individual leases and each should be evaluated separately and then aggregated to arrive at the final amount.
Due to the nature of many lease contracts, it is unlikely that the inputs required to arrive at the liability will be easy to identify. Estimates may be required in terms of likely lease maturity where renewal options are available; discount rates inherent in the lease are rarely explicit meaning companies need to determine the relevant discount rate for that particular lease, taking into account relevant security etc. Transition choices further complicate matters and are discussed further below.
As such, this behavioural change will take several years to fully feed through until a new status quo is reached, further diminishing like for like comparability year on year.
Additional complications, and potential divergence in practice, can arise when looking at service contracts. In particular, where service contracts incorporate an inherent lease – i.e. where a specific asset is exclusively provided as part of the service contract – then this component should be accounted for as a lease. Again, complexity over how exactly this component is separated from the host service contract is likely to involve a deal of judgment and is unlikely to be treated fully consistently across different companies and geographies, leading to a potential lack of comparability.
Transition adjustments can be carried out in different ways
Transition arrangements are also very important to understand, as the choices made here can have very significant implications for both the lease liability recognized at transition (and when) as well as impacts on equity and importantly earnings going forward.
Put simply, companies have the choice as to whether to apply the rules prospectively or fully retrospectively. The latter appears to be the most popular choice as it tends to lead to both a lower liability recognized at transition (due to higher discount rates being used) and a smaller earning impact going forward, both because the initial liability is lower and with IFRS16 "front-loading" expenses, by applying full retrospective transition, the leases recognized at transition are further through their relative lives at this time.
Again, these choices mean that different companies can apply different approaches and companies with similar expenses in terms of cash flows may end up reporting significantly different numbers in relation to existing lease contracts. This will be exacerbated further due to the estimates that are required to be made when going back in time. Some companies will have assets they have leased for many years, even decades, meaning they are required to estimate discount rates from many years ago. With liability values very sensitive to discount rates being used, even small discrepancies between companies in terms of these initial calculations could lead to noticeable differences in reported performance going forward.
Leases with similar economics can be reported differently
IFRS16 contains detailed guidance on variable lease payments, in particular how they should be treated depending on how that variability arises. For payments that are linked to an index such as inflation, there should be an adjustment made to both the lease liability and carrying value of the related right of use asset. However, for variable payments linked to performance, such as future sales, these addition costs are taken immediately to the profit and loss account. As such, it is possible that companies with similar lease costs in terms of cash flows, may report very different lease liabilities, assets and both operating and non-operating expenses.
Behaviour is likely to change
In our previous articles we discussed the potential impact on behaviour for those companies that use leases. Likely behavioural changes include a switch towards buying rather than leasing, shortening and standardization of lease terms as well as other contractual changes – potentially looking to add additional variability through performance related payments. All these changes will further decrease the comparability of performance over time, as the use and nature of leases changes from those initially identified and recognized on balance sheet at transition. But this change will not happen quickly as it is highly unlikely that companies will terminate existing leases immediately, rather wait until they are due for renegotiation and look to make changes then. As such, this behavioural change will take several years to fully feed through until a new status quo is reached, further diminishing like for like comparability year on year.
What are companies planning?
Many companies are looking at providing additional "non-GAAP" information, to assist stakeholders in understanding the new results, how they can be reconciled to before, and what they may look like going forward. Whether this is done by process of "frozen-GAAP", reversing all the new outputs and bringing results in line with previously existing accounting standards, or by developing their own "adjusted results" to clarify the impact of the new lease accounting rules and how they can be interpreted going forward is very much an individual company choice. What is clear is that communication is key, and companies are looking to ensure that there are no unexpected "nasty" surprises when the time comes to report performance.
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