IFRS 16 – Beware the secondary impact of FX

IFRS 16, the new accounting standard for leases, will become mandatory from 1 January 2019 in most jurisdictions. Treasurers should be aware of the potentially material FX impact that could arise if operating lease exposures are denominated in a foreign currency. The need to recognise the present value of all future lease payments as opposed to just those relating to current periods could significantly increase the FX translation risk and in turn reported earnings. It is therefore possible that there may be a fundamental change in the way the FX risk of such leases is viewed as impacting a business, even where the underlying cash flows have remained unchanged.

We examine the potential accounting implications in more depth below before considering how treasurers may seek to mitigate the potential impacts.

Key implications of IFRS 16

Removing the distinction between the current operating and finance lease models, IFRS 16 recognises all leases greater than 12 months on balance sheets as a right of use asset with a corresponding liability reflecting minimum lease payments. From a balance sheet perspective, this will lead to an increase in both assets and liabilities. In terms of earnings, operating lease expenses will be replaced by depreciation and inherent interest costs, all of which will lead to potentially significant changes in leverage and debt servicing ratios.

This table explains the IFRS 16 impact on various metrics from the lessee’s perspective.

Figure 1: IFRS 16 lessee accounting – recognition, measurement and effects on P&L compared to IAS 17

Whilst the impact on cash flow and PBT should be broadly neutral (as shown in Figure 1), if the lease contract is denominated in a foreign currency, there could be a significant and asymmetric P&L impact from FX. Newly recognised foreign currency liabilities could create FX volatility in earnings which will not be offset by a corresponding revaluation of the ROU asset.

Food for thought: Which is the ‘correct’ risk to manage, accounting or economic?

A rational risk management approach should take as broad of a view as possible, managing all economic risks a company may face. However, in practice, many hedging decisions are biased towards focusing more closely on those risks with an immediate and visible accounting impact.

Foreign currency operating leases create a complex issue for treasury managers. Whilst foreign currency payments present an economic risk in isolation, the economic currency of the underlying asset being acquired must also be considered, and can often be different to the functional accounting currency of the business. Until now the foreign currency risks on both sides of this decision were effectively off-balance sheet. However, under IFRS 16, the liability side of the equation is now very transparent.

It is a common rule that the accounting tail should not wag the economic dog, implying that this change of accounting should not impact risk management behaviour. However, in this case, it is also possible that the absence of any direct accounting impact from foreign currency movements may have led to suboptimal decisions being taken in the past.

Figure 2: The accounting tail wagging the economic dog

It is likely that the right response here will lie somewhere in between the two and be very bespoke for each company, based on its specific exposures. Understanding how risks can impact a company’s performance – both directly and indirectly – as well as how these risks materialise in terms of reported earnings is key.

Airline industry – an assessment of the FX impact from IFRS 16

Airlines as an industry will be particularly impacted by IFRS 16. The predominance of USD-denominated leases, particularly in Asia, on non-USD functional balance sheets is likely to lead to significant additional FX volatility.

One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet

– Sir David Tweedie, Former Chairman of the IASB, revealed during a speech to the Empire Club of Canada on 25 April 2008

Figure 3: Potential average increase in gross debt due to IFRS 16 for the airline industry in the region, by countries (# of companies surveyed). Source: Bloomberg and the latest company disclosures as of 5 March 2018. Note: For illustrative purposes only.

Figure 4: Potential average FX loss as a percentage of current EBITDA (resulting from a 5 per cent USD appreciation), by countries (# of companies surveyed). *One company from Thailand has been excluded because of negative EBITDA. Source: Bloomberg and the latest company disclosures as of 5 March 2018. Note: For illustrative purposes only.

Based on our simplified analysis¹ we calculate that on average, Asian airlines could expect a 134 per cent increase in gross debt and a potential negative earnings impact equal to 19 per cent of EBITDA for every 5 per cent USD appreciation against their local currencies due to the potential FX losses arising on the revaluation of these new foreign currency liabilities.

Conclusion

The accounting changes of IFRS 16 will undoubtedly have implications for the reported performance of many companies. On the surface, it can be argued that as this concerns only an accounting change, there is no real change to underlying risk and therefore no real change needed to any hedging policy or strategies. However, this ‘stay put’ approach may lead to unwanted accounting volatility, and in turn other undesirable side effects.

A more robust approach would be to use the upcoming change as an opportunity to revisit existing exposures and hedging policies to determine whether they should be refined to both better manage risk and its impact on reported performance.

Importantly, this analysis should consider how risks interact and impact on the entire business, both directly and indirectly, as well as any natural offsets that may exist between revenues, expenses and finance costs.

¹ We assume that the full PV of minimum lease payments from operating leases was USD-denominated and the resulting USD liability will be recognised on the local airlines balance sheet. We take simple averages to arrive at the country average with no regard to the size of each company. This is a crude analysis aimed at providing an estimate of the potential secondary order impact of FX movements once the new rules of IFRS 16 come into play. We have looked at the marginal implications only therefore have not taken into account the potential impact of a movement in USD on any other line items.