IFRS16 becomes mandatory in most countries for reporting periods beginning on or after 1 January 2019. Whilst the impact for lessors is minimal, the same cannot be said for lessees, with most leases coming on to balance sheet, with the exception of low value assets and short term leases. At present, financial statements will often be adjusted by analysts to reflect off-balance sheet lease arrangements. Going forward this will no longer be necessary with all companies required to present their assessment of their lease liabilities under a single consistent framework.

    Operating leases are a valuable instrument in the corporate tool box providing flexibility that cannot be achieved with more traditional purchased assets. At the same time, the accounting for operating leases has provided opportunities for companies to keep assets off-balance sheet which in turn has proved beneficial to a number of key ratios.

    IFRS16 heralds a change in the accounting for all leases, with most coming on to the balance sheet, and whilst it can be argued that accounting should not drive economic decisions, the changes to company balance sheets, earnings and key performance indicators may be do great as to change behaviour, particularly when coupled with the complexities of compliance which we examined in our last article.

    Implications on behaviour

    Although IFRS16 is just a change in the accounting for leases, and not the economics of the leases themselves, it is inevitable that there will be some change in behaviour as a result of operating leases coming on to balance sheet.

    The most obvious area where this behaviour will change is in respect to foreign currency leases. Previously these were able to manage in the same way as forecast, but unrecognised, foreign currency payments. Now with the need to recognise the liability on balance sheet, there is a corresponding revaluation through earnings of the entire lease liability, leading to significantly increased FX gains/losses in earnings, which ultimately will impact distributable profits and other key reporting metrics. Hedging ratios are likely to increase as many companies have a policy to minimise FX gains/losses arising on foreign currency monetary items. Whilst this may seem like a case of the accounting dog waging the accounting tail, it is equally true that the off-balance sheet nature of the liabilities previously may have been a cause of potential underhedging. Whatever the correct answer, it is clear that the change in rules will be driving companies to examine their hedging strategies and policies in relation to these items.

    Secondly, it is likely that companies will try to rationalise the types of leases they execute, with a particular focus on standardising the terms of leases of a similar nature. This will help minimise the effort required with ongoing compliance, and is an area where the accounting rules may help drive more efficient processes and centralised control.

    Hedging ratios are likely to increase as many companies have a policy to minimise FX gains/losses arising on foreign currency monetary items

    Commercial negotiations between existing lessees and lessors are another area where IFRS 16 will have an impact, at least with respect to new leases. Lessees will be looking for greater flexibility and potentially shorter lease terms, particularly if this will enable them to recognise a smaller lease liability at inception. Lessors will clearly look to maintain their current positions as much as possible, but it is likely that some changes to the existing structure of leases will occur that will be viewed as mutually beneficial.

    However, for certain assets, the benefit of leasing as opposed to owning may be more fundamentally examined. Leasing provides an element of flexibility, and under operating lease arrangements has the added benefit of being off balance sheet. With that benefit disappearing, and potentially large Right of Use assets and associated liabilities being recognised, companies may take the decision that it is better to outright own the asset directly and finance via other means than continuing with a lease model. Not only does this give greater certainty over the valuation of the asset, as it is derived directly from a transaction price rather than less transparent estimates, it also may be perceived of being of higher quality, being entirely under the control of the company, rather than representing a right of use. This in turn will lead to the greater use of other funding sources than previously envisaged, such as public or more general bank debt.

    Operating leases have commonly been used in structured arrangements as a way of taking existing assets, particularly property, off-balance sheet. This has generally been achieved via some form of sale and leaseback arrangement that also retains some equity interest in the asset itself. Transactions were structured such that an asset sale was recorded and an operating lease recognised, significantly improving gearing, other debt and asset turnover metrics. For companies that have entered into such structures in the past, or for those that have been heavily reliant on the use of operating leases, IFRS16 is likely to have significant implications in terms of reported key performance ratios. These companies may seek to develop alternative structures that achieve similar results, or may need to more fundamentally assess whether these arrangements still make sense given the new reporting environment.

    Finally, borrowing covenants are another important area of focus. Whilst many agreements are written with “frozen GAAP” language, allowing for previously existing accounting rules to be used when accounting standards change, this is only a temporary fix. Going forward, audited financial statements will have to comply with the new guidelines and so companies are carrying out impact assessments on their existing covenants and beginning the process of renegotiating existing covenants where necessary and determining suitable alternatives to existing ones for their future borrowing plans.

    The changes to the lease accounting rules have been a long time coming, with the project originally added to the International Accounting Standards Board’s agenda back in 2006. The impact on companies’ balance sheets and behaviour will be even more long lasting. The operating lease model and associated accounting allowed for companies to effectively have the use of significant amounts of assets whilst keeping them off the balance sheet. The initial shock of bringing these assets on to balance sheet, will lead to a re-assessment of why, when and how leases should be used. With IFRS 16 becoming mandatory from 1 January 2019, it will still be some time before the full picture becomes clearer as companies start releasing their periodic reports. Exactly how companies react to the changes is likely to take longer still and is something to watch closely.

    Disclosure and disclaimer

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