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.

    In this first article of two, we focus more on the technicalities of compliance and the potential issues companies may face in meeting the requirements of the new standard itself. Next month, we will consider how the new Standard may impact the corporate decision making process.

    Impacts at a glance

    The major impact from the new accounting standard is the need for companies to recognise a Right of Use Asset ("ROU Asset") and a corresponding financial liability for the present value of the expected future lease payments. Depreciation will be charged on the ROU asset and interest is recognised via the accretion of the outstanding liability at the effective interest rate of the lease. Whilst there is no impact to total cash flow or profits over the life of the lease, there is a reclassification of expenses from above to "below the line".

    Balance Sheet Profit and Loss Account Cash Flow Statement

    Increased assets

    Increased EBITDA

    Increase cash from operating activities

    Increased liabilities

    Increased depreciation and finance costs

    Reduction in cash finance expense

    Reduced equity1

    Neutral (over life of lease)2

    Neutral

     

    1The exact impact will depend on the specifics of each individual lease and its remaining maturity at the point of adoption. Equity is likely to be reduced due to depreciation charges leading to asset values falling faster than financial liabilities

    2Costs are relatively front loaded compared to existing accounting standards

     

    The importance of these changes will vary by industry due to the extent to operating lease usage. Most likely to be affected from a corporate perspective include retail, telecommunication, metals and mining industries, oil and gas and airlines. All of which have substantial operating lease usage or contracts that contain a lease. Companies in these industries will need to pay particular focus to the upcoming changes and the potential impacts to their financial ratios and indeed behaviour which we will examine later.

    Implementation challenges

    Whilst it is important to understand what the changes may mean in terms of behaviour, it is worth spending some time understanding some of the complexities and challenges in complying with the rules themselves. The initial challenge with compliance should not be underestimated and we cover briefly below some of the major considerations.

    Whilst, IFRS16 is purely an accounting change and there is no change in the underlying economics, there will be significant impacts on many key metrics, be it EBITDA, Asset, turnover and importantly Gross debt

    Firstly, whilst operating leases were relatively easy to account for, the information requirements under IFRS16 are much more onerous meaning compliance with the standard is a complex logistical exercise in itself. The need to gather detailed data on all leases, potentially from multiple countries where leases are negotiated in different ways is coupled with the need to make estimates and apply judgments consistently across the lease portfolio. The fewer standardised leases there are across the company, the harder this job becomes and all companies, even those with pre-existing lease management systems have found the data collection process time-consuming.

    Secondly, the required calculations themselves are not straightforward. The Standard requires that expected future payments, including any likely lease renewal where there is an option to do so, be discounted at the inherent cost of the lease. Where this discount rate is not readily available, a suitable incremental borrowing cost should be used. This can be tricky enough for companies in a market where borrowing costs are changing, but is particularly troublesome for very long dated, or potentially perpetual leases where extension options exist that are highly likely to be taken up. In some cases it is very difficult to pinpoint what the correct discount rate should be, with the average life of some leases exceeding that of the longest issued government debt for the country in which the asset being leased resides. Whilst these sort of issues are the exception rather than the norm, they are of sufficient quantum that specialist advisory teams, particularly within the accountancy profession, have been established to assist.

    Once these compliance issues are resolved, and expected values are known, understanding how key performance metrics are likely to be impacted, both on transition, and on an ongoing basis is important to understand and more importantly communicate effectively to all stakeholders. Whilst IFRS16 is purely an accounting change and there is no change in the underlying economics, there will be significant impacts on many key metrics, be it EBITDA, Asset, turnover and importantly Gross debt. For many companies, non-GAAP (non-Generally Accepted Accounting Principles) adjustments have been made by ratings agencies etc. to take accounting of off-balance sheet items. On the whole, IFRS16 changes will be broadly consistent with these non-GAAP measures1. However, for some companies, the changes may be unexpectedly large, and may need to be carefully communicated to stakeholders. The most obvious will be the level of lease liabilities themselves, which for certain companies may be significantly greater than that already disclosed. IFRS16 requires the recognition of expected lease payments, whereas current rules require the disclosure of the legal minimum amount.

     

    The introduction of IFRS16 this year will have significant impacts on many companies reported results, which in turn may ultimately lead to a change in behaviour in terms of both usage of leases and risk management of related exposures. Will we look into these aspects in more depth next month. In the meantime companies should not underestimate the potential challenges they could face in complying with the new rules and what they may mean for their key reporting metrics.

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