In the last two Rethinking Treasury newsletters, Nik Tandy, Head of Thought Leadership ASP, highlighted the key changes to lease accounting under IFRS 16 and the potential challenges these changes pose. Changes to lease accounting under US GAAP (ASC 842) have also been introduced, however, it is important to note some differences from IFRS 16.

    Accounting for Lessees

    Financial Statement

    IFRS

    US GAAP Differences

    Balance Sheet

    • Increase in assets
    • Increase in liabilities
    • Change in net equity due to differing rate of reduction between lease assets and liabilities
    • Net equity may fluctuate due to the assets and liabilities reducing at different rates – this effect may differ from IFRS due to US GAAP have two lease accounting models (operating and finance)

    Income Statement

    • Increased EBITDA
    • Increased depreciation and finance costs
    • "Front-loading" of expenses
    • Unlike IFRS, US GAAP retained 2 lease expense models
    • With the "operating" lease model, there is no change to the income statement compared to legacy lease accounting

    Statement of Cash Flows

    • Increase cash from operating activities
    • Reduction in cash finance expense
    • For "operating" type leases, cash flows reduce cash from operating activities

    Managing FX

    Changes to lease accounting do not alter the economic exposures. Under old lease accounting rules, if you had a foreign denominated lease, there was FX risk. That risk is still there under new rules, however how that risk will impact a company’s financial statements is changed. Under ASC 830, foreign currency denominated monetary items need to be re-measured into earnings each financial reporting period (i.e. quarterly), based on changes in spot rates. Companies may need to reconsider how they are managing FX risk in leases due to the change in how this risk manifests itself in the financials.

    Less of a lease accounting issue and more of a hedge accounting benefit (ASC 815) – in a cash flow hedge, new accounting rules now allow hedgers to assume critical terms are matched within a 31 day window. With this 31 day window, designating cash flow hedges on this exposure is simplified and multiple foreign lease payments can be covered by the same hedge. This will give hedgers some flexibility when determining how to hedge foreign leases.

    As with FX risk, accounting rule changes do not change the underlying economic exposures of lease agreements

    It's important to carefully consider whether to use a fair value hedge of the liability versus a cash flow hedge of the rental payments. Typically a lease will have increasing rental payments over the life of the lease. This is in contrast to the accounting model which will amortise the balance of the liability down over time. Cross-currency swaps are sometimes the more efficient derivative to hedge longer term FX exposures, however creating a cross-currency swap that matches the cash flow risk will look very different from one that is designed to offset re-measurement risk. Another consideration for developing an FX hedge is the discounting of the lease liability, only managing the liability may under hedge the overall cash flow risk.

    Impact to Leverage and Interest Coverage Ratios

    A key difference between IFRS 16 and ASC 842 will directly impact leverage and interest coverage ratios. IFRS 16 will have a different impact on some rates because of moving lease expense out of EBITDA (by creating depreciation and interest expense); the rule changes under ASC 842 do not change how leases impact earnings. Therefore operating lease expenses continue to reduce EBITDA. In developing loan covenants under new accounting rules, it should be noted all relevant numbers to revert financial statements to pre-ASC 842 amounts should be available under lease disclosures required under ASC 842.

    Interest Rate Risk Management

    As with FX risk, accounting rule changes do not change the underlying economic exposures of lease agreements. There has always been an element of interest rate risk in leases, however changes in accounting may allow companies to look at managing this risk differently. Theoretically, companies could have always attempted to hedge rate risk in their leases. However, by now recognising a liability, hedging that risk and applying hedge accounting may be simpler (especially considering new hedge accounting rules). An example is the ability to apply short cut if swapping to floating – this was not possible before as leases didn’t result in a recognised liability. If hedging against rate moves (swap to fixed), companies may want to include leases in their pre-hedging strategies. While there are many similarities in the new lease accounting guidance under both GAAPs, companies should be mindful of some of the differences. This will help as companies evaluate financing and risk management alternatives under the new accounting regime.

    Disclaimer

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