New lease commitments could leave CFOs with that sinking feeling

SIR DAVID TWEEDIE once remarked that he had never flown on an aircraft that was on an airline’s balance sheet. So irked was Tweedie, one of the chief architects behind the creation of international financial reporting standards, by this that he once quipped that “one of the great ambitions before I die” is flying on an on-balance sheet aircraft.

Sixteen years after the IASB’s former chairman voiced his complaint, the global accounting standard setter has published rules that will force companies around the world to add close to $3tn (£2.07tn) of leasing commitments to their balance sheets.

The new standard, IFRS 16, ends years of debate over off-balance sheet finances and will see more than one in two public companies around the world recognising leases as new assets and liabilities for the first time.

Heralded as “one of the most significant developments” in the history of IFRS, the new rules will provide investors with more transparent and reliable information about a company’s leasing commitments, without having to make difficult estimates about a company’s true level of debt. It will also improve comparability between companies that lease and those that borrow to buy.

“These new accounting requirements bring lease accounting into the 21st Century, ending the guesswork involved when calculating a company’s often-substantial lease obligations,” says Hans Hoogervorst, chair of the IASB. “The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows.”

Such landmark changes will alter the balance sheet, income statement and cashflow statements for companies with material off balance sheet leases. Indeed, research by PwC finds the new standard will see a 13% increase in EBITDA and a 22% increase in interest-bearing debt.

“For companies in some industries the impact will be even more stark. For example, the average expected increases for retail business are 41% and 98% respectively,” says James Chalmers, PwC’s UK assurance leader.

Entities that have significant operating leases, such as lessees of real estate, large equipment and machinery, and transportation vehicles, will be most affected by the standard, which is effective 1 January 2019. Worst hit will be airlines, retailers and hotel companies which lease property and aircraft over long periods. By its own calculations, the IASB estimates that future payments for off-balance sheet leases could equate to almost 30% of assets on average [see table]. Indeed, for some airlines, the value of their off balance sheet leases is equivalent to more than 100% of the value of the airline’s total assets.

The negative impact the standard will have can be seen instantly from the impact on Tesco’s accounts with one analyst suggesting the retailer’s liabilities will go from £8.6bnto £17.6bn at a stroke.

Broader impacts

There are some exemptions. In particular, short-term leases of less than 12 months and leases of low-value assets, such as personal computers, are exempt from the requirements. Nevertheless, finance functions dealing with big lease commitments will have to commence the process of collating the necessary data to accurately reflect their liabilities.

“Companies should not overlook the broader impact, including systems and data requirements, loan covenants, distributable profits and the effect on any targets for remuneration purposes,” says Chalmers.

The main challenge for finance functions is ensuring long-term leasing commitments are matched with economic substance in the balance sheet, Stephen Herring of the Institute of Directors’ policy unit tells Financial Director.

“The IoD position is we favour accounts reflecting the reality of transactions,” Herring says.

Companies will now recognise a front-loaded pattern of expense for most leases, even when they pay constant annual rentals. And the new requirements introduce a stark dividing line between leases and service contracts – the former will be brought on-balance sheet, while service contracts will remain off-balance sheet.

The accounting changes do not affect cash flows directly. However, given the scale of the accounting change, Brian O’Donovan, UK partner in KPMG’s International Standards Group, expects that companies will be keen to understand the size of the lease liabilities arising from transactions they enter into between now and 2019.

“No one wants to see accounting drive business behaviours – the tail shouldn’t wag the dog. But if accounting consequences are in the mix when a company is considering a deal, then the mix will change. For example, this standard essentially kills sale-and-leaseback as an off-balance-sheet financing proposition,” he says.

Agree to disagree

CFOs working at companies listed both sides of the Atlantic will also likely need to manage two sets of accounts for subsidiaries that use IFRS and US GAAP after the IASB failed to agree a converged leasing standard with US counterpart FASB.

FASB and the IASB spent ten years locked in convergence efforts, yet ultimately agreed to disagree about how corporate lease customers should report lease expenses on their income statements. FASB went its own way – it will require a dual approach that maintains the distinction between operating and capital leases – and is due to publish its own set of rules in the coming months.

“If you’re listed in both the US and the UK, you’ll need to produce two sets of numbers,” Eddy James, technical manager at the ICAEW’s financial reporting faculty, tells Financial Director. “What’s on the balance sheet would be the same; it’s just what goes into the profit and loss accounts will be some of the leases – the ones that used to be operating leases under the old regime.”

The primary area of difference, he explains, is on recognising expenses on certain leases. The end effect is that US businesses are set to continue with a straight-line expense profile, while IFRS will now be a more front-loaded expense, something the IASB predicts won’t make a drastic difference for companies, particularly if they have a big portfolio of leases at differing points in their lifespans.

The diverged standards will also likely harm comparability. “It’s ironic that the outcome of this long-running convergence project will be divergence in accounting for common lease types,” says Donovan. “The new IFRS and US GAAP standards will introduce differences in the profile and presentation of annual lease expense where none currently exist.”

More widely, the convergence of standards between the IASB and FASB has been a politically charged issue with some EU standard setters and policymakers unhappy with the IASB’s perceived focus on converging with US standards.

One concern for Nigel Sleigh-Johnson, head of ICAEW’s financial reporting faculty, is the need for the EU to formally endorse the standard before it can be used by European companies.

“I would urge the European Commission to get the complex process of endorsement underway as soon as possible, especially considering that some businesses may wish to adopt the new standard early,” he says.

The EU is currently mulling the endorsement of another significant reporting standard – IFRS 9 – and while both standards will likely be approved, and delay could hamper companies efforts to adopt.

That, though, is not only a small price to pay, but one that should not come as a surprise, ICAS’ director of technical policy James Barbour says.

“This shouldn’t be a surprise to anyone because it’s been so long in the pipeline,” Barbour tells Financial Director. “We welcome the fact the IASB has substantively achieved the one model for dealing with leases. This makes it more transparent for users of accounts, particularly investors, to see the true level of debt a company has and the true level of the assets.

“For companies, they’ll take the view that this will come in. There will be a lot of data collection and there may even be consideration as to whether they will still do business as they currently do,” he adds. “Will they potentially try to restructure transactions? There is a lot they will have to consider, but they have until 2019 to get it right.”

Leases: What you need to know

What changes in a company’s balance sheet?

IFRS 16 eliminates the classification of leases as either operating leases or finance leases for a lessee. Instead all leases are treated in a similar way to finance leases applying IAS 17. Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as lease assets (right-of-use assets) or together with property, plant and equipment. If lease payments are made over time, a company also recognises a financial liability representing its obligation to make future lease payments. The most significant effect of the new requirements in IFRS 16 will be an increase in lease assets and financial liabilities. Accordingly, for companies with material off balance sheet leases, there will be a change to key financial metrics derived from the company’s assets and liabilities (for example, leverage ratios).

What does IFRS 16 mean for a company’s income statement?

For companies with material off balance leases, IFRS 16 changes the nature of expenses related to those leases. IFRS 16 replaces the typical straight-line operating lease expense for those leases applying IAS 17 with a depreciation charge for lease assets (included within operating costs) and an interest expense on lease liabilities (included within finance costs). This change aligns the lease expense treatment for all leases. Although the depreciation charge is typically even, the interest expense reduces over the life of the lease as lease payments are made. This results in a reducing total expense as an individual lease matures. The difference in the expense profile between IFRS 16 and IAS 17 is expected to be insignificant for many companies holding a portfolio of leases that start and end in different reporting periods.

Are there any implications for cash flows?

Changes in accounting requirements do not change amount of cash transferred between the parties to a lease. Consequently, IFRS 16 will not have any effect on the total amount of cash flows reported. However, IFRS 16 is expected to have an effect on the presentation of cash flows related to former off balance sheet leases. IFRS 16 is expected to reduce operating cash outflows, with a corresponding increase in financing cash outflows, compared to the amounts reported applying IAS 17. This is because, applying IAS 17, companies presented cash outflows on former off balance sheet leases as operating activities. In contrast, applying IFRS 16, principal repayments on all lease liabilities are included within financing activities. Interest payments can also be included within financing activities applying IFRS.