With the removal of the distinction between financial and operating leases as IFRS 16 comes into force, more than $2.8trn of assets globally is set to come on balance sheet for IFRS and US GAAP reporting firms. Treasurers should pay attention.
When an estimated extra $2.8trn of property, plant and equipment lease commitments are required to hit the balance sheets by new IFRS 16 rule changes, a host of financial indicators will be affected. The impact will create an upheaval for all involved businesses and their stakeholders, the likes of which have not been seen for at least 30 years. As balance sheets expand, leverage ratios will deteriorate and capital ratios will decrease. Corporate treasuries will need to respond, not least as their financial covenant ratios, around profitability or gearing for example, face potentially significant revisions.
The new lease accounting changes are the result of a joint project to bring US GAAP and IFRS accounting regulations for leases into line. Although the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will be publishing slightly different treatments, they both require operating leases to be capitalised on balance sheet, recognising a right-of-use asset and liability.
With the US GAAP version of IFRS 16 being announced in the next few weeks, from now on, all financial functions need to be working together to ensure their companies are able to comply when the new standards come into force on 1st January 2019 or 15th December 2018 for US GAAP.
From the start dates, both financial and operating leases must be accounted for on balance sheet, excluding certain short-term and small–ticket items. Previously, under IAS 17, operating leases were not required to be shown, except as a footnote. Under US GAAP it is expected that the P&L will remain ‘as is’ regarding the distinction between financial and operating leases and the treatment of interest and capital payments, whereas this technical distinction is removed for IFRS 16; this is likely to be the only major difference.
Whilst nothing changes in the business per se – there is no extra liability or cost – the new standards present a fundamental shift in the recognition of all assets and liabilities arising from leases. IASB says the new standard will remove any interpretive or ‘creative’ element to reporting, bringing clarity and an easier comparison of companies’ financial statements for all users, not just the sophisticated analysts who will already incorporate footnotes into their assessments.
For the estimated half of all listed companies using IFRS or US GAAP that these change will affect, the most commonly used financial metrics (including gearing ratios, current ratios, asset turnover, interest cover, EBITDA, operating profit, net income, ROE and operating cash flows) will be impacted by the new standard. Banks and other lenders, investors and analysts may all expect changes as a result of the revised reporting. It is likely that many firms will even revisit the ‘buy versus lease’ discussion in the light of impact on their balance sheets: this may have further implications for functions such as procurement, operations and corporate real estate.
From a lessor’s perspective there has been considerable push-back from the industry which is essentially why the sector has taken so long to institute change. The first IASB exposure draft received around 1,700 objections. Although IASB managed to push through most of its requirements, FASB acceded to the industry request for finance lease liabilities not to be counted as debt under Uniform Commercial Code (UCC) definitions so it will not breach covenants in the US, notes Tricia Bolton, leasing industry consultant and a treasurer of many years’ standing. “One of the key benefits of operating leases at the moment is that they are off balance sheet; the new regulation will largely remove that benefit,” explains Martin Kennard, Director of independent global lease portfolio management firm, Innervision. “It does not destroy but it will disrupt the leasing market. The lessors will now need to focus on the other benefits.”
Although IFRS 16 and US GAAP compliance for lease accounting is unlikely to have featured at the top of the agenda for most firms (especially given the long lead time), all companies with substantial exposure to leasing contracts will have their work cut out gathering and reviewing their active contracts, lease by lease, in order to produce the required reports, says Kennard. One of the key issues will be in identifying and then working out how best to manage all active leases, a task made more difficult in large global decentralised operations. But, says Kennard, there is an opportunity here to develop long-term leasing management efficiencies, assessing the cost and even necessity of contracts, identifying unaccounted for leases and possibly affording greater negotiating power.
With the deadline almost three years away, Kennard acknowledges that compliance may not yet be pressing for most companies. There is a possibility of early adoption where current IFRS 15 revenue recognition is in place but for many businesses the change will be to deadline and this, he warns, will arrive quicker than expected.
With the requirements for restating 2018 financials as part of the comparison process, the data needs to be in place. This effectively moves the deadline forward one year. Furthermore, in that period, every single operating lease must be located, analysed and recorded across every division and trading entity for it to be accurately accounted for as an asset on the balance sheet. This is a data-intensive search, he says. For a large and geographically spread company which has grown by acquisition it can take up to 12 months to get an accurate picture of a lease portfolio. “It’s not complex work but it does require a lot of effort and tenacity. Companies need to start thinking about this sooner rather than later.”
Underlining the urgency, Bolton serves a reminder that non-compliance means failing audit which will have serious consequences for financing. She urges CFOs and Group Treasurers, perhaps working in tandem with the Controller’s office, to start looking at how they will come by the information. “I would expect treasurers will be revitalising this information for the group and already understanding what it means because the balance-sheet impact and any changes of their debt-to-equity ratios could have a huge impact on any covenants they have in place.”
It is now key for the treasury, accounts and procurement to be involved in the pulling together and analysis of the leasing portfolio to provide proper control. Not least, this gives oversight of the documentation and should flag up potential for any cross-defaults (where the borrower is put in default if they default on another obligation), notes Bolton. With the possibility of compliance issues, fraud and simple wasting of company money, centralisation of all portfolio data brings transparency and the capacity to review and manage both contractual suitability and spend.
Assistance may be needed
In order for large corporates to unwind the complexities of their lease commitments, the advisory and validation services offered by the likes of PwC, KPMG or E&Y may be necessary. In addition to its own lease accounting advisory services and white papers on the topic, Innervision also provides its global clients with a “unique” online lease management platform, LOIS, which takes automated or managed manual feeds on all live portfolio data, all the way through from new to the end-of-contract stages.
Although transition relief may be available to limit the financial burden of compliance, IASB will be seeking up to two years prior partial (referred to as ‘modified’) or full ‘retrospective’ reports from firms alongside the new version so that a clear comparative figure is available of how their balance sheets have changed under the new regime. “Leases are typically at least 12 months in duration so there will be transition rules to consider,” notes Bolton. Being able to model a forward-looking balance sheet and assess the impact of both modified and retrospective comparative reporting approaches will inform when a company should best start implementing IFRS 16 and she feels a solution such as LOIS is best placed to compute the results.
The discussion may have been ongoing for some time and the topic may have been pushed onto the back burner. But now the heat is about to be turned up. Where a business is leasing simply because it is off balance sheet, the new rules will end that advantage. A change in the market and the relationship between lessee and lessor is inevitable with the amendment of the standards. The impact of these changes could have a dramatic effect on a host of commonly used financial metrics as well as treasury fundamentals such as banking covenants and, as Bolton warns, “non-compliance is not an option”.