2018 has been a year of regulatory upheaval for corporates, with new directives such as MiFID II and GDPR forcing companies to change the way they operate. Company treasurers now face a similar fate, as a new accounting standard that will dramatically impact company balance sheets officially comes into force in just under six months’ time.
IFRS 16, which was first announced in 2016, will be momentous for all companies from January next year. The accounting standard will require companies to include operating lease debt on their balance sheet. While many companies have prepared their investors for the change, some have not been as organised, says Simon Lello, Head of Global Multinationals, MUFG. “This could lead to a big surprise for investors and companies alike, both of whom could face a cliff-edge transition while attempting to implement the new rule.”
Volatility could be of particular concern, as the reclassified debt which will appear on the balance sheet will simply be a hypothetical figure calculated by discounting the value of future lease commitments. In essence, notes Lello, the calculations “could be highly volatile”, with “a large amount of subjectivity baked into the assumptions”.
This method means that while transparency will be improved, there will be issues around comparability. This is also true when it comes to credit rating agencies, who will adjust for operating leases in different ways.
IFRS 16 should not have an impact on companies’ ratings, as agencies have already factored in the risk from IFRS 16. Indeed, they have been lobbying to bring operating leases onto the balance sheet for the past 20 years. However, says Anil Jhangiani, Director, MUFG, the difference in calculation between rating agencies and companies “could be material and will cloud comparability”.
The implementation of IFRS 16 will be particularly felt in the UK and Nordic countries, due to the disproportionate use of operating leases. The UK and Denmark are among the countries with the longest lease terms, at five to ten years, compared to European averages of three to five years. As a result of the new accountancy standard, net debt across the S&P Euro 350 is expected to increase by 16% to €306bn. “Although Denmark, Sweden, Switzerland and Norway will all see their net debt increase proportionally more than the UK, Lello believes that the UK will still be most affected, given its already high level of net debt at €400bn versus €175bn in the other countries combined.
“Corporates in these countries will feel the effects of IFRS 16 more acutely, especially in industries such as retail and aviation, which depend on operating leases,” says Jhangiani. Indeed, the industrial sector, which includes airlines, will see net debt increase by 43%, compared to the average of 26%. “It should be noted that while there will be no cash impact on companies once IFRS 16 comes into force, many companies and investors are not prepared for the huge increase of recorded debt on balance sheets.”
In order to mitigate the effects of such a cliff-edge transition, corporates need to begin communicating these effects to debt and equity holders well in advance of its implementation. While more financially-solid companies will be able to continue to apply the old accountancy standards for financial covenants purposes by leveraging the frozen GAAP clause, Lello says the impact of IFRS 16 will be far more significant for those companies who are not investment-grade rated, particularly retailers. “Companies with financial covenants on their bond and loan documents will need to undertake discussions with their banks and lawyers to redraft different covenants,” he says. “Compounding this issue is the simple fact that the market has not yet reached a consensus on how to redraft financial covenants.”
Window of opportunity
Those companies that are weaker on the ratings spectrum will have less negotiating power with debt investors around tweaking covenants. Banks could insist that covenants are increased to include the operating leases that will now sit on the balance sheet.
However, says Jhangiani, we know that the market is currently borrower-friendly. “Treasurers should take advantage of this window of opportunity by proactively negotiating with their banks now. If the credit cycle were to turn, as many expect, and we entered a less creditor-friendly environment, the impact of IFRS 16 could be even more pronounced.”
While there have been some early adopters already of IFRS 16, with only six months to go until it comes into force, it is vital that all companies begin preparing now. For Lello, complacency towards IFRS 16 could leave companies in a worse position, “with confused investors and banks unwilling to renegotiate financial covenants”. Through early negotiation and communication, companies will be able to mitigate against the worst shocks of IFRS 16.