Regulation & Standards

Making work for busy hands? IFRS 16 and the treasurer

Published: Jul 2019

Closeup of business people working together and pointing at a pie chart

IFRS 16 is the new accounting standard that requires companies to include operating leases on their balance sheets. Since it came into force on 1st January this year, what has been its impact and how have treasurers been getting involved?

There can be few regulations that don’t have at least one downside. The IFRS 16 lease accounting standard brings transparency to the balance sheet but, for most finance functions, is a source of rather a lot of extra work.

The underlying assets of finance leases have always been reported on balance sheet. The new regulation, which applies to all listed firms with accounting periods ending on or after 1st January 2019, requires operating leases to now be recorded on balance sheet. The statistics in 2016 showed that listed companies had US$3.3trn of lease commitments of which 85% or US$2.8trn were probably off balance sheet then.

Previously, under IAS 17, operating leases could be reported in notes to the accounts of the financial statement as ‘lease commitments’, and even then, only as an imprecise contractual amount; future exercised lease options, for example, were excluded.

The main rating agencies have been incorporating adjusted lease impact for many years, treating off balance sheet operating leases as if they were on balance sheet. However, most other stakeholders could not accurately assess a company’s debt if it was not on the balance sheet. IFRS 16 effectively eliminates the difference between operating leases and finance leases for lessees (though not lessors). It is a rule intended to create transparency for investors, lenders and analysts, giving them greater precision when comparing companies in the same industry or rating category.

Impact

The annual Corporate Debt and Treasury Report issued by international law firm, Herbert Smith Freehills, notes that where IFRS 16 applies, even though it has no cash impact on companies, the effect is that “lessees will appear to have more assets but also more debt”.

Although in the financial services sector it does not necessarily form a material balance (one that could influence the economic decisions of report users), the same cannot be said in the corporate space, where lease numbers can be immense.

Indeed, as a result of that vastness, some corporates chose to be early adopters of the IFRS 16 full retrospective model. This requires them to calculate every single lease to try to reduce the P&L impact. They are effectively restating figures at year-end, as if IFRS 16 had always been applied; the other option – the modified retrospective approach – means comparative figures are not restated to reflect the adoption of IFRS 16, but then the figures appear massively skewed.

IFRS 16 is far-reaching. Approximately 120 nations and reporting jurisdictions permit or require IFRS for domestic listed companies. Of these, around 90 countries have fully conformed with IFRS requirements. Where IFRS 16 has not been directly adopted (in the US, for example), a version that follows it closely will usually have been subsumed into domestic GAAP (US GAAP is broadly the same but does have some key differences with IFRS, particularly in relation to the application of discount rate and the exclusion of the low value exemption in the US).

Obviously, the sectors that have depended more on operating leases, will be most affected by IFRS 16, especially where price of debt is linked to amount of debt. The likes of consumer and retail, telecommunications, transportation, and energy (especially oil and gas) now have their work cut out to maintain compliance. With a retailer such as UK supermarket Tesco citing upwards of 9,000 leases, that effort is significant.

Some corporates have retained pre-IFRS 16 treatment of operating leases in their bank facility agreements. This is the so-called ‘frozen GAAP’ provision that allows the use of accounting principles active when a facility was entered into, thus not requiring adherence to principles that follow, such as IFRS 16. These companies have a degree of protection for a while, but may have to reconcile pre- and post-IFRS 16 figures for covenant compliance purposes.

The challenge here, according to the Herbert Smith Freehills report, “will be for borrowers to agree with lenders the required flexibility for permissions baskets, ratios and related definitions in their bank financings as well as to solve the issue more generally for their floating GAAP financings”.

What’s also particularly interesting to CFOs and CEOs – and shareholders – is the impact that the implementation of IFRS 16 has on EPS too; it is dilutive for EPS because interest charges on leases tend to be higher in the early years, hitting earnings per share initially but becoming EPS accretive at the end of a lease when interest charges are less.

Simon Lello, Managing Director UK Corporate Banking, MUFG

The implication, in part, is that companies that are weaker on the ratings spectrum, or without frozen GAAP protection, will have less negotiating power with their banks around tweaking covenants. Indeed, with IFRS 16 in force, banks could start insisting that covenants are increased to include the operating leases now sitting on their clients’ balance sheets.

Where ladder pricing is used on loans (greater debt equals higher pricing), the sudden increase in booked debt could see pricing increase significantly, perhaps as much as threefold, notes Simon Lello, Managing Director UK Corporate Banking, MUFG.

However, because lease liabilities now have to be calculated precisely, with each and every lease modelled using a particular borrowing rate as an assumption, he adds that there have been “some happy outcomes” in terms of that liability being a little bit less than expected. For others though, it has gone the wrong way.

Typically, a company will have to compute an incremental borrowing rate (IBR), being the rate of interest that a lessee would have to pay to borrow over a similar term and with a similar security the funds necessary to obtain an asset of similar value to the right-of-use assets in a similar economic environment. Alternatively, lease payments can be discounted using the interest rate implicit in the lease, if that rate can be readily determined. Treasurers are well placed to opine and advise on all this within their companies.

Treasury role

As part of the preparation for IFRS 16, treasury would have seen the need to put in place robust financial frameworks around the new measure. A basic principle of corporate governance is that companies are subject to restrictions in their memorandum and articles of association in terms of overall borrowing powers, says Lello. “Clearly there was need in every case to check that suddenly having a large number of leases coming onto the balance sheet would not breach that borrowing power.”

There was a lot of work done behind the scenes at most big users of lease debt as they sought to amend agreements, governance and build mechanisms to track compliance. The discussion now, notes Lello, is for any new leases to be evaluated in a similar light as for any other new debt obligation.

Treasurers will also now be looking at the economics of lease transactions, rather than primarily as an accounting ‘solve’ for getting debt off the balance sheet. Indeed, notes Lello, some companies are now more closely comparing the cost of a lease debt with a bond issuance, private placements or bank loans.

A side effect of the new standard is that IFRS 16 is dilutive to EPS at the beginning of a lease and accretive to EPS at the end of a lease as interest charged is higher in the earlier years and reduces over time.

Anecdotal evidence from Lello suggests some treasurers have been “surprised” by some of the high costs of lease debt seen, particularly looking further down the curve in terms of lease size (for example for vehicles, plant and equipment). A silver lining of IFRS 16 is that it presents an opportunity for companies to explore, through the necessary high degree of precision and granularity required to compute IFRS 16 calculations, a data set capable of comparing the relative cost of lease obligations. There is a cost saving opportunity for treasurers who now cast a more critical eye over lease contracts and can promote productive “internal discussions to optimise cost efficiency of now on balance sheet lease debt”.

Due to their skill sets and financing, treasurers have been key players in helping to communicate the balance sheet and profit impact of IFRS 16 both to internal and external stakeholders. Primarily treasurers have been interacting with banks and rating agencies but, they have also been “well-placed” to explain the recalculation of leases more widely, says Lello.

“Treasurers find themselves very much in the box-seat following the introduction of IFRS 16, and this has triggered more regular reporting,” he notes. Whereas before, lease liabilities were typically calculated at the time of the annual and semi report, there is now a continuous testing. Indeed, it is not just a question of increased debt now, it is also a matter of handling raised EBITDA metrics, used to measure a company’s operating performance: this has to be assessed at least quarterly, explains Lello.

“What’s also particularly interesting to CFOs and CEOs – and shareholders – is the impact that the implementation of IFRS 16 has on EPS too; it is dilutive for EPS because interest charges on leases tend to be higher in the early years, hitting earnings per share initially but becoming EPS accretive at the end of a lease when interest charges are less.” This has all had to be articulated carefully to shareholders. Some industries (airlines, retailers) are much more impacted than others.

What’s involved?

Calculations are not always straightforward. They are divided into two parts, with an interest expense and a depreciation charge; it is not something for the inexperienced. The role of the treasury is significant as both an advisor to the business, and as a source of information around new leases taken on and the existing portfolio.

In the calculation of IFRS 16, a discounting formula is used, explains Charlotte Lo, Director, Banking Accounting Advisory Services, KPMG UK. The recognition of assets and liabilities is based on the “relatively simple” idea of discounted cash flow (DCF). DCF calculates the present value of future cash flow, applying a discount because present value is always lower than the cash flow future value.

In this context, a discount rate determines the present value of a lease payment as a measure of the firm’s lease liability. Lease payments can be discounted using either the interest rate implicit in the lease (IRIL) or, more likely, the firm’s incremental borrowing rate (IBR).

Calculating the present value of DCF thus first requires collation of all lease details, including any intentions to exercise options (such as an extension). A discount rate can then be generated, but because leases vary in tenor and the rate represents a specific period only (a ten-year rate cannot be used for a five-year lease calculation, for example) this has to be accounted for. Similarly, where different currencies are used across contracts – and large MNCs may use many – rate calculation requires considerably more work.

Where IBR is used to calculate the discount rate, a market rate such as LIBOR, or another risk free rate (such as SONIA), could be used, says Lo. But this then needs to be adjusted, taking into account the credit risk of the lessee, the lease tenor, the underlying value of the asset, the amount ‘borrowed’ by the lessee, and even the economic environment in which the lease is active (and this may include country and currency).

“It is not easy to come up with the discount rate, but the treasurer can help by providing the risk-free rate and the credit risk of the entity, and they can help source the borrowing rate,” she says. “For that, treasury may be considered one of the key functions to supply inputs of IFRS 16 calculations.”

Of course, every time a batch of new leases comes through, when a new contract is signed for example, a new rate must be secured. Some firms may refresh rates periodically, say every quarter, says Lo, “so it is important that the auditor accepts these rates”.

She believes that treasury can take a more proactive stance here, establishing a self-service model. “In the past, treasury did not necessarily make these rates available but I think there now needs to be a process where it publishes rates from which all internal group companies can source.”

However, Lo offers anecdotal evidence (from the banking sector) revealing that treasurers were initially surprised that IFRS 16 is their problem. “There has been an initial reluctance to incorporate IFRS 16 as part of their processes and controls,” she recounts.

Furthermore, some have been unwilling to offer rates “other than for a few core currencies”. This is unhelpful if the finance department then has to agree with auditors how proxy rates are to be used. In its defence, Lo fully accepts that the additional burden on treasury has come as “an unpleasant shock” to some.

Next steps

IFRS 16 demands a complex data exchange. For a business with thousands of leases to manage, it will need “more than a spreadsheet” to manage, suggests Lo. To create a useful system, many processes and data flows must be incorporated, including those of treasury.

Although third-party systems are available, allowing journal entries to be created at asset or contract level before uploading into a SAP or Oracle general ledger, it is evident to Lo that manual processes persist.

To overcome this (and many other issues), companies need to be aiming for data centralisation and process automation, with the treasurer a guiding force, looking at the different lease rates across the enterprise. From here, the outliers can more easily be called out – lease rates that seem high, for example – and replaced with other forms of debt, a more economical lease, or even purchase of equipment.

Post-IFRS 16 many companies still have work to do in resetting their covenant packages, notes Lello. The treasurer now has a key role to play, acting as “independent arbiter” to evaluate whether leasing is ultimately a cost-competitive source of ‘finance’. Indeed, he adds, IFRS 16 has ensured treasury now has an additional area in which to be the “expert advisor” to the business.

The essence of IFRS 16 for treasurers

Michael Keeler, CEO of LeaseAccelerator, suggests some key IFRS 16 action points for treasurers:

Expect increased auditor scrutiny. The new rules will result in greater auditor scrutiny over companies’ leasing processes and controls, so companies will need to track their leases more closely than in the past.

Monitor financial ratios. IFRS 16 will impact financial ratios including the leverage ratio, return on assets, and current ratio which could impact agency ratings, existing debt covenants and future debt arrangements.

Improve data management. Leases will need to be tracked more closely under the new rules, so robust data management will be essential.

Assist accounting in determining the incremental borrowing rate or discount rate to use for calculating the present value of the lease payments. Also, accounting will need help in capturing key financial variables, including weighted average cost of capital (WACC).

Advise on long-term processes, policies and controls. Treasury can help develop sourcing policies to optimise capital use in the leasing programme. One control could be requiring a lease-versus-buy analysis for every asset request to ensure that the best acquisition decision is made.

Develop long-term lessor relationships. As the leasing process becomes more visible, relationships with a company’s vendors and landlords will become more important. Strong relationships with lessors will give advantages in the sourcing data and in the negotiation processes for equipment and real estate assets.

Keep financial metrics up-to-date – and share them. Treasurers can establish an internal process for their organisation to ensure that they keep financial metrics relevant to the leasing programme up-to-date in the organisation’s lease administration software. These data points include the company’s incremental borrowing rate and current market rates.

All our content is free,
just register below

Already have an account? Sign in

Please only use letters.
Please only use letters.
Please only use letters.
Please complete this field.
Please select an answer.