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.
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.
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.
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.