IFRS 16, which was issued today (Wednesday), treats all leases as finance leases and so will ensure that for the first time a large part of the estimated $2.8trn (£2trn) worth of lease commitments that are currently off balance sheet will be included in to the balance sheets of the world’s listed companies as assets and liabilities.
Under the old lease accounting standard, IAS 17, leases were categorised either as finance leases, in which case they were included in the balance sheet, or operating leases which were disclosed in the notes to the financial statements.
This made it difficult for investors to compare companies and to work out the effects of a company’s off balance sheet lease obligations.
Under IFRS 16, only short-term leases (12 months or less) and leases of low-value assets (such as a personal computer) will not need to be recognised.
“These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligations,” said International Accounting Standards Board chairman Hans Hoogervorst.
“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.
“It will also improve comparability between companies that lease and those that borrow to buy.”
The new standard, which comes into operation on 1 January 2019, will affect around 50% of the world’s listed companies, particularly those in the airline, retail and travel/leisure sectors. Currently, the IASB says, the value of the off balance sheet leases of some airlines is equivalent to more than 100% of the value of the airline’s total assets.
It also points out that under IAS 17 the understatement of long-term liabilities by the heaviest users of off balance sheet leases is as high as 45% in Latin America and 32% in Asia/Pacific. The lowest understatement is in North America (22%) and Europe (26%). Africa comes in at 27%.
Because IFRS 16 represents such major change in accounting, the IASB has carried out a particularly extensive due process. Since 2009 it has undertaken three public consultations and held hundreds of meetings, round tables and other activities.
IASB chairman Hans Hoogervorst
Off balance sheet lease financing is no longer lurking in the shadows
It also worked alongside the US’s Financial Accounting Standards Board, hoping to reach convergence on lease accounting. In the end they agreed to disagree although, like IFRS 16, the FASB’s new standard, which will be published shortly, will require a lessee to recognise assets and liabilities for its leases, have the same requirements relating to the definition of a lease, and have substantially carried forward previous lessor accounting requirements.
Although the FASB reached different conclusions on other major aspects – including deciding to retain a dual accounting model – the IASB does not believe that the practical effects of the differences will often be significant in most lessees’ financial statements.
Feedback to the IASB’s latest exposure draft (2013) showed that there was widespread support for the main changes. However, many of the 1,700 comment letters the board received over the period that the standard was being developed raised concerns about the cost and complexity of applying the new standard.
Although the IASB has made changes to reduce the costs and complexity, it defends the inevitable added expense of implementation. It points out that they are far outweighed by the benefits of the new standard for investors and analysts through significantly improved financial reporting.
The significance of the implementation costs, it says, will depend on the size of a company’s lease portfolio, the terms and conditions of those leases and the systems the companies already have in place to account for leases under IAS 17.
The majority of the information required to apply IFRS 16 is already available in accessible form as it is currently used for accounting and disclosure purposes under IAS 17.
Obtaining any additional information, it adds, should be manageable because of the three-year implementation time before IFRS 16’s effective date and transitional reliefs.
Commentators are less gung ho. ICAEW financial reporting faculty head Nigel Sleigh-Johnson warns that the impact of IFRS 16 should not be underestimated. “There is much work for companies to do to understand and implement the changes, not least in the area of data collection, and this work should be started sooner rather than later.
“The potential implications also go way beyond a mere change in accounting. The standard will have a significant effect on financial ratios and debt covenants because of the leased assets and liabilities newly recognised on lessee balance sheets. Employee compensation arrangements, dividend planning and taxation may also be affected.”
EY’s financial accounting advisory services leader Andrew Davies agrees. “Because most leases will be recognised in the balance sheet under the new standard, lessees will put more focus on whether an arrangement is or is not a lease. For contracts that include significant services, this assessment may be challenging.”
James Chalmers, PwC’s assurance leader, says that companies are going to have to think carefully about how they communicate the impact of the new standard.
“Our research shows that the average company 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.”
KPMG international standards group partner Brian O’Donovan thinks that, given the scale of the changes, companies will want to understand the size of the lease liabilities arising from transactions entered into from now until 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 is also concerned about other unknown quantities. “For example, the new accounting could prompt changes in the tax treatment of leases. And a key question for the financial sector is how the prudential regulators will treat the new assets and liabilities for regulatory capital purposes.”
Nevertheless, despite all these challenges, life under IFRS 16 will be much improved, says Veronica Poole, Deloitte’s global IFRS leader and UK head of accounting.
“The final result should be clearer for both preparers and investors, since a very obvious part of financing will become explicit rather than remain implicit. Ultimately, today’s standard will ensure a more accurate outcome that investors will welcome.”
Matthew Stallabrass, partner at Crowe Clark Whitehill, said that it was “disappointing” that a project lasting 10 years is not fully converged with USGAAP.
“Whilst both standards bring operating leases on balance sheet USGAAP will retain the distinction in the Income Statement, continuing to recognise a rental expense. In my opinion this treatment better aligns financial reporting with the underlying cash flows and hence gives a fairer presentation than the approach taken in IFRS 16,” he added.
Several organisations called on the European Union to endorse the new standard as soon as possible so that it can be used by European companies.