Companies that use international financial reporting standards are gearing up for the biggest change since the standards were introduced in 2005 with the finalisation of IFRS 16. The aim of the new standard is simple: in effect, to treat all leases as finance leases. But implementation is likely to be anything but easy.
Although the changes don’t come into effect until financial years starting in 2019, the operational complexities mean lessee companies need to start looking into this now, says Jake Green, head of financial reporting at Grant Thornton. The main problem is not technical: “The biggest challenge is going to be around practical implementation and getting the information needed. Don’t underestimate the time and effort involved.”
Under IFRS 16, lessee companies will need to identify every single lease they have everywhere in the world, irrespective of the location. Most companies and groups don’t have a designated department responsible for all the leases they enter into. The reality of collating this information from all corners of the organisation is already proving to be a logistical nightmare.
Then there’s the question of how companies can determine detailed terms of leases written under local law and in the local language and accounted for under local GAAP, says Peter Hogarth, lead technical partner at PwC. This might make it difficult to manage the overall lease identification project from the centre. “Companies will need to train people to make judgements themselves locally based on the translations of whatever the agreements happen to say. And because of the different laws, the contracts will all be structured differently and not standardised on a global level.”
The need for judgement comes from the fact that, despite its aim, the standard does not do away with expensing lease payments altogether. There are two main exemptions to the interest-and-depreciation treatment of IFRS 16: leases that are for less than 12 months, or low-value leases. (The standard doesn’t define what this value is but the basis of conclusions suggests a figure of $5,000/£3,480.)
The value exemption extends to every leased low-cost item in the company. Crucially, these are not aggregated. Potentially there could be thousands of small-ticket items which, taken together, could be material to the financial statements. But if each of them falls under the limit, their leasing cost is expensed.
This may seem like good news. But Green points out that it could be a headache to implement in practice. “Say a company leases all its printers. The contract is mainly for thousands of desktop printers, all of which fall under the low-value threshold. But the contract might include a small number of high-value machines, specialised reprographic units, which don’t. How does the company distinguish them in the contract and determine how much it is paying for which items?”
KEY FINANCIAL RATIOS
The reporting implications of IFRS 16 have caused most controversy, and led to the compromises in the final standard. Assets will go up – but so will liabilities. Net profit should not change, but operating profit will rise. The key question for companies is what this will do to their key financial ratios and to stakeholders’ perception of their results.
Gearing is a big worry for many. Companies will need to assess whether any bank covenants will be breached by their leases coming onto the balance sheet. “Companies should think about re-negotiating their covenants now, or at least negotiating some kind of frozen GAAP covenant so the terms are assessed with reference to current GAAP instead of IFRS 16,” advises Green.
Few companies are keen on increasing the debt on their balance sheet says Kirsty Ward, partner in PwC’s accounting advisory team. “The general perception in the market is that this is bad news, even if the company can explain why it’s happened.” The good news is that professional investors have for years been adjusting for off-balance sheet debt by taking the operating lease payment in the accounts and multiplying by a factor, usually seven or eight, to derive an implicit balance sheet obligation. “We think companies won’t get a strong reaction unless the actual obligation is wildly different from that which the institutional investors have already been assuming,” says Hogarth.
EBITDA will rise as interest and depreciation charges replace operating lease costs in the profit and loss account. This can have some unexpected consequences. “What if employee bonuses are calculated based on EBITDA?” asks Green. “Companies need to think what this will mean for their cash flow. And what if a company has a contingent consideration agreement for a business combination and the value is based on EBITDA? Will the increase because of the new standard mean it will have to pay more for the business than expected?”
The effects of IFRS 16 will fall mainly on companies that currently hold material off-balance sheet leases: obvious sectors include construction, mining and transport. But the sector expected to feel the change most is retail.
The trade-off between security of tenure and flexibility means most retail business is carried out through leased premises. At the same time the move to online means the sector is increasing its warehousing, transport and logistics capacity, using leases rather than purchasing assets.
The harsher impact on the retail sector is borne out by a study carried out by PwC, which estimated the impact of the new standard based on the reported results of more than 3,000 listed companies that use IFRS. “A typical company would expect to see its debt increase by about 22% and EBITDA improve by 13%,” says Ward. “For retailers the numbers were 98% for debt and 41% for EBITDA.”
SEPARATING OUT SERVICE
While IFRS 16 eliminates the current dividing line between finance and operating leases, it includes another distinction: between the service and leasing elements of a contract. The point where this line is drawn will depend on the subject of the lease and where it’s entered into. For instance, real estate leases in the UK generally have little service element, whereas real estate leases elsewhere often do.
It might be easy to split off maintenance fees for simpler assets such as photocopiers, but this could be a nightmare for large-ticket items. Aircraft leases (the poster child for the change in standard) are particularly complex and include servicing obligations on many different parties to provide maintenance for individual parts.
There are other factors to consider in the service-versus-lease evaluation, such as who has control over the asset. If control is deemed to be with the lessor then it’s a service lease, says Georgietta Ogundeyi, finance business partner at asset finance provider Lombard. “Say for example a company hires a lorry. If that company can’t choose how and when the asset is going to be used, if the lessor prescribes the times and dates it is available for within the contract and provides the driver, then control is deemed to be with the provider and the deal is a service contract.”
The final standard deals principally with lessees’ accounts, as opposed to lessors’. This is in line with IFRS 16’s stated aim of bringing financing on balance sheet, something that’s not a problem with lessor financial statements. But this lack of symmetry could have unintended consequences says Nigel Sleigh-Johnson, head of ICAEW’s Financial Reporting Faculty. “It’s perfectly understandable why the IASB decided to exempt lessors from the new regime in the main but it does mean there are some odd results, particularly for groups that lease in and lease out the same assets.”
The potentially huge impact on companies’ financials means it’s vital that they explain the changes and their significance to stakeholders and investors, says Sleigh-Johnson. “It’s important for companies to take ownership of the message and communicate the changes clearly. Explaining the estimated changes is important, as is explaining there is no change to the total cash flow or the economics of the situation – just what is reported and disclosed.”
ICAEW will be holding a joint conference with the IFRS Foundation on the new standard in the autumn. IFRS 16 will also be a main feature in ICAEW’s annual IFRS conference this November.
Estimated effects of IFRS 16*
Increase in debt
Overall median increase: 22%
Retail sector median increase: 98%
Increase in EBITDA
Overall median increase: 13%
Retail sector median increase: 41%
*Based on a survey of more than 3,000 listed IFRS reporting organisations across a range of industries and countries (excluding the US)