IFRS 16, the new international accounting standard on accounting for leases, will change many companies’ balance sheet metrics – but will it change behaviour as well?
When the IASB issued IFRS 16, the new accounting standard on lease accounting, in early 2016, its chair Hans Hoogervorst went to the trouble of asserting that the new standard would not put the leasing industry out of business and that leasing would remain attractive as a flexible form of finance. This was an unusual and, indeed, sympathetic statement for an IASB chair to make. It contrasted with the often-quoted statement by former chair of IASB, Sir David Tweedie, that he wished to fly on an airplane that was on an airline’s balance sheet before he died. Mr Hoogervorst’s statement was also considerably more sympathetic than the IASB’s attitude to concerns expressed some years ago that the revised rules on accounting for defined benefit pension schemes in IAS 19 would threaten the popularity of those schemes. The IASB noted at the time that it was not its problem if changing IAS 19, in the interests of better financial reporting, had such consequences. The IASB was equally unsympathetic to the concern that bringing a pension liability onto the balance sheet would cause difficulties with debt covenants, pointing out that it was up to companies to take action, such as renegotiating covenants, in these circumstances.
What is the concern?
So why did Mr Hoogervorst feel it necessary to address the question of whether IFRS 16 would affect the attractiveness of leasing as a form of finance? To understand this, let us recall some of the main changes in lease accounting brought about by IFRS 16 as compared to the previous standard, IAS 17. Under IAS 17, leases were classified as either operating leases or finance leases. Finance leases were recognised on the balance sheet as an asset and liability, with depreciation and interest in the income statement. Operating leases were not recognised on the balance sheet, giving rise to their being referred to as off-balance sheet finance, with the lease rental expense being recognised on a straight line basis in the income statement. The distinction between finance and operating hinged on whether substantially all the risks and rewards of ownership of the asset had transferred to the lessee. IFRS 16 represents a fundamental change to this approach. Under IFRS 16, all lease obligations are recognised on the balance sheet as a right-of-use asset and a lease liability (except for low value and very short leases). Depreciation on the asset and interest on the lease liability is recognised in the income statement, as with finance leases under IAS 17. IFRS 16 also sets out rules on how to determine the discount rate to apply to the lease payments when bringing the asset and liability onto the balance sheet, as well as how to determine the length of the lease term and how to deal with variable lease payments.
So, how do these accounting changes affect financial metrics that are calculated on the basis of IFRS accounts? The most obvious one is that it will increase the amount of liabilities that are recognised on the balance sheet, as well as the amount of assets. Allied to this is the effect on the key financial metric of gearing because of the change in the relationship between the amount of liabilities recognised on the balance sheet and the amount of balance sheet equity.
In the income statement, while earnings before interest, tax, depreciation and amortisation (EBITDA) will increase, as will operating profit, the interest expense will increase with consequences for debt covenants with interest cover requirements. Where the lease obligation is in a foreign currency, exchange gains and losses will arise on the full amount of the lease liability as exchange rates change. As we will see later, this can be particularly significant in some industries. Compared to the straight line operating lease expense under IAS 17, recognising interest on the lease liability will tend to front-load the total expense, with dramatic effects for companies that are financing their growth through leasing.
Although the mandatory commencement of IFRS 16 is for years commencing 1 January 2019, accounting regulators such as IAASA (the Irish Auditing and Accounting Supervisory Authority) have reminded listed companies that IFRS requires this year’s accounts to provide information about the impact that IFRS 16 is expected to have when it is implemented. Indeed, IAASA published a survey in 2016 of Irish listed companies’ operating lease commitments to provide a possible indication of the scale of lease commitments that will be recognised under IFRS 16.
Industries affected by IFRS 16
While the IFRS accounts of all lessee companies with operating leases obligations will be affected by IFRS 16, it is generally recognised that the retail, airline and telecoms industries are likely to be particularly affected. This is because of the scale of property leases in retail, aircraft leases among airlines and equipment and network asset leases in telecoms.
In each of these industries, leasing offers the key benefit of flexibility in relation to how long and at what cost the lessee wishes to be committed to the use and cost of the property, aircraft or equipment involved. Under IAS 17, there was also the additional perceived benefit that operating leases represented off-balance sheet finance. Under IFRS 16, some lessee companies may consider shortening the duration of their leases so that the amount of the lease liability and asset to be recognised on the balance sheet is reduced. Alternatively, options in leases to extend or renew the lease term that give rise to further liability where they are reasonably certain to be exercised may be renegotiated or eliminated.
In the airline industry in particular, where leases are often denominated in US dollars, euro companies are exposed to exchange losses on the whole lease liability under IFRS 16. Lessees may consider seeking to alter the currency of the lease or, more realistically, hedging the accounting exposure by using derivatives.
In telecoms, where lease arrangements may include access to an asset together with the receipt of other services from the lessor, the expense for the access to the asset may be separated from the service element in order to restrict the amount to be recognised on the balance sheet to the amount relating to the lease rental for the asset.
As IFRS 16 applies where the lessee controls the use of a specific asset for a period, some lessees may be content to leave control over the choice of asset to the lessor in order to avoid being scoped into IFRS 16.
Recognising right-of-use assets on the balance sheet under IFRS 16 will expose those assets to the risk of becoming impaired for accounting purposes, with the resulting charge against profit being recognised perhaps earlier than an onerous lease charge would have been recognised before IFRS 16. This is likely to be particularly relevant in industries where technological obsolescence is a feature of the industry.
Practical challenges for companies affected by IFRS 16 include the cost and effort of developing systems to capture the detailed data about their operating leases that they need to bring these leases onto the balance sheet, communicating the accounting impact to stakeholders and considering whether compensation arrangements need to be amended in order to accommodate the revised numbers.
Under UK and Irish GAAP, operating leases remain off-balance sheet. Some companies that had adopted IFRS may consider whether IFRS continues to be the appropriate accounting framework to use where they believe the negative accounting effects of IFRS 16 are very serious.
While some lessee companies may see fit to consider one or more of the avenues referred to above to minimise or reduce the negative accounting effect of IFRS 16, there remains the larger question of whether some companies will conclude that those negative effects would justify a fundamental change in their lease or buy decisions. This may be more likely where the benefits of leasing are marginal and do not outweigh the negative effects of worsened financial metrics. Clearly, a key factor in all of this is whether lenders and investors are likely to change their attitudes to lessee companies solely because of this accounting change. So, the follow-on question is whether this is likely to occur.
Conclusion
As Mr Hoogervorst noted in a speech on IFRS 16, it is a well-known practice of lenders and investors to adjust the balance sheet borrowing numbers of companies for the effect of off-balance sheet leasing when establishing the real gearing position. Given this well-established practice, together with the degree of publicity that the change in lease accounting under IFRS 16 has received, I think it would be disappointing if lenders and investors were to change their behaviour based on an accounting change that reflects no change in commercial reality. Such a change in behaviour might indicate that lenders and investors had not already been seeking out and utilising the relevant information on companies’ leasing arrangements.
Even if the negative effects of IFRS 16 on balance sheet metrics, such as gearing, and on the volatility of profit do alter the behaviour of certain lenders and investors, lessee companies that are convinced that leasing is the right commercial decision may well stick to their guns and maintain their leasing strategy.
After all, it would be a pity if the accounting tail were to wag the commercial dog now, wouldn’t it?
Terry O'Rourke is Chairperson of the Accounting Committee of Chartered Accountants Ireland.
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