IFRS 16 – Gearing up your balance sheet

After more than a decade of discussions, exposure drafts and development, the International Accounting Standards Board (IASB) issued the new IFRS 16 Leases, a new accounting standard that is set to bring dramatic change in accounting for leases in financial statements. IASB has estimated that the present value of approximately two trillion dollars’ worth leased assets do not appear on the balance sheet of listed companies, using either the IFRS or US GAAP accounting framework.

IFRS 16 is set to become operative from 1 January 2019, this will result in recognition of number of off balance sheet lease arrangements on the balance sheet. The underlying economic transactions remain the same, arguably with a more transparent representation of leasing arrangements in the financial statements by taking off-balance sheeting lease financing out of shadows. Under the new standard, lessee recognizes a right-of-use asset and a lease liability. The lease liability would be amortized using the effective interest rate method. Whereas, the right-of-use asset is amortized.

Recognizing off balance sheet assets and liabilities will affect financial ratio calculations and could have an impact on debt covenants, debt capacity and dividend policies. Companies can expect their non GAAP based key performance indicators (KPIs) to be drastically changed. Key impacts may include:

  • Earnings before Interest Tax Depreciation and Amortization (EBITDA) to go up as a consequence of nonrecognition of operating lease expense.
  • Balance sheet asset and liabilities to gross up, impacting the leverage, net current asset/liability ratios.
  • Gearing and debt equity ratios to significantly go up.
  • Earnings per share (EPS) in early years would decrease due to higher finance costs, resulting in front-loading.
  • Net assets would decline as the depreciation/amortization of leased asset would outpace the reduction in lease liability, at least in early years.
  • Interest cover and asset turn over would go down.

In particular. front-loading effect creates artificial volatility in the income statement that does not properly reflect the economic characteristics of a lease contract, particularly if the risk and rewards incidental to ownership stay with the lessor (operating lease). However, where lessee has a portfolio of similar lease assets that are replaced on a regular basis, the effect should even out.

Changes to lease accounting will impact the way companies approach leasing strategies, including restructuring the lease contracts to take advantage of the exemptions available in the new standard. Short term leases and low value assets have been included as possible exemptions resulting in possibilities that companies may seek to structure their lease arrangements to take advantage of these exemptions.

Further, It is also possible that there could be an increase in service contracts entered into by companies seeking to avoid leasing arrangements within the scope of IFRS 16. Currently, the accounting for an operating lease and a service/supply contract is the same (i.e. there is no recognition on the balance sheet and straight-line expense is recognized in profit or loss over the contract period).

However, irrespective of any accounting play around, financial institutions, rating agencies and other capital providers that have always taken into account all economic transactions of a company, including off-balance sheet lease contracts.

Final thoughts

Even though the introduction of IFRS 16 means significant changes for the management it should always be considered that lease decisions ought to be based on the needs of the business and not should not be governed by their accounting treatment. The more important drivers are likely to be factors such as access to capital, cost of capital and the flexibility afforded by leasing arrangements.

However, with 2019 fast approaching, companies may be underestimating the work necessary to meet the requirements of IFRS 16. Even though, a company may have well established systems and processes to administer the assets they own and operate or consume as part of normal business operations. However, the same rigor and systematic approach is usually not adopted for leased assets (particularly those falling under operating lease).

Changes to the current or investing in a new system to capture and administer lease data might be required to provide some insights into leasing strategies, allowing for better business decision making. However, as mentioned earlier, an accounting requirement should not be driving business decisions. Lease arrangements should represent sound business decision and optimal utilization of capital.

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