IFRS 16 & ASC 842 Lease Accounting – A positive change for analysts and investors

For as long as businesses have been “renting” assets, investors, credit-rating agencies, and analysts have had to assess the effect and impact that operating lease commitments might have on a company’s future performance by using difficult to calculate estimates based on entries in the Notes to the financial statements rather than the P&L or Balance Sheet.

Now, following the publication of the new FASB and ISAB leasing standards – ASC 842 and IFRS 16, the reporting of lease transactions will, at last, reflect the financial commitment associated with any “asset rental”. For reporting periods from January 2019, all leases with a duration longer than 12 months will have to be recognized on the balance sheet as a “right of use” asset and a corresponding financial liability under both International Financial Reporting Standards (IFRS) and the US generally accepted accounting principles (GAAP). This means that operating leases and finance lease will be treated in exactly the same fashion – as if the asset had been purchased.

It is expected that the IFRS 16 and ASC 842 standard will give investors and analysts a more transparent and comparable view of a company’s leasing obligations replacing the confusion that investors and other users of financial statements faced in the past. Under previous guidance, leases were classified as either “finance” leases or “operating” leases. The former appeared on the balance sheet of the lessee, along with a related lease liability. In the case of the latter, both an asset and the liability are off-balance sheet, with rental costs expensed in the profit and loss account over the lease term. 

Under the new standard, almost all major lease arrangements will appear on the balance sheet of the lessee for the first time. This major shift in a core aspect of global financial reporting addresses concerns about the extent of off-balance sheet financing in listed company accounts. As already stated, investors and analysts will now review financial reports that better reflect, with reliable information, an entity’s leasing commitments, without having to make those already discussed difficult estimates about a company’s true level of debt. 

"The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organization's leasing activities," stated FASB Chair Russell G. Golden.

It ends what the U.S. Securities and Exchange Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting by requiring more disclosures in relation to leasing transactions.

Not surprisingly perhaps with such a fundamental change in lease accounting, some inconsistencies remain. With the aim of generating comparable balance sheets the International Accounting Standards Board and the Financial Accounting Standards Board have both issued standards that require companies to recognize the liability of future lease payments over initial lease periods, as well as an offsetting right-of-use asset for all leases. The income statement, however, presents a new inconsistency since, under IFRS, all lease payments will have to be split into depreciation and interest charges, neatly separating operating expenses and finance costs in both the profit-and-loss and cash-flow statements but by contrast, US GAAP will still recognize the concept of an operating lease, and companies will record lease expenses for them fully in the operating-expenses portion of the two statements.

As a result, investors and analysts wanting to compare companies’ return on capital, EBITDA, EBITA, margins, and enterprise-level multiples will still have to reassess the data for businesses reporting under US GAAP by adding back the implied interest cost to reported operating profits. Whilst not a difficult task, it is necessary to make them fully comparable.

Depending on how leases were previously reported the adoption of the standards will affect different sectors and different companies in different ways buy transparency and comparability will be achieved. In certain industry sectors the use of operating lease reporting has been very much favoured, in other sectors, not so and in some further business sectors it really varied across companies.

As a result, traditionally lease-intensive industries, such as retail, travel, and transportation and logistics, are facing changes. Reported debt for such players (and consequently, reported assets and invested capital) could increase by between 30 percent and 60 percent. No materially new information will be disclosed, but at a high level, the change in rules will make it easier for investors and analysts to compare performance across companies.

Summary

Operating leases vs. Finance leases

Though Operating Leases were previously simple to account for (you pay cash each periodic payment and expense that payment on your P&L for the period), but that accounting method left something to desired from a transparency and comparability viewpoint when reported in financial statements.

Finance Leases, however, are more complicated. Taking substance over form, with Finance Leases the lessee is, in substance, buying the item and essentially being granted a loan from the lessor which of course is repayable over time usually with an explicit interest element. Finance Leases force the company to capitalize the value of the asset to the balance sheet and place the lease liability, the “loan”, as a liability for future committed payments.

Impact to financial statements

The new accounting lease standard will essentially recognize nearly all leases as Finance Leases – the optional exceptions being leases of less than 12 months and leases for “low value” assets. The impact to any financial statements will be an increase in non-current assets with an offsetting increase in both current and non-current liabilities – usually resulting in a decrease in the working capital of the business.

Effect on investors, customers or lenders? 

Having seen how these changes will have an impact on the business, investors, lenders and even customers will make more qualified decisions about a company based in part on the more transparent financial statements.

While for some industries financial results aren’t as important as technological development, mining or oil and gas exploration results or other non-financial metrics, business owners and executives should have been asking themselves the following questions:

How will investors, shareholders or strategic partners react to a large increase in liabilities and assets?

Are any loan covenants in danger of being compromised? The increased debt reporting will be reflected in calculations assessing a business stays within its covenants.

From a comparability stance does the business still look attractive to investors, lenders, customers and suppliers? The mandatory capitalisation of operating leases will influence other key metrics and impact debt-to-equity ratios and debt-to-asset ratios, current ratio and Return on Assets of a company. The Return on Assets is a particularly important metric that investors use to judge a company’s performance).

These changes to financial performance may also result in a lower perceived equity value for many companies. It necessarily follows that in order to draw meaningful conclusions from analyses over long time frames investors and analysts alike will need to take care when bench-marking performance that they restate pre-rule-change financial data as best as they can to be consistent with post-rule-change figures.

For executives in industries with extensive leasing portfolios, the message is also clear: these changes in accounting rules, by themselves, warrant no shift in real-estate or other asset financing strategies. These accounting-rule changes don’t require companies to disclose more information but just the same information in a more consistent and clear manner and therefore won’t necessarily reveal new insights that might lead investors to change assessments of a company’s value just as in the past there was no great revaluation following the required expensing of stock options or the changes in “goodwill” accounting.

Investors, lenders and analysts all know and understand that cash flows don’t automatically change when the rules do—and ultimately that’s what is important to them.

Where can I find more guidance on transitioning to IFRS 16 and ASC 842?

For further guidance on implementing the new lease accounting standards, we have put together this inclusive guide to transitioning to the new standards – IFRS 16 or FASB ASC 842. Just follow the link below to access the guide.

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Disclaimer: this article contains general information about the new lease accounting standards only and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.