Applying IFRS 16 – How will it Impact Business Leasing Strategies

This article looks to explore what impact the introduction of the new lease accounting standards may have on the way businesses view, evaluate and consider leasing, as well as examining how business leasing strategies might be affected.

What’s Happening?

Following years of debate, the International Accounting Standards Board (IASB) has just issued the new IFRS 16 on leases. Applicable for accounting periods beginning on or after 1 January 2019 (that is from now), it will potentially have major impacts on group balance sheets and require significant work in advance of implementation to identify all group company leases. Ultimately, it could also affect negotiations on, and the structuring of, commercial leases.

There is no longer a distinction between a finance lease and an operating lease. IFRS 16 eliminates, for lessees, the classification of leases as either finance or operating, and treats nearly all leases similarly to how finance leases are treated currently (there are exceptions around leases of low- value assets or agreements with less than one year to run). This means that the total values of both assets and liabilities recorded on balance sheets will increase.

1. Accounting Impacts

The balance sheet will certainly reflect the changes in accounting but there may also be temporary profit and loss account effects. Over the life of a lease, there should be no profitability impact due to IFRS 16, but this need not hold in any given year.

As already alluded to, the main impact of IFRS 16 will be to bring assets previously treated under the guidelines for operating leases together with the associated lease liabilities onto balance sheets. As a consequence, profitability and leverage ratios will also be affected, impacting most companies and some more than others with more significant effects likely to trigger the need for renegotiations of remuneration incentive schemes and/or debt covenants.

1.1 Benefits

To the extent that operating leases (with the exception of short-term and low-value leases) are similar in nature to debt obligations, bringing them on to the face of the financial statements is likely to have a number of benefits for users of financial statements:

• It will improve the ease of any assessment of a lessee’s financial position and credit risk.
• It will discourage lessees and lessors from engineering the terms of lease contracts to disguise committed liabilities.
• The inclusion on the balance sheet of the assets and liabilities previously subject to operating leases and income statement makes the accurate estimation of a company’s liabilities readily available to less sophisticated investors and potential stakeholders.

1.2 Concerns

• Companies that previously relied on operating leases as a financial instrument to acquire assets may find that their future plans are projects are adversely affected as they are unable to secure financing lines.
• Companies should be aware that the changes may well impact internal remuneration schemes and need to have a mechanism in place to ensure a zero-sum game brought into play to reflect the effects of IFRS 16.
• Innervision has continually championed communication, externally as well as internally, as one of the best aids to manage the transition to and compliance with IFRS 16. If stakeholders, lenders and investors do not fully understand the impact of the new regulation on reporting outcomes, then a realignment of views on a company’s worth might be the consequence. Though in many assessments operating leases will have been treated as finance leases undoubtedly the result of compliance will improve comparability and valuation.
• The involvement of your auditors is equally key. They may already have seen the effects and will understand the benefits and pitfalls.

1.3 Behavioral changes and potential unintended consequences

• Since both loan debt and lease liabilities will now be treated equally in financial statements, lessees might, given the choice, have stronger incentives to buy assets outright. See 1.4 below.
• Those still keen on the benefits (particularly the operational ones) of operating lessees might try to renegotiate the terms of current and future leases such that they can be classified as short-term or low value (which do not have to be reported on the balance sheet). The risk moves to the lessor.
• Suppliers may be encouraged to dress assets as services so their customers can acquire those assets with a minimum impact on the balance sheet.
• Could a new type of “leasing instrument” with no impact on the balance sheet be engineered and marketed?
• As lessees desire shorter lease terms then that will inevitably result in higher costs for the lessee but additional risk for the lessor.

1.4 Lease versus buy

A company may have foreseen any number of benefits in entering into an operating lease.

• Where its long-term funding needs are unclear a company might have chosen such a mechanism but from now a financial instrument is likely to be treated as a purchased “right of use asset” and loan.
• The operational decision to lease may have been where an asset’s potential life was perceived as longer than its useful life to the lessee and here operating leases appealed as a way of matching cost to income/benefit. They also offered the flexibility of refreshes, upgrades and downgrades. Now the effect of the full cost is realised on day one.
• The financial decision between leasing and purchasing, however, will ultimately depend on the main reason a company chose to lease. If off-balance sheet finance was the reason, then there is no longer that strong incentive to lease.

In order to reduce any impact, lessees might seek to retain the off-balance sheet nature of operating leases, by seeking to take advantage of the exemptions and modify the terms of current and future leases so that they are classified as short-term. As already stated, this will mean shifting the risk primarily towards lessors as they would be exposed to lessees not renewing contracts and assets not being fully utilised. Lessees may benefit from additional operational flexibility (e.g. leasing plant that is subject to ongoing rapid technological change) but would also be compensating lessors for this by higher payments.

Lastly, sale and leaseback transactions become less attractive in terms of balance sheet presentation, since if the potential lessee cannot prove that the transaction does indeed constitute a sale (within the meaning of the new IFRS 15), the underlying asset will continue to be recognised on the balance sheet and the amount received regarded as financing.

IFRS 16 risks affecting relations between lessors and lessees for years to come. In addition, although it removes the distinction between operating leases and finance leases, it creates a requirement on all interested parties – auditors, lenders and investors – to recognise and assess the mix of leases and service contracts.

For more information on the effects and impact of IFRS 16 and for guidelines on how to comply today then download Innervision's 7 Step Guide to lease accounting compliance below:

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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.