IFRS 16 Insights – Changes in Rating Agencies’ Views

The introduction of the new lease accounting standard – IFRS 16 Leases – issued by The International Accounting Standards Board (IASB) will require lessees to account for their leases under a single accounting treatment, bringing almost all leases on balance sheet, recognising a right of use asset and an associated liability.

IFRS 16 is effective for accounting periods beginning on or after 1^st January 2019.

Transitioning to the new standard is expected to have far-reaching business consequences as it is likely to have an impact on many financial metrics and performance indicators.

This article seeks to explore how the effect of these new standards may be considered by rating agencies and factored into their assessments of a business.

What is a rating?

Issued by a rating agency such as Standard and Poor’s it is an opinion based on analysis on the likelihood that investors/holders of debt will receive payments of interest and principal on time and is arrived at by applying consistent criteria and a well-documented publicly available approach. Such analyses will focus on:

Business Risk: Industry, Market position, Operating efficiency, Diversification, Management

Financial Risk: Profitability, Cash flow, Capital structure, Financial flexibility

Is leasing relevant?

Financial risk assessment (in part) uses reported financial statement information and this assessment will be adjusted based on specific criteria to calculate various ratios and credit measures. Viewing the accounting distinction between operating and finance leases as being substantially artificial, rating agencies have consistently treated operating leases as capital expenditure when assessing the financial statements of any business and have interpreted this together with the adjusted ratios into the overall ratings decision. To be clear agencies have not been fully replicating an acquired asset financed with debt but have just attempted to capitalize existing minimum payment obligations. In summary, leasing is relevant now post IFRS 16 because adjustment and interpretation will be replaced with certainty.

Will IFRS 16 impact how financial statements are viewed?

There are a number of factors that will or will not have an impact, negative or otherwise, on the view a rating agency may take of a company’s financial standing post implementation of IFRS 16 or its FASB equivalent ASC 842. The adoption of IFRS 16 will have an effect on several ratios including FFO/Debt, Debt/EBITDA, Debt/Equity and Interest Cover.

1. If the company has never used leasing as a tool for the acquisition of assets, then the impact will be minimal if felt at all. It will continually need to assure itself and its auditors that there are no extant service agreements that should be reclassified as leases but other than that there is no work to be done and no change in financial status to be reported as a result of adopting the standard. The view of investors, stakeholders, lenders and rating agencies will remain pretty much the same in most aspects though comparability assessments against other businesses in the same sector may reflect its position.
2. Where off-balance sheet finance has been employed in the past by a business the new standard requires all such leases still “live” to be brought on to the balance sheet with the appropriate recording of “right of use” assets and associated financial liabilities. Worldwide, trillions of dollars’ worth of assets and liabilities will now be declared where previously they were hidden away as ongoing expenses. The impact of the new standard is difficult to judge and though the view of the business from an outside perspective will change it may remain comparable to other businesses in the sector and this we will discuss further in this article.
3. The new standard requires lessees to determine service elements and asset lease elements of any lease. Where a business can convince itself, its auditors and of course its stakeholders that agreements previously classified as leases no longer meet the definition and should now be treated as service contracts then the adoption of IFRS 16 may result, as in the case of television broadcaster ITV, in a scenario where reported future lease payments actually shrink.
4. The application of the guidelines of the new standard may result in the duration of certain leases being recalculated and lengthened with an associated disclosure of much higher future cash flow requirements and the metric associated with free cash flow.

Will there be an impact on ratings?

As seen previous to IFRS 16, agencies have been considering all aspects of leasing and making qualified adjustments, but these have been based on broad estimates which will undoubtedly be less accurate than the results of the new lease accounting standard.

As with any accounting change, ratings should not be expected to change significantly but will change for some businesses in response to those factors identified above –

• Increased information on existing risk not previously disclosed
• Associated changes in risk, such as any related to covenants, regulation, market reaction or changes in business practise.
• Beyond numerical adjustments, analytically important points about leasing include:
  • Economic need to use the asset beyond the committed lease term
  • Contingent rentals - in many cases, the disclosed stream of minimum future rental payments has been significantly understated though this shortfall will be reduced or eliminated with IFRS 16
  • Benefit of sublease income is not necessarily included in debt adjustment but is usually included in cash and earnings measures
  • Cost-effective financing (e.g., lower interest rate or all-in cost, tax objectives) and cash-flow timing (e.g., lower down payment, matching cash flow with asset use).
  • Flexibility to meet changing needs and protect against obsolescence (e.g., technology-based equipment, vehicle fleet) – temporary need for asset.
  • Borrowing flexibility (e.g., less restrictive covenants, escalations).
  • Residual risk shifting - company wants to avoid being exposed to the disposal / residual value risk.
  • Regulatory (e.g., company may be precluded from ownership of such asset, assets are subject to sale restrictions).
  • Covenants (both lease covenants and their impact on other debt covenants) and the recourse or non-recourse nature of the lease.
  • Lessees do not own the leased assets, and leased assets are not available to satisfy claims of the company’s other creditors (in most cases).

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.

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.