On 1 January 2019, IFRS 16 will come into effect, sounding the death knell for operating leases and starting the long process of bringing an estimated $2 trillion of off-balance sheet assets onto corporate balances sheets worldwide. The new standard will apply to all companies applying IFRS, and eventually also to those using UK GAAP under FRS 101, though not yet FRS 102. Asset-heavy companies that have used short-term leases for the majority of their real estate, along with airlines and shipping companies, are those most obviously and immediately affected. Former ISAB Chairman Sir David Tweedie might yet achieve his ambition to fly on an aeroplane that actually sits on the balance sheet of the airline.
The most immediate effect is on their accounting itself. Accountants must assemble all lease portfolio data for leases that will continue in 2019 and work to calculate present values (PV) from information in each of them, such as break points, subletting and subletting, break clauses, and expiry date, as well as assumptions about discount rates. The next step will be to decide if any leases will be, or can be made to be, short-term, small or in line with local interpretations of the exemptions from on-balance sheet treatment provided within the standard. All that cannot meet the exemptions must then be put back onto corporate balance sheets. Most real estate leases will move from the current straight line rental deductions to the curve characteristic of finance deduction, i.e. an upfront weighting that IFRS 16 will bring. There may be a need to change software – now might be a good time to move from that clumsy old spreadsheet to a new cloud-based corporate performance management software package with a fresh IFRS 16 module. This will be the quarter to do, if at all – by now companies should be working on shadow accounts for this and the next two quarters, in preparation for the changeover.
But the indirect effects are likely to be still greater.
First, the finance function. Assets and liabilities will rise. But the impact on the income statement is the most significant. Replacing rent, an operating expense, with interest and depreciation, which are not, will likely cause a rise in EBITDA. What is certainly the case is that early renegotiation with lenders of existing covenants is therefore essential: it should be underway now. Future covenants, and issues such as cash sweep mechanisms, should also be discussed as IFRS will impact financial ratios such as ROCE. Meanwhile national tax authorities are still determined to treat leases differently depending on their length. HMRC for example are working to create a new seven year ‘short lease’, which will still allocate capital allowances to the lessor. Although the first reporting period will be Q1 2019, now is the time for management to analyse the accounting impact and where required talk to stockbroking analysts the rating agencies, and investors generally to reassure them that the fundamentals of the business remain sound despite changes in the costs reported on income statements, increased earnings volatility and changes in returns.
Second, management and HR. As income and resultant performance measures, especially financial ratios, will be affected, incentive structures will need to be brought into line with their revised equivalent values. This is especially important between divisions, as the impact of IFRS 16 will vary widely between capital intensive and service divisions of the company.
Third, corporate strategy. This may eventually turn out to be the most important impact of all. Some companies at least may end up changing their entire asset strategy. If the advantages of operating leases are no longer available, the choice between buying the asset through an amortised or bullet on the one hand, and a finance lease without a purchase option on the other is a much more even one. This applies especially if management takes a short-term view of income, given that the cost of a finance lease is born disproportionately early. Moreover, if lease finance costs become interest, then BEPS 4 will apply, further reducing the usefulness of leasing arrangements, including sale and leaseback transactions. The choice will depend on asset resale values, and the need for operational flexibility, depending on what may be on offer from leasing companies in that regard.
Companies are moving to readiness for IFRS 16 this year, communicating both internally and with all external stakeholders. The only companies that cannot do so are the leasing companies themselves. They must sit, and wait anxiously on each IFRS 16 Update, for the impact on their business.