Preparing the Treasurer for IFRS16

30 April 2018

Sir David Tweedie, former Chairman of the International Accounting Standards Board (“IASB”), once said; “One ambition before I die is to fly in an aircraft that is on an airline’s balance sheet.Fortunately for Mr Tweedie, with the replacement of the old IAS 17 lease accounting standard with IFRS 16 (effective from 1 January 2019), we are steps closer to achieving his objective.

This is the first in a short series of blogs following on from a Treasurers briefing held in late March 2018. This blog will assess the potential effects on the treasury community. Our next blog will consider how corporates might consider undertaking an IFRS 16 conversion project.

Introducing IFRS 16 – Leases

To shed some light on the subject for those less familiar with lease accounting – previously (under IAS 17) only financing leases were recorded on balance sheet, whilst operating leases were left off balance sheet.  Under the new IFRS 16 treatment of leases, all leases greater than 12 months and not of ‘low value’ will be included on the balance sheet of the business potentially seeing significant impacts in terms of increasing debt and affecting EBITDA.

The businesses that we expect to be affected the most are those with high value (‘big ticket’) or a large quantity of long term assets funded with leases. A PwC study in 2016 of more than 3,000 entities reporting under IFRS suggested that those in the Retail, Airline, Healthcare, Real Estate, Transport and Infrastructure sectors would be most impacted.

So what does this new standard mean practically for Corporate Treasurers?

Whilst underlying lessor accounting remains largely unchanged, the effect of moving leases on balance sheet may affect business models and commercial decision making and hence how the Treasurer manages risk.

FX exposure and hedging strategy may change. From an accounting perspective, monetary liabilities (i.e. lease liabilities) are retranslated at current FX rates at the balance sheet date however non-monetary assets (i.e. the right of use asset) are recorded at historical FX rates. Therefore, there is an accounting mismatch for FX in profit and loss accounts.

For Corporates with operating leases, this is not a new FX risk, however under IFRS 16 as operating leases are brought on balance sheet, the extent of the accounting exposure is now highlighted. 

Corporates may consider hedging the accounting volatility but need to be sure this makes sense from an economic perspective. Alternatively, if running FX gain/losses through the profit and loss account, the key will be to manage stakeholder communications.

Financial ratios and covenants will be impacted. The new standard will affect virtually all commonly used financial ratios and performance measures required within financial covenants; balance sheet debt will grow, gearing ratios will increase and capital ratios will decrease.

The effect on financial statements and ratios may trigger breaches of loan or other pre-existing debt or interest covenants, unless an entity has included ‘frozen’ GAAP clauses in its financing arrangements. Businesses should consider commencing conversations with lenders and ratings agencies as soon as a formal impact assessment has been completed.

Lease versus buy decisions may change. At first glance, it may appear that the elimination of off balance sheet accounting for operating leases might reduce the attractiveness of leasing, however, as with most corporate evaluations, there are pros and cons to both leasing and buying assets. For example, IFRS 16 actually increases transparency and improves comparability between companies that lease and those that borrow to buy. Internally, this added transparency could enable lease portfolio optimisation and cost savings. In our view, corporates should ensure that decision making frameworks and financial modelling / due diligence approaches are reviewed to take consideration of this new standard.

So many potential issues for the Treasurer to consider and so little time to act – only 8 months and counting.  In our next blog we shall discuss how you might implement the change.

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