In early 2016, the International Accounting Standards Board released the new lease accounting standard, IFRS 16, in an effort to increase transparency around the state of a corporation’s lease liabilities. Since then, CFOs and treasurers have invested a considerable amount of time and resources into becoming compliant when this new standard was implemented. For most companies the need to be compliant started in January of this year, but businesses such as KLM and Nestle adopted the standards early. 2019’s quarterly and half year results will mark the first time that most companies have had to disclose their operating leases for the previous standard on their balance sheets. But what does this mean for reporting season?
IFRS 16 will now make all leases completely transparent. Where previously most leases had been reported in the footnotes of financial statements, they will be brought onto the balance sheet to be recognised as right-of-use assets and lease liabilities. These changes will impact key financial metrics, such as return on assets, EBITDA and the quick ratio. Our latest report, which looks at the leasing obligations of FTSE 350 companies, found £180bn will be added on to the balance sheets of these companies.
Companies will have to consider how they are going to communicate these large, and now transparent, numbers to investors. This may seem to investors to have a huge impact, but in reality, IFRS 16 has no economic impact on a company, since leases are already factored into a company’s cash flows. Analysts will already be familiar with this and account for it in their reports. However, for many investors, the impact IFRS 16 has on many company balance sheets and income statements, does in many cases result in a significant amount of additional debt on the balance sheet – this could come as a shock to the average investor.
Companies that adopted the IFRS 16 standard on a fully retrospective basis including Tesco and KPN have already presented their 2018 restated results, providing a like for like comparison. Companies applying the new lease accounting standard on a modified retrospective basis must disclose and explain the difference between the operating leases disclosed under the previous lease standard IAS 7 and the lease amounts reported under IFRS 16, illuminating the comparison since the historical results are not restated.
Debt – a burden or not?
There is a natural temptation for investors to view debt as a burden when actually we know that large leasing debts tend to be a more cost-effective way of making use of depreciating assets. Why use your own capital to buy a depreciating asset when you can use someone else’s capital? As long as the cost of that capital is lower than your weighted average cost of capital, it seems to make perfect economic sense. However, this is only the case if the lessee has secured an effective lease and is not overpaying. It also requires that the lessee manages the equipment lease portfolio in a proactive manner and executes on the contractual end of term conditions.
A lease program that is not well managed can easily end up being very costly when you evaluate the full life cycle of a lease. Fortunately, there are software solutions in the market that will help with the proactive management and support the notion that lease debt is not something to be worried about.
With new and potentially large numbers appearing on your balance sheets, businesses need to be prepared to answer questions on how efficient their leases are. This added transparency offers an opportunity for proactive management accountants to assess the processes their business currently has and relay potential savings onto investors. For example, the creation of a standardised lease contract for the organisation to use in their procurement efforts not only ensures that the company will receive competitive terms, but also help create an open capital market in which the firm can leverage competition among asset vendors and leasing companies to receive the best lease prices, hence driving overall cost savings and real cash flow benefits.
While these changes can prompt initial fears from investors, the restating of 2018 results in the new format can quell these, as we’ve already seen from Tesco and RBS. Companies need to consider the questions and conversations that will come next – not all debt is bad, but is this debt good?
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What will IFRS 16 mean for 2019’s reporting season?