IFRS 16—a new lease of life?

What impact will the new accounting standard have on lenders and practitioners? Brian O'Donovan, partner at KPMG, comments on the changes introduced by the new International Accounting Standards Board (IASB) accounting standard, notably the on-balance sheet accounting for lessees.

Original news

The New International Financial Reporting Standards report ‘Leases’ (IFRS 16), released by the IASB, has been created to revise the way in which companies account for leases, the regulator announced. IFRS 16 will come into effect on 1 January 2019, though early application is permitted for companies that also apply IFRS 15‘Revenue from Contracts with Customers’.

Why has the IASB decided to create a new accounting standard?

The IASB’s new lease accounting standard—IFRS 16—requires lessees to recognise most leases on-balance sheet. It also requires lessees to disclose more information about their lease obligations.

The IASB believes this change will make financial statements more useful to users. At present, most analysts adjust published financial statements for lease transactions. The new accounting means analysts can see a company’s own calculation of its lease liabilities, calculated using a common methodology. The additional disclosures will allow an analyst to interrogate those liabilities further.

The new requirements take effect in 2019, though companies can choose to apply them earlier.

What are the major changes?

The number one change is on-balance sheet accounting for lessees. In effect, a lessee will treat each lease as the purchase of an asset, financed by the future lease payments.

As a result, a lessee will recognise an interest-bearing liability each time it enters into a lease. This liability will be calculated as the present value of the future lease payments. At present, a lessee only recognises a financial liability in this way if the lease is a finance lease, ie if the lease is economically similar to an outright purchase of the asset. At the same time, a lessee will recognise an asset for its right to use the items that it leases. As a result, lessees will appear more asset-rich, but also more heavily indebted.

Will this have an impact on lenders and if so what?

Much of the general accepted accountancy principles (GAAP)-based financial information lenders receive will change. In turn, this will impact many key financial ratios that lenders monitor based on GAAP-based financial information. Most obviously, the new lessee accounting liabilities will increase reported gearing. Lessees will also recognise interest on lease liabilities, which will decrease interest cover.

Some other ratios may move in unexpected directions. For example, lease expense will now comprise depreciation and interest expense, both of which are excluded in calculating earnings before interest, taxes, depreciation and amortisation (EBITDA)—so EBITDA will actually increase.

It is important to remember that this will not affect cash flows—at least not in the first instance. However, the change in accounting could influence business behaviours—eg buy versus let decisions—and the taxation of leases. This could change cash flows over time.

What impact will this have on drafting and negotiating of financial covenants?

A key priority will be to check the impact of the new lease standard on compliance with existing covenants. At present, many financial covenants are monitored on a ‘frozen GAAP’ basis—ie they are monitored based on the accounting requirements in place at the time the agreement was entered into. And many loan agreements include specific requirements on the treatment of lease transactions.

However, given the extent of the accounting change, it will be important to identify any existing covenants for which this is not the case, so that they can be reconsidered before this accounting change creates a technical breach. Going forward, the question is whether the new lease accounting—and the associated disclosures—provides the information that lenders need, such that more financial covenants can be driven by the new GAAP information.

Are there any other factors lenders or borrowers should be aware of?

The IASB’s standard applies to companies reporting under IFRS. The US financial accounting standards board is expected to release a new US GAAP lease accounting standard this quarter. The US standard will also feature on-balance sheet accounting for lessees, though it differs from the IASB standard in numerous points of detail.

It is clear that lease accounting will be a hot topic on both sides of the Atlantic for some time to come.

Interviewed by Nicola Laver.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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