For most public companies, it is less than two years before they have to report leases on balance sheet. Regulators have estimated that the accounting change will bring $3 trillion of leasing commitments onto balance sheets, materially increasing the debt that must be reported. The impact of the accounting change is slowly emerging and, in some cases, prompting innovative responses. The use of leases is concentrated on some industry sectors and companies more than others and for those, we can expect to see major changes in company reports. In certain cases, we may see commercial changes as well to mitigate the impact of IFRS 16, Leases – the new lease accounting rule, although ratings agency Fitch says application of IFRS 16 will not affect its corporate ratings.
Over the past two decades, sale and leaseback transactions have become very popular, particularly in sectors and companies that required lots of big assets. By using sale and leaseback, a company’s balance sheet implied a smaller asset base and less financial debt. But regulators argued that the picture was not a complete view of a company’s actual position. The final version of the accounting rule has taken more than a decade of negotiation and debate to finalise but, ultimately, the International Accounting Standards Board (IASB) in conjunction with the US standard setter, the Financial Accounting Standards Board (FASB), concluded that the benefits – such as improved quality of financial reporting and better comparability – outweighed the costs of data capture and implementation. IFRS 16 will result in a more “faithful representation of a company’s assets and liabilities, and greater transparency about the company’s financial leverage and capital employed,” the IASB says.
The accounting shouldn’t change the economic decision-making
Stephen Cooper, IASB board member, says: “Investors and ratings agencies like it because it allows them to do fewer adjustments. They want more disclosure.” The IASB expects the number of sale and leaseback transactions to fall as companies apply IFRS 16. This is because the new rule reduces management’s incentive to use them, but the accounting should not affect the fundamentals of a business model. “The accounting shouldn’t in theory change the economic decision-making in a company. In practice, however, the fact that leases were off balance sheet gave companies a reason to lease. It was an artificial incentive to lease for the wrong reasons – so that bias in the system has been removed,” Cooper says. There has been a mixed reaction from companies. But some like the rule and argue that the accounting should have changed a long time ago. German engineering group Bosch recently told an IASB conference that it would be adopting the change early. But it is unlikely that many other companies will follow suit.
Airlines, retail and hotels are sectors that will be materially affected by the reforms. However, even within each of these sectors, some companies will be significantly more impacted than others. According to IASB analysis, for 36% of retailers (73 of 204 companies), the estimated present value of future payments for off-balance sheet leases to total assets was more than 50% as compared with 21.4% for all companies sampled in that sector. Virgin Atlantic, like many airlines, has leased many of its planes over the years. Since 2014, the airline has implemented a new strategy to buy a greater percentage of aircraft with the aim of owning just over a third of the fleet by 2021. The airline’s finance and treasury team worked proactively and rather innovatively last year to secure a landmark deal to restructure their finances in order to buy plans. Last year, Virgin Atlantic arranged a £220m senior secured note transaction using the airline’s takeoff and landing slots at London’s Heathrow Airport – which scooped an accolade at The Treasurer’s 2016 Deals of the Year Awards. It was the first time in European air-transport history that airport slots had been leveraged in such a way. “Virgin had always leased its aircraft, but it is now looking at owning between 30% and 50% of its aircraft. We used the deal to raise funds to buy some,” Nathan J Dunton, group treasurer, says. “It’s about altering the asset base to on-balance sheet debt and assets in line with the new accounting rules. Those [aircraft] are good assets and so having that expense of the asset isn’t seen as such a big risk as it was in the past,” Dunton says. He adds, however, that IFRS 16 was not the primary driver of this strategy and that the airline is still working through the full effect of the new accounting rule. Karlien Porre, partner in Deloitte’s treasury advisory services, says: “Treasurers may look to refinance arrangements based on the charges of the leases. Treasurers will need to manage and think through how it will impact cost of funding, debt covenants, credit ratings and interest rate on debt as debt will increase. “The whole topic around managing the impact will be a big role for treasurers.”
Loan documentation is often worded such that covenants are tested using generally accepted accounting principles (GAAP) at the date the loan was negotiated, so companies will likely face the challenge when they refinance, rather than straightaway. Not all airlines will necessarily look to own planes, either. BA Airlines, owned by Spanish company International Airlines Group, has traditionally owned a large portion of its aircraft and will already have many aircraft on balance sheet. Some lower-cost airlines may continue to opt to lease planes. Their flight schedules and routes are seasonal and must be agile enough to respond to market and consumer changes. “We don’t see leases disappearing completely,” says Alan Teixeira, global director of IFRS at Deloitte. However, Jake Green, head of financial reporting at Grant Thornton, says that we can expect to see management seeking more flexibility in leases so companies can avoid capitalising them. Not all leases are required on balance sheet by the new rule. Short-term leases of 12 months and under, and leases of low-value assets won’t be included on balance sheet. “Those companies that are cash rich may seek to buy assets, but many businesses will still want the flexibility. More risk sharing with the lessor and flexibility on leases with earlier break clauses will be needed,” Green says. The situation is the same for retailers and hoteliers, too. Aside from their flagship stores and hotels, retailers and hotels will require the agility of a leased asset rather than a bought one, advisers say. A lot will depend on a company’s position. Jessica Taurae, partner in PwC’s accounting consulting services, says: “It will probably come down to how much a company would have to borrow to buy an asset versus how much the lease payments would be. It’s a cost/benefit analysis issue. “Could you get a good rate to borrow? Do you want to buy an asset or do you have cash lying around? Companies will be figuring all of this out.”
Analysts and professional investors in sectors where there are material off-balance sheet commitments have typically adjusted companies’ income statements to factor in any lease obligations, so it is unlikely to be a huge shock. “As a result of new accounting rules, some companies are rethinking the decisions about whether to lease, because the change has provided them with the opportunity to sit down and think about it. I’m sure companies are using this as a bit of a catalyst to review business decisions, as well as change their accounting processes,” Cooper says. Leasing still makes good economic sense in many regards, particularly in an increasingly uncertain economic landscape. However, the new accounting rule is providing boards with another opportunity to review their leasing arrangements and consider the narrative they wish to provide investors, customers and other stakeholders ahead of 2019. It seems likely we will see more creative thinking along the lines of Virgin Atlantic’s leveraged landing slots over the new few years.
Michelle Perry is a freelance finance journalist
In this ACT webinar from 24 May 2017, host Michelle Price, Associate Policy & Technical Director, ACT spoke to Henry Wilson (BP) and Matthew Stone (M&G Real Estate) to discuss the impact of the new the impact of the new leasing rules on corporate treasurers. You can access the recording here.
This article was taken from the June 2017 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership