Companies Need to Act Ahead of New Rules on Lease Accounting

This article was authored by Ben Hanslip and Mike Weaver for Trade Winds, August 2018.

At the start of next year new international accounting rules will bring leases onto companies’ balance sheets, with significant implications, write Michael Weaver and Ben Hanslip.

Forthcoming changes to lease accounting rules will significantly impact key financial metrics for a number of the industry’s biggest names, with some set to recognize billions of dollars of incremental lease liabilities.

IFRS 16 Leases, published by the International Accounting Standards Board in January 2016 and due to come into effect in January 2019, introduce new principles for the recognition, measurement, presentation and disclosure of all leases.

Balance sheets and credit ratings
Under the new rules, investors and analysts for the first time will be able to see a company’s own assessment of its lease liabilities, calculated using a prescribed methodology that all companies reporting under IFRS will be required to follow.

For some shipping outfits, particularly those with a high proportion of chartered-in tonnage, IFRS 16 will cause significant changes to balance sheets, profit and loss, as well as Ebitda and credit ratios.

Consequently, it may affect market sentiment, share prices, analyst coverage and credit ratings. It has been two years since the new rules were announced, and companies should by now have a solid grasp of how their numbers will look and the key changes in presentation and metrics.

Changes to business practice and strategy
So how are companies reacting? It appears some have made significantly more progress than others in evaluating the impact of transition options and practical expedients, whether taking a full retrospective approach (restating comparative reporting periods) or a cumulative catch-up (the net effect of applying IFRS 16 on the first day of the first accounting period — January 1, 2019).

However, to smooth the transition, they should consider their communications to the market as early as possible, especially if there are likely to be any nasty surprises.

There will certainly be greater scrutiny of lease contracts, which will systematically appear on balance sheets rather than just being recorded in the notes (off-balance sheet) of the financial statements.

For stakeholders who have a firm handle on the operations of the company, this change should not uncover any unwelcome surprises.

However, companies would be well advised to engage with their key stakeholders ahead of time, walk them through any changes and address any potential issues that arise.

How some companies do business is likely to change as a result of this shift in accounting rules — sale-and-leaseback transactions in particular may no longer be an attractive option.

Asset-rich, but in debt?
On the one hand, a decrease in operating expenses will make lessees appear more asset-rich, but they will also appear more heavily indebted.

Higher reported total debt levels will mechanically affect gearing ratios. Without renegotiation, loan covenants based on total debt may, therefore, be breached owing to the accounting change. To mitigate this, companies should have conducted, and ideally completed, discussions with their lenders well before the changes take effect.

Those companies that have already made an attempt to publicly quantify the impact on their balance sheet should be commended — and those that haven’t should do so as soon as possible.

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