Niall Naughton, Partner, KPMG Ireland, discusses challenges lessors and lessees face when IFRS 16 comes into effect in 2019.
After nearly 10 years of discussions, the international accounting standard setters (IASB) published IFRS 16 Leases in January 2016 with the new standard requiring companies to bring all significant leases on-balance sheet from 2019. The US standard setters (FASB) issued the new US GAAP standard on leases, a month later in February 2016. Key aspects of the new standards under the two frameworks are converged but there are some important differences which will result in different practice under the two frameworks.
A key long-standing objective of the IASB has been to bring leases on-balance sheet for lessees. All companies which lease major assets for use in their business will see an increase in reported assets and liabilities. This will affect a wide variety of sectors and the aviation sector will be significantly impacted given the high volumes of operating leased aircraft.
Currently, operating leases are off-balance sheet for lessees. Companies are required to disclose details of their off-balance sheet leases and many analysts already use this information to adjust published financial statements. The key change will be the increase in transparency and comparability. For the first time, analysts 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.
The impact of the new standard is not contained to the balance sheet. There are also changes in accounting over the life of the lease. In particular, companies will now recognise a front-loaded pattern of expense for most leases, even when they pay constant annual rentals.
The new standard takes effect in January 2019. Before that, companies will need to gather significant additional data about their leases, and make new estimates and calculations.
The lobby for the lessor community was successful in achieving a result of very limited change in lessor accounting. The lobbying approach for the lessor community was very much one of “why try and fix something that’s not broken”, which the IASB ultimately listened to.
Lessor accounting remains similar to current practice – ie, lessors continue to classify leases as finance and operating leases. Leases that transfer substantially all the risks and rewards incidental to ownership of the underlying asset are finance leases; all other leases are operating leases. The lease classification test is based on the criteria in the current lease accounting standard, IAS 17 Leases.
This accounting model is inconsistent with the accounting model to be applied by lessees – lessees follow a new single accounting model, whereas lessors retain a dual model. For example, in the case of an operating lease, the lessee will recognise a financial liability for its obligation to make fixed-lease payments, but the lessor will not recognise a financial asset for its right to receive those lease payments. This is causing some issues for sub-leases or intermediary lease structures.
At the simplest level, the accounting treatment of leases by lessees will change fundamentally. IFRS 16 eliminates the current dual accounting model for lessees, which distinguishes between on-balance-sheet finance leases and off-balance-sheet operating leases. Instead, there is a single, on-balance sheet accounting model that is similar to current finance lease accounting.
Bringing operating leases on-balance sheet also changes the profit-and-loss account of lessees. Currently, operating lease expenses are charged to the P&L on a straight-line basis over the life of a lease.
From 2019, leases will be accounted for as if the company had borrowed funds to purchase an interest in the leased asset. This typically results in higher interest expense in the early years than in the later years, similar to any amortising debt. In turn, this means that total lease expense in the profit-and-loss account will be higher in the early years of a lease – even if a lease has fixed regular cash rental payments.
Key financial metrics will be affected by the recognition of new assets and liabilities, and differences in the timing and classification of lease income/expense. This could impact debt covenants, tax balances and a company’s ability to pay dividends. The additional assets and liabilities recognised and the change in presentation will affect key performance ratios – eg, asset ratios and debt/equity ratios – and consequently could impair the ability to satisfy any debt covenants that are not applied on a “frozen GAAP” basis.
To minimise the impact of the standard, some companies may wish to reconsider certain contract terms and business practices – eg, changes in the structuring or pricing of a transaction, including lease length and renewal options. The standard is therefore likely to affect departments beyond financial reporting – including treasury, tax, legal, procurement, real estate, budgeting, sales, internal audit and IT.
In the last reporting cycle, given the new standard had less than 12 months to implementation date, airlines have been disclosing the likely impact in future period financial statements. A number simply disclose that the current operating lease commitments disclosed is a reasonable proxy of what will be recognised as lease liabilities and corresponding right of use (ROU) assets when the new rules take effect.
For example, Singapore Airlines disclosed in its 31 March 2018 financial statements: “As at the reporting date, the Group has non-cancellable operating lease commitments amounting to $3,127.8 million. The Group expects a large proportion of these operating leases to be recognised as lease liabilities with corresponding ROU assets under the new standard. This will increase the Group’s leverage ratio and its foreign exchange volatility arising from revaluation of lease liabilities that are denominated in USD. There will also be an impact on the timing of expense recognition in the profit and loss account over the period of lease. Interest expense will be recognised using the effective interest method on outstanding lease liabilities and the ROU assets will be depreciated, rather than operating lease payments being the expense.”
Wizz Air provides similar disclosures in its 31 March 2018 financial statements and, as well as disclosing the estimated balance sheet impact, it discloses that “the impact on profits for the year of initial application will be a loss of €15–20 million”.
There are also other less obvious impacts that airlines may need to consider outside of the operating lease of aircraft. For example, do various contracts at a hub airport such as customised lounges, hangars or common areas meet the definition of lease and need to come on-balance sheet and how are similar contracts in airports other than its hub dealt with?
However, the single issue that comes up most often when we discuss the new standard with airlines is the foreign exchange volatility introduced for non-US dollar reporters. This is an issue for all sectors but is particularly pronounced in aviation where leasing contracts are generally denominated in US dollars. For airlines which do not prepare their financial statements in US dollars, that foreign currency liability needs to get retranslated at each balance sheet date and potentially causes foreign exchange volatility in the reported results.
This article appeared in the Airfinance Journal Magazine, September/October 2018 Edition, and is reproduced here with their kind permission.