Balancing the impact of leasing

Listed companies using IFRS standards or US GAAP are estimated to have $3.3trn of lease commitments, of which more than 85% do not appear on their balance sheets according to the International Accounting Standards Board (IASB).

From January 2019, IFRS 16 will require all leases to be reported on a company’s balance sheet as assets and liabilities.

One of the more observable impacts is likely to be in relation to property leases, which were previously treated as operating leases and are most used by retailers and corporates.

“The changes will also be noticeable for contracts for other long-lived assets in the airline, transportation, extractive and construction industries,” explains Veronica Poole, global IFRS leader and UK head of accounting at Deloitte. “In addition, some industries have leases that could be more difficult to classify, such as telecommunications where it can challenging to distinguish between a service contract (which is off-balance sheet) and a lease.”

IFRS 16 does not directly affect any business that does not use IFRS and companies will have to wait to see whether the changes are extended to other accounting regimes such as UK GAAP, observes George Tonks, partner at Invigors EMEA.

“Credit ratings/assessments for IFRS companies already in general reflect adjustments in respect of off-balance sheet finance, using information disclosed in the notes to the accounts,” he says. “Loan or banking covenants is another area that will need to be considered, but many include ‘frozen GAAP’ provisions. In the income statement, operating lease rental expense will be replaced by interest and depreciation expenses.”

Gathering the necessary data for IFRS 16 is easy in theory, but complex and time consuming in practice suggests Innervision director, Martin Kennard. “Companies with devolved decision making, multiple divisions or subsidiaries in different countries will find the task particularly difficult. Gathering all the data could easily take 12 months.”

Paul Fry, global consulting partner at Cushman & Wakefield agrees with this view, suggesting that perfect property data will become an absolute necessity. “In addition, occupiers will need a clear business strategy for each property in their portfolio – where leases include either break options or options to renew, they will need to make a judgment on whether they are likely to exercise a future break or renew a lease and be prepared to justify this to an auditor. These judgments will directly impact the liability calculated.”

On the question of how multinational companies will be affected by the differences between IFRS 16 and the revised Financial Accounting Standards Board (FASB) standard issued in February 2016, Jeroen Van Doorsselaere, director business development for global finance and performance at Wolters Kluwer refers to a number of areas of divergence.

“The way profit & loss is recognised means the carrying amount would be higher under the FASB model than under IFRS 16,” he explains. “For companies that have material off-balance sheet leases, the IASB expects IFRS 16 to result in higher profit before interest compared to the amount reported applying the FASB model, where the entire expense for former off-balance sheet leases is included as part of operating costs.”

The difference in operating profit and finance costs depends on the significance of leasing to the company, the length of its leases and the discount rates applied.

For the finance and accounting departments of multinational companies, the changes introduced by IFRS 16 will be manageable as change is a constant feature in accounting particularly in areas of tax and accounting and interpretation, suggests Maxxia CEO, Roger Skinner.

“The real issue is how well the revised financial statements will be understood by the investment community and lending institutions, particularly as key ratios such as gearing may be affected and more transparent in the balance sheet,” he says.

While the introduction of IFRS 16 does not change the accounting requirements for income taxes or tax laws, it may change how a company applies these requirements to its leases and therefore may result in changes to the timing and amounts of tax paid by the company and the timing of tax expense or benefit recognised in the financial statements, says Kimber Bascom, a partner in KPMG’s US member firm.

The IASB notes that the specific impact will depend on the tax rates and treatment for leases in each jurisdiction. EY financial accounting advisory services partner, Rebecca Farmer, observes that the UK Government has already committed to issuing a discussion document before the summer with options for change to the tax treatment of leases of plant and machinery.

From HMRC’s perspective, the leasing standard brings with it a number of challenges, she explains. “There is a potential duplication of assets, with a right of use asset sitting on the lessee’s balance sheet and a corresponding investment property or other fixed asset sitting on the lessor’s balance sheet. The new standard could have consequential impacts on taxation through capital allowances, interest deductibility and, potentially, transfer pricing arrangements.”

From both a cash and deferred tax basis perspective, tax practitioners and businesses must wait for the outcome of HMRC’s deliberations, which will understandably take some time. In the meantime, businesses are faced with the need to maintain parallel ‘frozen GAAP’ lease accounting if a new tax treatment has not been introduced by the time the new standard is introduced.

According to Farmer, this could be a significant additional reporting burden at a time of unprecedented accounting change following the introduction of new UK GAAP, IFRS 15, the new revenue recognition standard and IFRS 9 on financial instruments.

“We would therefore urge companies and advisors to engage with HMRC in their discussions and to support them in reaching a conclusion on the new tax treatment as soon as possible,” she concludes.

Paul Golden is a freelance journalist and editor specialising in finance and professional services.

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