Written by Jen South FCA MA (Oxon)
It’s an exciting time to be involved in financial reporting – over the 2018/2019 period there are three key new standards which are coming into play for companies – IFRS 9 (Financial Instruments) and IFRS 15 (Revenue from Contracts with Customers) in 2018 and IFRS 16 on Leases for accounting periods starting on the 1st January 2019, all of which will have a significant effect on almost all companies in some way.
The need for a new standard
Broadly speaking, up to now when a company rented an asset (such as machinery or
property), the most important test was whether they enjoyed the “risks and rewards” of ownership of the asset – for example, responsibility for repairs and maintenance, or the benefit if the asset increased in value.
If this was the case, the company included the asset within its financial statements and showed a liability for the amount it was due to pay over for renting the asset. If the company did not have the risks and rewards of ownership (such as merely renting an office block on a 10 year lease), no liability was included (even if there was an agreement to pay rent for quite a few years into the future) - an arrangement known as “off balance sheet financing”; the company got the use of the property but did not have to show a liability.
The fundamental purpose of producing financial statements is to help stakeholders make useful decisions about a company – so not including (in some cases quite significant) liabilities left some companies looking in a healthier state than they truly were. But all this is about to change…
The new principles
Under the new standard, nearly all lease contracts that companies enter in to will need to come “on balance sheet” – the amount owing will need to be recognised. This will impact the amount of debt the company discloses, and will increase the interest expense shown in profit or loss.
Which key industries will be affected?
Companies working in industries which have a lot of short term, high value rental
agreements will be significantly affected by this change – retailers with shop leases, airlines leasing aircraft and the telecoms industry with the various phone shops, cables and towers being leased spring to mind. Analysis by PWC in 2018 suggests the debt shown by retailers will, on average, double due to the many short term shop rental agreements they have. This may well have a knock on effect on companies’ covenants with other debt providers, since key metrics such as gearing and interest cover will also be adversely affected.
It’s worth remembering, though, that these contracts were already in progress before the standard changed – fundamentally nothing has intrinsically changed within the company – it’s just now users have a better, fuller picture about the commitments the company has to fulfil in the future. It will be interesting to analyse and investigate the effect of the standard as companies start to implement it – and to see which companies manage stakeholders’ expectations well to ensure they understand the rationale of the standard and the reasons behind the change in position.