Starting on January 1st, 2019, public companies will be required to account for all long-term leases on their balance sheets. If you consider changing your lease contracts – you will have to disclose your intentions in your 2018 annual report.
Almost all companies have long-term leasing commitments of some kind – either because they lease their premises, lease cars for their employees, or lease valuable computer equipment.
For this reason, if you manage a company, you have probably come across the words ‘IFRS 16’ in recent months. Perhaps you have also been exposed to warnings about the significance of this new standard: namely, increase in reported liabilities on the company balance sheet. The truth, however, is that pessimistic warnings about ‘accounting shock’ and ‘doubling the amount of liabilities’ are exaggerated. Like every other new standard, companies will have to adjust to IFRS 16. However, it is a very reasonable standard, which creates important transparency, and certain financial metrics are even set to improve as a result of its application.
Before we explore the ramifications of the new standard, it is important to understand the reasoning behind it. When it was first issued, in January 2016, its developers claimed – with a great deal of justice – that it made no sense for long-term expensive commitments to be hidden in clauses which nobody bothered to read. Such commitments, according to IFRS 16, should be capitalized and recorded on the balance sheet. This way, everybody reading the balance sheet will notice that the company has long-term liabilities which might affect its financial situation.
An Accurate Picture
The more long-term leases the company has, the more its balance sheet will be affected by IFRS 16. For example, a retailer which leases its stores will now have to record all of its many leasing commitments on the balance sheet. Such companies might dislike the idea of their on-balance-sheet liabilities being doubled, but history proves the new requirement is very sensible. After all, the role of the balance sheets is to provide an accurate picture of the company financial health.
There have been many cases in which investors discovered too late that the company in which they had chosen to invest was a sinking ship because of its long-term leasing commitments. A well-known example is the bankruptcy of the US Borders Group bookstore chain in 2011. In accordance with the previous standard, Borders didn’t record its lease commitments on the balance sheet. The total of these commitments was $2.8 billion – or seven times Borders’ registered liability on the company balance sheet.
The new standard wouldn’t have solved the company’s problems but their highly leveraged balance sheets would have warned investors in time about the riskiness of the investment.
Doing it Differently
While companies whose business model is based on long-term lease contracts will just have to put up with the new transparency on the balance sheet, other companies might decide to abandon their current policy of long-term leasing, since the new standard does not apply for leases with a lease term of 12 months or less.
Short-term leasing is not always an option: most car leasing companies, for instance, will not lease their vehicles for less than three years. When it comes to leasing offices, though, a company can opt for using coworking spaces, which can be rented on a month-to-month basis. Such spaces are becoming increasingly popular due to their lower costs and their demonstrated ability to encourage collaborations and productivity, and the implementation of IFRS 16 might tip the scales in their favor for many companies.
Whatever you decide, if you seriously consider changing your lease contracts because of the new standard, note that you do not have all the time in the world. Your 2018 annual reports must include a disclosure of all known or reasonably estimable information about the impact IFRS 16 will have on your financial statements.
At the end of the day, we should remember that IFRS 16 does not change a single thing about the financial health of a company. This is an accounting change only – moving around the items in a window display if you wish. Investors looking at financial reports will receive a more accurate picture of the company’s liabilities, but will also be able to disregard the effects of the new standard in order to reach a decision about the company’s financial health. Like all changes, the new standard requires adjustment and creates a buzz – for a while. Then it, too, will become old news.