One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.
Sir David Tweedie, former chairman of the International Accounting Standards Board (IASB), 2008.
As well as being a surprisingly witty comment for an accountant (with apologies to any accountants reading this), this was also a good prediction. On January 1st 2019, changes associated with the new accounting standard IFRS 16 come into effect that may see Sir David’s wish granted. IFRS 16 is more than just a minor tweak to some rules – it is expected to bring $2.8tn onto companies’ balance sheets. It is time to get interested in accounting!
The end of the operating lease
The new standard covers all leases, whether the company acts as lessor or lessee (although the changes for lessors are fairly minor) and so will have a big effect on the entire logistics industry, including intermodal tank operators, container leasing organisations and intermodal equipment traders. The main change is that all leased assets will have to be reported on the balance sheet and not just those applicable to finance leases. The operating lease is almost dead – the only exceptions are for short term leases and low value assets.
The definition of a lease has been revised to “a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”. In the shipping industry, bareboat, time charter contracts and other arrangements are likely to fall under the definition of a lease.
Current operating leases are usually spread evenly over their lifetime. Under the new rules, the charges will have two parts – the depreciation of the asset and the interest charge due to the financing. Even though the total charges don’t change, this means higher charges in the earlier years and lower in the later ones.
Leases and service contracts
IFRS 16 also affects how to treat contracts that have lease and service elements (for example Time Charters). Only the asset element of the charter falls within the lease – the service element will be dealt with separately. These contracts often don’t give a value to each element, which creates a problem. Organisations will need to use their own judgment to allocate the amounts attributable to the lease and the service.
Those are the key changes. More information is available here and here. The overall aim is to bring greater clarity allow for easier comparison between businesses that buy and those that lease. While that aim is laudable, in the short term there are likely to be a lot of questions and challenges with compliance.
An increase in debt
What affect will all these changes have? The use of the sale and leaseback mechanism to finance leases is likely to decline. Businesses that currently have lots of operating leases will soon see a much higher debt figure on their balance sheets. PwC has estimated that there will be a median debt increase of 24% and a 20% median increase in EBITDA (earnings before interest, tax, depreciation and amortisation). There will almost certainly be other knock on effects in the tax treatment of leases.
There could also be big changes to gross assets and liabilities – total debt could be shown as higher than before. In the worst case scenario, companies with loan covenants based on total debt levels could find themselves breaching them simply due to an accounting change.
January 2019 is not far off. In the short term, we would recommend that logistics businesses involved in leasing should consider the following steps:
- Carry out an impact assessment to work out what the changes mean for your business and how ready you are for them. This will involve collating lease documentation and assessing your current lease portfolio;
- Think about allocating extra resource to prepare for the first year in which IFRS 16 will apply;
- Get ready to train key staff about the new standard;
- Analyse the impact on your business – including financial ratio – such EBIDTA and capital expenditure. The metrics that calculate compensation packages and bonuses may need to be changed
- Consider changes to IT systems and controls to make sure compliance is as smooth as possible. This will require updating information systems, processes, data and governance policies.
On the final point, MRI Intermodal’s lease accounting software helps organisations to convert operating leases to finance leases and then manage those leased assets effectively as well as providing visibility of lease exposure. This can help comply with the new regulation and minimise disruption to the business.
While these changes may seem daunting at first and could lead to some boring meetings (again, sorry to any accountants reading this), it is worth remembering that these changes have been made after an extensive consultation process and may, over time, have a beneficial effect in increasing transparency. Having started with a quote from an accountant, it seems right to end with one from one of the great business minds of the last 100 years, who has succeeded by focusing on the fundamentals – Warren Buffet: “In the long run management stressing accounting experience over economic substance usually achieve little of both”. Any logistics business that stays focused on the substance will succeed, whatever accounting rules apply.