Accountants are now being told by IFRS to account for all lease contracts as if they were all finance lease contracts. As opposed to life before IFRS 16 where you had to decide whether a contract should be classified as an Operating Lease or a Finance Lease, no judgement is needed now!
Will this affect managers’ decisions? I would say yes! And in a helpful way!
Take an example of a normal lease contract whereby you pay rentals for a piece of equipment, on a monthly basis with the intention to use that item for a number of years.
How is this shown in the financial statements? Easy! You show a cost of a rental. End of story!
‘But hang on’, I hear you ask… what is the reality, as in what is actually happening? Are we showing that?
Well, that is also easy: the company has an asset that it is using for its operations. And as the company was not able to buy this asset it decided to lease it.
OK, so this is like taking a loan and using that loan to buy an asset, right?
Yes I think that is fair to say!
Fine, so far so good.
But now, let’s step into an analyst’s shoes: how are they going to view the company?
Let me tell you that this is also easy! It will look like a company that has no possession of an asset and no matching loan!
Exactly! No loan! Which means that the financial gearing of this company will look low compared to a company that has bought an asset against a loan. Is that right?
Yes that is correct.
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In the past, managers had to apply judgement and decide whether a lease contract was one where the asset was temporarily rented with no intention to use it for most of its useful life, i.e., an operating lease, or one where the asset was effectively intended to be used for most of its life by the lessee, i.e., a finance lease contract.
In the case of an operating lease there is no asset and no liability. In the case of a finance lease, there is an asset but unfortunately there is a liability too.
The decision on how to classify a lease contract would have implications on the ratios.
Beyond definitions, back to reality
Life for managers is easier now with IFRS 16. Effectively, all leases (there are some exceptions) are assumed to be finance leases! And this is to reflect reality!
Let’s look at numbers to make sure we get it right!
So you need to acquire an expensive machine for €1m.
The company’s current debt to equity (gearing) ratio is already at 100%. Companies with relatively high gearing ratios are perceived as “risky” and hence lenders are reluctant to extend loans to them; this is why the market values the shares as low.
If you get a loan, your gearing will jump to 150% and your shares will tumble! So you hide the liability under an operating lease!
In other words, you enter into a lease agreement with the manufacturer of the machine and you pay rentals.
IFRS 16 makes the above impossible from 1 January 2019, so the asset and liability have to be shown.
There are exceptions of course: for example, if the lease period is short and below 12 months. But generally, IFRS 16 insists on the above transparency.
The assumption is that you will be entering into a lease agreement solely because you cannot afford to buy by cash – that is why you are interested in getting a loan! So do not hide it! Show you are geared up and tell the market to lower the value of your shares!