The latest accounting standard issued by the International Accounting Standards Board (IASB) will have a fundamental impact across virtually every entity in the Middle East.
Called IFRS 16 – Leases, the standard changes accounting practices that have been accepted for many years, collectively moving trillions of dollars of assets and liabilities on to companies’ balance sheets around the world.
Currently substantial lease obligations are off balance sheet and, as a result, financial statements are not comparable, nor transparent. Accordingly, the IASB has issued the new leasing standard, changing accounting practices by adopting a single lease accounting model that brings assets and liabilities on to the balance sheet.
Almost every business has operating leases in some form or another. This could encompass anything from office equipment to property. Leasing makes a lot of sense, and some industries such as retail, logistics and airlines are extremely heavy users of operating leases.
These leases currently have the benefit of keeping leased items and their funding off balance sheets. Companies might want to do that when there is already significant debt in the balance sheet.
The new standard will change all of that.
This standard will bring significant assets and liabilities on to the balance sheet, changing key performance indicators that are commonly used by analysts and investors to measure performance. Measures such as current ratios, gross profit percentages, Ebidta (earnings before interest, depreciation, tax and amortization), operating cash flows and others will change as a result of the new standard, potentially changing perceptions of company performance and affecting share price.
What does this mean?
PwC’s research indicates that lease holders are likely to record significant increases in interest-bearing debt and the amount of long-term debt that companies are shown to carry. In industries such as retail, interest-bearing debt may increase by more than 200 per cent and balance sheet gearing (the ratio of debt to equity) could increase by more than 60 per cent, while Ebitda may increase by more than 50 per cent as costs for such leases will not be recorded as amortization and interest.
So what should companies do?
A good place to start would be to take stock of your company’s leases. Lease arrangements may be entered into for a variety of reasons, covering vehicles and housing for staff, machinery for use in production, land for storage purposes and buildings for administrative purposes. Accordingly, lease information is often scattered across various functions and departments from human resources to legal.
The issue for many leasing entities is that they will simply not know what operating leases they have. More than 60 per cent of entities surveyed by PwC in Europe indicated that they had not assessed the impact of the requirements of the standard on their current and future lease arrangements.
Another issue is that the standard is retrospective from 2019, when it is expected to take effect. As such, leasing entities may have already entered into, or are about to enter into contracts that will have a very different accounting consequence in 2019. Careful management of both old and new contractual arrangements is required to optimise liquidity and avoid potentially detrimental implications on funding arrangements already in place.
Lease holders need to ready themselves for the implementation of the new standard as soon as possible. Lease arrangements are often not readily changed, particularly if there are longer term operating leases of property in place. Such leases could give rise to substantial assets and liabilities being recognised in 2018, when the standard becomes applicable and entities may wish to try to amend the terms of such leases to avoid the potential accounting consequences.
Given that systems are largely not set up to manage and report these assets and the data is often scattered across departments, entities should expect that adopting the requirements of the standard will take significant time.
Few companies in the region have engaged in proactively assessing the implications of the standard and many entities have a significant number of leases that will need to be assessed.
Delaying this assessment further will restrict a chief financial officer’s ability to adopt different leasing strategies in advance of the implementation of the standard should it have a fundamental impact on results and the company’s financial position.
Gavin Steel is partner in charge of accounting advisory services at PwC Middle East.
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