Fitch: IFRS 16 Lease Accounting Lacks Comparability

First page of lease contract
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Financial results of early adopters of IFRS 16 indicate reduced comparability due to management discretion in accounting for lease terms and discount rates, Fitch Ratings said on Wednesday.

In addition, evolution in business models could encourage greater use of service contracts or other off-balance sheet alternatives, potentially resulting in less lease debt on the balance sheet, the rating agency noted.

“The changes also widen differences between IFRS and US GAAP with respect to accounting for leases, affecting global comparability,” Fitch said..

IFRS 16 will come into force in January 2019, requiring companies to include virtually all leases on their balance sheets.

Fitch said it reviewed about 30 companies that have already adopted this standard.

Of these companies, 17 have provided interim disclosure, which was generally minimal, to assess the impact of changes in lease accounting on their financial statements, the firm observed.

Lease debt expected to vary significantly among similar firms

The amount of lease debt recognized for similar companies could vary significantly, Fitch pointed out.

Accounting choices over what determines a lease, what discount rate to use, the length of lease term, and whether it is reasonably certain that a lease extension option will be exercised, will give management discretion in what numbers to present, Fitch explained.

In addition, there could be structural factors, such as widely differing average lease terms in different geographies, the firm added.

Expect your bottom to be affected

The companies' bottom line is likely to be affected by the new requirement, according to Fitch.

The longer the lease, the more front-loaded the interest cost would be, the firm said, adding that this could shift some net profits to a later lease period due to the mismatch between, typically, straight-line depreciation and interest amortization.

“Lease accounting will also increase volatility in finance cost over the total lease period for IFRS issuers,” Fitch noted. “Everything else being equal, high-yield issuers are likely to see more variation from historical results due to different borrowing costs.”

US GAAP and IFRS differences will affect global comparability, Fitch pointed out.

While the balance sheet treatment of leases is generally similar, stark differences remain in the income statement and cash flow, it added.

“Broadly, US GAAP retains the difference between finance and operating leases, and their traditional accounting treatment, while IFRS 16 mandates finance-lease type accounting for all leased assets,” Fitch said. “The change has replaced minor differences between US GAAP and IFRS with major ones.

Based on its review of 670 US and UK non-financial listed companies, the rating agency estimates that an additional US$790 billion in operating lease commitments will be recognized as on-balance sheet liabilities next year.

“We expect the retail sector to contribute more than a quarter of this, followed by commodities and materials (13%) and transportation and logistics (11%),” Fitch said.