How the new IFRS 16 impacts retailers
Most enterprises in Asia Pacific are aware that International Financial Reporting Standard (IFRS) 16 took effect on January 1, entailing significant changes to the way leases are accounted for, particularly for lessees.
Less understood are the broader impacts of the standard, which will have ramifications beyond finance in virtually all business operations, from information technology to human resources.
IFRS 16: Regional readiness
Put simply, to enhance transparency for lessees, IFRS 16 eliminates the distinction between finance leases, which were previously capitalised on corporate balance sheets, and operating leases, which were not. Virtually all businesses lease property and other assets and equipment and in some industries, such as retail, leases are central to the business model. With all leases (bar a few short-term, lower-value exemptions) brought on the balance sheet, both the total liabilities and assets of lessees adopting IFRS 16 will increase.
This will have knock-on effects on key financial ratios like profit and loss (P&L) and earnings per share (EPS), which will decline in the early years of a lease; and earnings before taxes, depreciation and amortisation (EBITDA), which will increase as rental expenses are no longer presented above the line.
IFRS 16 has been adopted relatively consistently across most Asia Pacific markets. However, there will be variances in implementation influenced by different reporting periods and local regulatory requirements.
In Hong Kong, for example, most companies have a December financial year-end and submit financial statements to the Inland Revenue Department in August the following year. IFRS 16 impacts may become more apparent when listed companies release interim results in July 2019. In Australia, most year-ends are in June, so some companies will not technically need to grapple with IFRS 16 until the second half of 2019.
Similar patterns are evident in Singapore, Malaysia, India and the Philippines, where common accounting periods and reporting practices mean many companies won’t have to address IFRS 16 until later in the year. The equivalent standards in Thailand and Indonesia are not effective until January 2020. In China, the Ministry of Finance only released the local version of the standard in December 2018, giving non-listed companies up to 2021 to adopt.
The net result is that while IFRS 16 is already a reality, actual implementation is sporadic across Asia Pacific and is likely to remain so for some time. Firms that are listed, active across several markets or moving in line with the practices of international parents, are generally adopting a more proactive approach, but may still resort to boilerplate disclosures in their 2018 financial statements. Awareness and preparatory efforts among smaller, private firms remain limited.
The concern is that this will result in panic as subsequent reporting deadlines approach, with companies scrambling to comprehensively reflect IFRS 16 on their balance sheets for the first time; explain the changes that result to investors and other stakeholders; and manage the impacts on other aspects of their operations, all at the very last minute.
This process is likely to present specific challenges for companies whose business models depend on leasing, but will not prove easy for any business, as any potential fallout from IFRS 16 will only be apparent when it is adopted in full. This is why companies should begin integrating IFRS 16 into their financial, operational and strategic planning at the earliest opportunity – and to pay close attention to outcomes that may have been less discussed or expected.
We have already seen unexpected impacts in the food and beverage and retail sectors in Hong Kong, where it is common for companies to enter into leases in which a portion of the rent is variable based on shop turnover. Under IFRS 16 variable lease payments will, in many cases, remain off the balance sheet, but the standard may change the appetite for agreements of this kind, and the way they are negotiated with landlords.
A substantial part of the IFRS 16 burden will fall on the treasury function, which may need to reallocate resources and revise policies as a result. The main pressure points will include:
Discount rates: The treasury department is likely to face demands to produce estimates of the discount rates or discuss these rates with lenders. Before, many organisations’ discount rates were considered only on an entity-wide level. Now, more resources and close coordination with accounting and operational functions will be needed to determine discount rates for individual leases. These rates will also need to withstand possible scrutiny from analysts and external auditors.
Foreign exchange (FX): We have seen cases where lessees with many leases across various markets denominated in different currencies – such as airlines – realised only upon examining their leasing arrangements in detail that IFRS 16 would cause additional volatility in the P&L through FX gains or losses. This has potential consequences for companies’ hedging strategies, and will need to be managed carefully by treasury and factored into planning.
Loan covenants: As IFRS 16 will typically result in companies appearing more indebted, the standard may challenge the covenants made with lenders. As with compensation, some companies and their banks are managing this by accounting for loan purposes on a Frozen GAAP basis, but this will only defer the issue until a loan has to be renewed or renegotiated. As IFRS 16 takes hold, a sudden surge in debt levels could have consequences for a company’s credit rating. While there is a view that major ratings agencies had already effectively been factoring leases (previously off the books but disclosed in financials) into their calculations, some firms may face an uneasy transition period before the practical impact of the new standard on lending arrangements becomes clear. Close cooperation and transparency in communication with lenders will be key to managing this transition successfully – and in many enterprises, treasury will need to lead the charge.
The importance of an informed choice
IFRS 16 presents organisations with a choice of two basic transition approaches, both of which must be consistently applied to all leases: full retrospective, in which the new standard is applied retrospectively to all comparative periods with the financials for these periods, restated as if IFRS 16 had always been in effect; and modified retrospective, in which the impact is booked from January 1 this year (or whenever the initial application date is for the company), and past financials are not restated.
The main thing enterprises should keep in mind is that in choosing a transition option and overall IFRS 16 implementation, there is no ‘one-size-fits-all’ approach. A course of action should be determined based on the structure and situation of the organisation.