23rd February 2018

Will larger organisations be negatively impacted by imminent new accounting rules that specify the inclusion of contract hire vehicles on balance sheets?

Sir David Tweedie will be happy. As former chairman of the International Accounting Standards Board (IASB), he’s famous in accountancy circles for having said: “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet”. This daydream wish of his has become reality following the IASB’s issuance of new accounting standard IFRS 16 to replace IAS 17.

Until now, one of the key benefits identified and enjoyed in relation to leasing by the huge number of organisations who contract hire vehicles via operating leases is that such financial commitments have traditionally been accounted for on profit and loss accounts as a business expense but have been legally kept off-balance sheet and not treated as an asset or liability.

This has allowed organisations with relatively high debt ratios to obtain finance and secure the use of certain goods without further worsening their standing, while the depreciation of the assets involved has remained the problem of the lessor – which in the car leasing industry would be the ‘funder’ who originally bought the vehicle. Fixed monthly rentals are typically recognised on a straight line basis over the lease term, as explained in the Vehicle Funding guide from the BVRLA, who themselves have long extolled this advantage.

Operating leases to soon appear on balance sheets

From airlines, which reportedly disclose just 15% of the estimated £2.3 billion total worth of plane leases on balance sheets, to train operating companies, large-scale machinery operators and any other sizeable organisations that use operating leases, many of such financial contracts will have to be accounted for on balance sheets from 1st January 2019.

Arval’s owners, BNP Paribas, explain operating leases excellently and define them as situations where “the length of an agreement is shorter than the economic life of the asset and the rentals payable are substantially less than the cost of purchasing the asset”.

Why the change?

In addition to achieving greater transparency and more direct comparability among and between certain organisations, IFRS 16 also strives to recognise the right of use (ROU) that arises from assets and lease liabilities. For entities that lease cars, vans and/or larger commercial trucks on contract hire, the new financial rules take into account the right of use of such vehicles. Under IFRS 16, the depreciation and interest elements of operating leases will have to be reported separately, whereas monthly rentals have traditionally encompassed both components in a single and over-simplistic sum that somewhat hides the effect of operating leases on an organisation’s standing.

What will the impacts include?

IFRS 16 will introduce a broader definition of what constitutes a lease, meaning that organisations will have to scrutinise existing and imminent new contracts to identify assets and the rights of use associated with them.

Financial metrics will be significantly affected, from gearing, EBITDA, operating cash flows and asset turnover to debt-to-equity ratios and net income, and certain organisations may find it harder to access credit.

Finance departments will have to go the extra mile in separating depreciation, interest and also non-lease components such as a vehicle servicing and maintenance agreements, which will be deemed to be ‘services’. The first year or so following the official switch in January 2019 will see organisations having to liaise much more closely with their contract hire brokers, which we can see adding extra strain as organisations try to plan their post-Brexit futures.

Are all organisations affected?

EY and PWC have published some excellent guides on IFRS 16. Before anyone panics after reading the paragraph that says “virtually every company that uses rentals or leasing as a means to obtain access to assets will therefore be affected by the new standard”, though, it’s important to note that only organisations listed on the stock exchange or which report and publish their accounts under IASB/IFRS standards will be affected. A large chunk of the UK’s SMEs adhere to Generally Accepted Principles (GAAP) for their reporting and are therefore unlikely to be impacted by IFRS 16.

Many organisations still acquire their vehicle fleets via finance leases, which have always appeared on balance sheets anyway, signalling no change in their cases.

How is the automotive sector reacting?

Despite Sewells’ Fleet Market Report 2016 identifying that off-balance sheet reporting of vehicle leases is important to 81% of the fleet managers surveyed, the BVRLA’s Gerry Keaney believes that leasing’s unstoppably growing popularity has “very little to do with any balance sheet advantages.” Speaking to FleetNews, he explained that leasing’s “main value comes elsewhere, sheltering companies from the risk of fluctuating vehicle values, providing them with extra flexibility and purchasing power and freeing-up precious working capital that would otherwise have been spent buying an asset.”

Short-term vehicle rentals of less than 12 months in duration are exempt from the new balance sheet rules and various automotive voices such as Nexus’ David Brennan perceive that fleets will increasingly adopt such rental solutions to avoid balance sheet implications. However, Caroline Sandall from the ACFO has urged organisations not to make a beeline towards short-term rental unless the admin burden or the change in accounting rules will truly make a significant difference.

Alphabet expects operating leases to remain popular for vehicle acquisition because the overall cost typically works out lower than actually owning vehicles, while lessees are kept protected against depreciation. Meanwhile, in the white paper produced by Lex Autolease, another of the fleet leasing market’s main funders, the realistic car lease example provided shows that the front-loading of interest under IFRS 16 won’t have a significant impact because vehicles are much lower in value than properties and typically involve relatively short-term arrangements of no more than four years.

Ever changing times

While the move from IAS 17 to IFRS 16 is an accountancy milestone reached after many years of deliberation and will undoubtedly create extra administration for some organisations, the change is widely regarded as positive, particularly amongst contract hire brokers and their ultimate funders. Greater financial transparency is generally to be welcomed in any areas of business. Besides, fleet managers and finance directors are used to change these days, with GDPR and Brexit on the horizon, plus new concepts of multimodality, vehicle sharing and subscription models to get used to.