Changes under IFRS 16
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1 IFRS 16 Proposed changes to the analytical approach by rating agencies Background The International Accounting Standards Board has issued IFRS 16 Leases (IFRS 16 or the new standard), which require lessees to recognise assets and liabilities for most leases. For lessors there is little change to the accounting standard. The new standard will be effective for annual periods beginning on or after 1 January We consider how the new standard is likely to be adopted by rating agencies: Moody s Investors Service (Moody s), Standard & Poor s (S&P) and Fitch Ratings (Fitch). Changes under IFRS 16 Under the new standard, a lease is a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. In order to qualify as a lease, a contract must convey the right to control the use of an identified asset, which could be a physically distinct portion of an asset such as a floor of a building. The introduction of the new accounting standard will mean the commitment relating to operating leases needs to be recorded on the financial statements and will focus on the present value (PV) of future cash outflows discounted at a borrowing rate. The new reporting standard will provide disclosure relating specifically to leases and it is widely considered that financial statements will more accurately reflect the company s financial risk relating to an operating lease. Current treatment of leases by rating agencies For some time now rating agencies have made adjustments to financial statements in order to recognise an operating lease on balance sheet, effectively simulating a purchase of the asset via debt issuance. The balance sheet is adjusted to increase debt and fixed assets by a value relating to the lease commitment. Adjustments are also made to the profit and loss to reclassify the rent expense to interest and depreciation, and the cash flow is adjusted to reclassify assumed depreciation expenses to capex. The concept is broadly consistent across the three largest rating agencies but there are some differences.
2 Standard & Poor s adjustments S&P use a fixed discount rate of 7% for all rated companies to calculate the net present value (NPV) of future lease commitments. The NPV of future lease commitments is added to debt to reflect the lease liability and adjustments are made to the income statement and cash flow to reflect the reclassification of rental expense to depreciation and interest. Fitch Rating s adjustments Fitch currently apply a multiple of total rental expense which varies depending on where the issuer is domiciled, currently 8x for issuers in North America, western Europe, and developed countries in the Asia-Pacific region (with the expectation of New Zealand and Australia at 7x). There are some cases where Fitch will not apply the rent multiple to part of the rental expense, such as rent relating to: assets with a short useful life; leases with bespoke termination clauses; shared usage of the asset and if a company is able to match stages of the business cycle to lease payments. Moody s Investors Service s adjustments Moody s apply a dual approach using a PV of lease commitment at a discount rate depending on the company s credit rating, with a cap and floor applied. The floor ensures any liability adjusted for leases is a minimum of a multiple of between 3x 6x rent expense (depending on the sector) and the cap ensures an adjustment of no higher than 10x the rent expense. Treatment of leases post IFRS 16 Through various discussion papers Moody s, Fitch and S&P have all provided an indication of the approach that they may adopt once the new standard is effective. Moody s and S&P have indicated that they are considering adopting the lease liability estimates reported under the new IFRS 16 standard which will replace their current treatment. Fitch are considering adopting a hybrid approach using a multiplebased lease adjustment, but only in certain sectors, with lease costs treated as operating expenses in other sectors. In sectors where the use of specific long lived assets is core to operations, such as retail or airlines, where the use of such assets from third parties is unlikely to be restructured as a service agreement the agency has indicated it is considering using the multiple-based adjustment (keeping the approach consistent with the approach used today). For other sectors, Fitch has indicated that they are considering adopting the lease treatment as outlined in IFRS 16. 2
3 Changes in the approach, if adopted, will result in the following key changes: Rating agency Adoption of IFRS 16 Proposed Changes 1 Effect on Metrics 2 Explanation Moody s Yes Removal of rent multiple floor Any liability adjusted by a minimum of a multiple (3x 6x) of rent expense depending on the sector will be removed. Removal of the floor has a positive effect on metrics reducing the adjustment made to debt. Removal of 10x cap rent multiple cap Changes to the discount rate used to calculate the PV of leases. S&P Yes Changes in the PV used to calculate leases Any liability recorded was capped at a 10x multiple of rent expense. Removal of the cap could have a negative effect on metrics increasing the adjustment applied to debt. / The discount rate used to calculate the PV will change from a borrowing rate linked to Moody s credit rating to a borrowing rate agreed at commencement of the lease. This will result in a subtle difference in the PV of the liability depending on the new borrowing rate. / Currently S&P assume a borrowing rate of 7% for all companies. The new standard will closely mirror S&P s existing approach, with the net present value of future minimum lease payment commitments included on the balance sheet, and with profitability and cash flow measures amended to reflect the financing nature of the lease. Under the new standard companies will follow a similar method using a discount rate attached to the cost of the lease or the company s borrowing rate instead. This will result in a subtle change to metrics, the direction will depend on the discount rate attached to the cost of the lease. Fitch Partially Adoption of a hybrid approach depending on the sector: 1. Continue to capitalise under the current approach by applying a rent multiple but only to sectors where the management of a physical asset is key to operations. 2. Adopting disclosure under IFRS 16 for all other sectors. 1. Fitch will continue to apply the multiple approach similar to the one that is currently used for certain industries that rely on a leasing model. Sectors specifically mentioned by Fitch include issuers rated under retail, lodging, shipping and airline industries. 2. For most other sectors Fitch is proposing to adopt the treatment of leases as disclosed under IFRS 16. This will have a broadly positive effect on metrics because the PV of leases is currently lower than rent multiples currently applied. Ultimately, the final effect on metrics will depend on the amount of new information that is disclosed. The new accounting policy will require far deeper analysis for reporting purposes which may result in a difference in the size of the lease liability reported under IFRS 16 compared with the current accounting policy. Positive effect on metrics Negative effect on metrics No effect on metrics 1 Whilst each agency has indicated a proposed approach to IFRS 16, methodologies have not yet been formally updated and the final approach to IFRS 16 may differ to the one currently proposed. 2 The overall effect on metrics will also be determined by the disclosure of new information. 3
4 What are the likely implications for credit metrics and ratings? The new accounting policy is conceptually very similar to the one that rating agencies have already been applying. There are likely to be some changes to the adjusted financials of Moody s, S&P and Fitch following the adoption of IFRS 16. This is due to the removal of the cap and the floor and change in policy from use of a PV and rent multiple in the case of Moody s, a difference in the discount rate used to calculate the lease liability for S&P, and a change from using a rent multiple approach for some issuers in the case of Fitch. Whilst we anticipate changes from the new accounting policy is likely to result in a change to some financial metrics reported by rating agencies, we expect that the changes in isolation are unlikely to result in many rating actions (positive or negative) because a change in reporting does not affect a company s underlying financial position. Disclosure of new material information is likely to be the biggest factor to affect the ratings The most likely driver to any rating changes will come from new material information brought from the new accounting standard. We anticipate that any rating action based on the disclosure of new material information is also highly unlikely for the vast majority of issuers. The possibility of disclosure of new information is mitigated by the fact that rating agencies tend to have access to, and make their assessment based on, private management information not just the information disclosed in financial statements. Further adjustments to leases may apply The new accounting rules still allow scope for companies to differ as to how they report liabilities. Where ratings agencies consider an issuer has obtained an accounting outcome that is not reflective of the true liability relating to a lease, agencies may apply agency-specific analytical adjustments. 4
5 EY contacts Anton Krawchenko Associate Partner 1 More London, London SE1 2AF, United Kingdom Tel: Mob: akrawchenko@uk.ey.com Simon West Associate Director 1 More London, London SE1 2AF, United Kingdom Tel: Mob: simon.west@uk.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London, SE1 2AF Ernst & Young LLP. Published in the UK. All Rights Reserved. ED None EY indd (UK) 06/18. Artwork by Creative Services Group Design. In line with EY s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. ey.com/uk
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