Accounting: Dealing with the Implications of Accounting Changes

With the introduction of three new accounting standards, IFRS 9 Financial Instruments,
IFRS 15 Revenue from Contracts with Customers and IFRS 16 Leases. This ‘Triple Whammy ’ of
standards will impact how bad debt provisions are calculated, cause more financial assets to be
measured at fair value, introduce very complex rules as to when revenue can be recognized and
effectively scrap the operating lease classification, bringing all leases, together with the lease
liability onto an entity’s balance sheet.

The primary effect of these standards is the timing of profit recognition and
reported earnings. Changes to bad debt provisioning rules meaning that bad debts will be
recognized earlier than they are currently. Application of the new rules on revenue recognition
will most likely delay revenue, with the new leasing standard front loading lease expenses but
improving reported EBITDA.

As entities adopt the new standards, they will post journals to retained earnings
to reflect the impact of adoption. In many cases, the application of the new standards results in a
debit entry to opening retained earnings. This in turn will most likely improve post adoption
earnings and EBITDA whilst at the same time weakening an entity’s balance sheet.

Out these three major changes in accounting standard, what's making a big headline
currently is the IFRS 16 Leases which take effect since 1 January of the current year, after
Philippine Airlines result to a profit plunge upon its adoption with the new standard.

Under the current accounting standard, the obligation to make future payments under an
operating lease arrangement is not included on the balance sheet even though the company is
committed to those future expenditures. The concern of many stakeholders was that this did not
give an accurate reflection of the company’s true financial position.

The changes to the accounting standard (which apply to reporting periods beginning on
or after 1 January 2019) will result in the inclusion of a lease liability and a right of use asset on
the balance sheet. In other words, the business will now include the costs of use of the leased
asset and the associated benefits on its balance sheet.
 The IFRS 16 changes give a more accurate representation of the financial position of the
business by fully reflecting all its liabilities, and provides more useful information in financial
reporting for investors and shareholders, but there is a downside.

The changes will substantially increase the level of commercial and financial reporting
risk given the increase in complexity and the hidden issues which may arise on implementing the
new standard.

Firstly, the new standard will change the profile of the expense. Rather than being a
straight line rental expense, there will be more expensed in early years and less in later years,
impacting earnings profiles. It will also cause potentially large increases in metrics such as
EBITDA. Rather than an operating rental expense, there will now be a movement of expenses
below the EBITDA line which has a range of associated issues. In addition to the possible
financial reporting anomalies, the right of use asset will be non-current whereas the lease liability
will be split between current and non-current. This mismatch could potentially cause issues with
working capital with a partly current liability funding a non-current asset. There may also be
substantial impacts with bank covenants which could lead to possible breaches if companies are
not proactive about approaching their financiers. Another impact could be that more companies
will now qualify as large proprietary companies with the inclusion of right of use assets on their
balance sheet increasing total assets and potentially requiring audited financial statements to be
lodged. Companies may potentially have large balance sheet changes which will need to be
explained to investors, financiers and shareholders. Furthermore, there will now need to be more
integration between departments of the business entering into lease agreements and the financial
reporting function.

Locally, the Philippine Airlines publicly reveal the impact of this standard on the
aviation, but PAL is not alone in this adjustment because even foreign company particularly
retail, aviation, and oil companies, to name a few, also facing the same adjustment as PAL.

Below are foreign company that adopted the new IFRS 16 Leases

 Kingfisher Retail Company (Kingfisher faces £2.6bn lease liability on balance sheet)
The company stressed that the lease standard ‘has no economic effect on Kingfisher's
business or cash flow, however it does impact the way assets, liabilities and the income
 statement are presented’. This has resulted in an estimated £2.6bn in discounted future
lease payments recognized as lease liability, with a right of use asset of around £2bn.
As a major retailer with multiple leases, Kingfisher operates under four retail brands -
B&Q, Castorama, Brico Dépôt and Screwfix. It has over 1,300 stores in 10 countries
across Europe, Russia and Turkey.
The group has multiple retail leases, particularly in the UK where it has over 900
stores, split between B&Q and Screwfix, the majority in lease arrangements. These now
have to be accounted for on the balance sheet. The main impact is from the UK due to
high proportion of leasehold stores in this geography, Kingfisher said, where only 12% of
retail space is owned.
Kingfisher has adopted the full retrospective transition approach replacing IAS 17
Leases with IFRS 16 from 1 February 2019, which requires the restatement of
comparative P&L, balance sheet and cashflow statements.
It has released an analysis of the impact of IFRS 16 with an unaudited profit and
loss impact statement for 2018/19, showing that the majority impact is on store costs with
a minimal impact on gross margin. The rent charge has been removed from the P&L,
offset by depreciation of lease right-of-use assets.
Under IFRS 16 the income statement expense comprises a straight-line
depreciation charge on the right-of-use asset and a front-loaded interest charge on the
lease liability, both over the term of the lease. For an individual lease, this provides an
overall front-loaded expense profile compared with the straight-line rental charge
recognized under IAS 17. The standard is not expected to result in a material impact on
restated underlying profit before tax.
The Kingfisher update stated: ‘At the commencement of the lease, total P&L
charges are higher than under IAS 17 as interest is charged on the outstanding lease
liability, which reduces over the term. Toward the end of the life of the lease, total
charges fall below IAS 17.’It added that asset and liability re-measurement included
market rent reviews/indexation and changes in assessed term. At the same time, rent
prepayments and accruals removed from working capital receivables and payables.

 Petrobras (Petrobras posts R$ 4 billion net profit in the first quarter of 2019)
Petrobras reported a net profit of R$ 4 billion in the first quarter of 2019, an increase of
92% over the fourth quarter of 2018, mainly due to the lower occurrence of special items,
with a total of R$ 600 million (negative). Adjusted EBITDA of R$ 27.5 billion was 6%
 lower than the fourth quarter of 2018, mainly driven by lower Brent prices, while free
cash flow was positive for the 16th quarter in a row, with a total of R$ 12.1 billion.
The disclosure of the financial results for the first quarter of 2019 marks the adoption of
the IFRS 16 accounting standard by Petrobras. The new standard, which is being adopted
by all companies that follow the IFRS standard (international accounting standards),
refers to leasing operations.
Among the changes in the standard, IFRS 16 eliminated the classification between
financial and operating leases, so there is a single model in which all leases result in the
recognition of assets related to the rights to use leased assets and a lease liability.
With the adoption of IFRS 16, the company no longer recognizes operating costs
and expenses arising from operating leases, acknowledging in its income statement: the
effects of the depreciation of the rights to use leased assets; and the financial expense and
foreign exchange variation determined based on the financial liabilities of the lease
agreements.
Economic-wise, nothing changes in relation to the company and there is no
relevant impact on the company's cash. However, in accounting terms, there are effects
on the balance sheet, since lease expenses are no longer recorded, which are now posted
as depreciation and interest. This impacts some of the company's indicators, such as the
adjusted Net Debt/Adjusted EBITDA, which increased to 3.19x. If the effect of adopting
IFRS 16 was purged, this metric would end the quarter at 2.37x. The adoption of IFRS 16
does not change the company's deleveraging strategy, while maintaining the target of
reducing the Net Debt/Adjusted EBITDA to 1.5x by 2020.
The company's gross debt decreased by US$ 23.6 billion over the last 12 months,
reaching US$ 78.8 billion at the end of March 2019 (excluding the effects of IFRS 16).
The benefits are already being felt by the company: the financing expense in the first
quarter of 2019 was US$ 1.6 billion, a decrease of US$ 294 million compared to the first
quarter of 2018, which represents annualized savings of US$ 1.2 billion.

With this, it clearly depicts that the change in the accounting standard for leases from
IFRS 17 to IFRS 16 will not just give burden to companies but also a benefit and advantage in
some way. The biggest change to accounting standards since the introduction of the International
Financial Reporting Standards (IFRS) brings with it multiple challenges. Companies should keep
in mind that implementing the new standards is not just a compliance exercise for their finance
teams to deal with. It's also an opportunity for companies to gain a deeper understanding of some
of the most important elements of their business: their revenue and customer engagement
process; the impact of financial risks and the volatility this creates in their earnings profile; and
the levers involved in capital investment decisions.

References:

 New accounting tweaks hit PAL, forcing profits to plunge. (2019, November 16).
Inquirer.net. Retrieved from
https://www.google.com/amp/s/business.inquirer.net/283526/new-accounting-tweaks-hit-
pal-forcing-profits-to-plunge/amp
 Arnold, J. L. (2012). Dealing with the Implications of Accounting Changes. Financial
Executive Magazine. Retrieved from
http://www.financialexecutives.org/KenticoCMS/Financial-
ExecutiveMagazine/2012_11/Dealing-with-the-Implications-of-Accounting-
Change.aspx#ixzz2Hd7cEn005
 Warren, M. (2019, March 17). New Leasing Standard (IFRS 16) brings significant
impact. Retrieved from https://www.hlb.com.au/new-leasing-standard-aasb-16-brings-
significant-impacts/
 Petrobras posts R$ 4 billion net profit in the first quarter of 2019. (2019, May 8).
Retrieved from http://www.petrobras.com.br/en/news/petrobras-posts-r-4-billion-net-
profit-in-the-first-quarter-of-2019.htm
 White, S. (2019, August 16). Kingfisher faces £2.6bn lease liability on balance sheet.
Retrieved from https://www.accountancydaily.co/kingfisher-faces-ps26bn-lease-liability-
balance-sheet