By now, most of those involved in preparing or using accounts should be familiar with the headline changes that will be introduced by the new lease accounting standards starting in 2019 under IFRS 16 Leases or ASC 842 Leases.
While lessors will see only limited changes to their accounting practices (but a lot more disclosure), lessees will be much more obviously affected by changes in the numbers as well as by increases in disclosure. In very simple terms, for any charter previously treated as an operating lease, the lease arrangement will give rise to both an asset (representing the right to use the asset under lease) and a liability (representing the liability generated by the promise to pay) based on their present value, rather than simply being disclosed as commitments. Under international rules, the asset will then be depreciated and interest charged on the liability; the US rules are designed differently, with the effect that the costs of operating leases will be recorded on a straight-line basis over the lease term rather than on the basis of separate interest and depreciation amounts. The main exception to this will be short-term leases — ones that will run for 12 months or less — where the current accounting treatment may continue to be applied.
In the shipping industry, that means that the companies that will be most affected will be those that charter in tonnage under longer-term arrangements currently treated as operating leases. Some of the highlevel changes likely to affect such companies’ accounts under each of IFRS and US GAAP respectively can be set out in the form of a table:
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But knowing the broad direction in which changes are to be made is only part of the story. Companies will need to come up with actual numbers for each item affected. And that is when this all starts to get difficult.
The mechanics of the calculations will be familiar to anyone who has ever been involved in preparing accounts in the past. The modelling required is really no different from that which has previously been used when dealing with finance leases. The issue is going to be determining the inputs into the models. Not all of these will be factual, and judgement is going to have to be used in determining many — and, in some cases, all —, of the inputs.
LEASE TERM
This won’t always be a problem. Where a company enters into a simple three-year charter, then the lease term is three years.
It becomes more complex where the charterer has the option to extend for some further period or, conversely, where a charter is written to cover a longer period but there is an option to terminate early. In either situation, a decision has to be made as to whether the extension or termination is reflected or ignored.
For an extension option, the additional period must be included if it is “reasonably certain” the option will be exercised, whilst termination options are ignored where it is “reasonably certain” that they will not be exercised. In making that assessment, the standards require that “all relevant facts and circumstances that create an economic incentive” be taken into account. This will include matters covered in the charter, such as rates, penalty clauses, or the terms of purchase options, but also any other factors that would affect a decision, such as the expected ease of replacement.
Presumably, options in the charter are only there because the charterer wanted some degree of flexibility, so there has to be some possibility of them being both exercised and not. The difficulty is going to be trying to decide whether it is “reasonably certain” they will be used and, of course, the further in the future the option date, the more difficult that assessment is likely to be. In some cases it might be clear that the longer period was always expected to apply, and the options are there just to offer some protection to the charterer if things go wrong.
Companies will need to come up with actual numbers for each item affected. And that is when this all starts to get difficult.
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Similarly, it might be clear that the shorter period is by far the most likely, and the longer is there just in case. It is the situations between these extremes that will require significant judgement. The judgement made could have a major effect on the financial statements. Even with discounting, the difference between accounting for a ten year and a five-year charter will be substantial.
LEASE PAYMENTS
Again, this will not always be a problem. Under both IFRS 16 and ASC 842, bareboat charters are leases, so all of the payments required under the charter will form part of the lease payments. There can still be some complications – for example, where there is a purchase option in the charter, when this will be included or excluded according to whether or not it is “reasonably certain” to be exercised. Nonetheless, most situations will be fairly straightforward.
Time charters are not leases under IFRS 16 and ASC 842 – they are contracts with customers that contain an lease. They also contain non-lease components, covering the operating or service elements. The question then becomes how much of the total payment is attributable to the lease element and how much is not. Time charters do not specify the split between the lease and non-lease elements. Even if they did, accountants would be required to ignore what they said. The allocation must be based on the stand-alone price of the lease element and the aggregate stand-alone price of the non-lease components.
The stand-alone price means the amount that would be paid for fulfilment of that part of the contract in isolation. So a time charter can be seen as the combination of a bareboat charter and a contract for services, and the amount payable for each of these needs to be determined. That is easier said than done.
Whilst there is quite a lot of data available on rates and operating costs in the shipping market, that data is not complete. It is not possible, for example, to obtain bareboat charter rates for all vessels for all durations at all dates. Instead, preparers have to work from incomplete information and adjust the data they have to cover the situation they face. The standards recognise this and note that, where observable stand-alone prices are not readily available, there will be a need to estimate them. To try to introduce as much rigour as possible into this process, preparers are still required to maximise the use of observable information. Despite this requirement, there will still be considerable scope for judgement and there will be assumptions, whether implicit or explicit, in the lease component rates that are used.
It is open to companies to decide that this is all far too complicated and instead use what the standards describe as a “practical expedient.” Rather than splitting the total time charter between its lease and non-lease parts, a company may, by class of asset, elect to treat the whole of the payment as though it were a lease.
Whilst this may be a practical expedient, it is not expected to prove a popular one. It would flatter the apparent operating profitability (and cash flows) of a company following international standards, as a result of the matters set out in the table above, but it would make the statement of financial position look worse through the deterioration in gearing and liquidity measures.
DISCOUNT RATE
The amounts that are initially recorded in respect of both the asset and the lease liability are not the cash flows associated with the lease, but the present value of those cash flows. To get from one to the other, there observis a need to apply an appropriate discount rate.
Where possible, charterers are required to use the interest rate implicit in the lease. In practice, this will rarely be possible, as that rate will often have been based on information known to the owner but not to the charterer.
It is open to companies to decide that this is all far too complicated and instead use what the standards describe as a “practical expedient.”
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The more common situation will be that charterers are required to estimate their incremental borrowing rate. This is the rate at which they could borrow for a similar term — with similar security — the funds needed to acquire an asset of similar value in a similar economic environment. That is a lot of “similars” and, again, judgement is going to be needed. The charterer may be able to use observable data as a starting point. For example, if the charterer is also an owner and has recently arranged finance for an acquisition, then the rate obtained will be a good place to start in determining the incremental borrowing rate. But that is not the same as an end-point, and adjustments may still be required to reflect relevant differences between, for example, the assets acquired, the length of the loans, and simply the fact that the rate is intended to be incremental – that is, in addition to any finance the charterer may already have.
THE EFFECT OF JUDGEMENT
It is worth going back to why we have IFRS 16 and ASC 842. In the view of the standard setters, the previous accounting treatments for many leases – dealt with on either a straight-line or nearcash basis but with disclosure – did not adequately reflect the obligations that a company had entered into. This was driven by a desire to record “missing” liabilities, not a desire to record missing assets. The new standards remedy this but, in doing so, require a number of judgements to be made. The standard setters acknowledge this. The standards attempt to place bounds on the exercise of judgement and, as with many standards these days, require the use of as much readily available observis able data as is possible. But, in a world where not all relevant data is ever going to be readily available, that still leaves a considerable requirement for judgement to be applied. This is one of the reasons why there is much more disclosure required than previously. It does not eliminate the need for judgement, but at least it makes many of those judgements transparent.
Both preparers and, a little later, users of financial statements will need to come to grips with the changes — preparers to think about the judgements they will make and how they will justify them, and users as to how they will make use of the new information available to them. The standard setters have noted that there is anecdotal evidence that many users were already making notional adjustments to the information in financial statements to reflect lease commitments, apparently with very little consistency of approach. They won’t have to do that any more, but they will have to consider what effect the judgements made by companies will have on their assessments.
Source: Chopping, D., & Halkias, M. J. (n.d.). Understanding the New Leasing Standards. Marine Money International, 34(6), 14-17.