Impact of IFRS 16 on Vehicle Leasing Practices

IFRS 16, the new standard for lease accounting, is scheduled to come into full effect in 2019. Companies covered by it will see significant changes in the appearance of their financial reports, writes Clive Buhagiar, head of pricing and planning at Alphabet GB

Initially, IFRS 16 will affect banks, listed companies and a few other, predominantly large, entities.

Attention to IFRS 16 in the fleet operating and vehicle leasing sectors is mainly focused on its requirement for assets financed via operating leases to be brought onto the balance sheet.

This will change debt to equity relationships, gearing ratios and capital ratios. It will also affect the reporting of other financial metrics, such as earnings before interest, taxes, depreciation and amortization.

Companies covered by IFRS 16 will see significant changes in the appearance of their financial reports. The International Accounting Standards Board believes that affected businesses have £2.5trn (€2.8trn) of lease commitments, ranging from aircraft and ships to property and vehicles. Over 85% of these do not appear on their balance sheets.

However, around 90% of UK business will not be touched by the standard when it comes into effect in 2019. Moreover, the UK Financial Reporting Council (FRC) has said it is reconsidering whether key parts of IFRS 16 will be copied into UK accounting rules at all, due to concerns about their practicability for small and medium-sized firms. If so, IFRS 16 will have no impact on the great majority of fleet operators for the foreseeable future.

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In respect of affected companies, the FRC said in April 2017 that it expects to provide information on their progress towards implementation of IFRS 16 over the next 18 months. It predicts that they will disclose the likely impacts of the new standard once they can be reasonably estimated.

Lack of information

The question mark over whether the new lease accounting rules will apply to UK SMEs, together with the fact that it is too soon for feedback from companies implementing them, has undoubtedly contributed to uncertainty among fleet operators.

Research published in May 2017 by Sewells Research & Insight showed that just over a quarter of fleet decision makers claimed to have a clear idea of the rules’ likely impact, with 74% either unclear or only fairly clear of the implications.

Whenever clear information is lacking, speculation tends to fill the vacuum. Some commentators have predicted that listed businesses will step away from vehicle leasing; experts with fleet industry knowledge see it very differently, however.

Accounting rules

The chief executive of the British Vehicle Rental and Leasing Association, Gerry Keaney, points out that the popularity of vehicle leasing has little to do with balance sheet considerations.

“Its main value comes elsewhere: sheltering companies from the risk of fluctuating values, providing them with extra flexibility and purchase power and freeing up precious working capital,” he said in 2016.

IFRS 16 will not have a significant impact on the attractiveness of operating leases such as contract hire, according to Colin Tourick, professor of automotive management at the University of Buckingham Business School.

In his opinion, the vast majority of companies have chosen operating leases because they are a great form of financing rather than because of any accounting considerations.

Alphabet’s view

Alphabet believes that operating car lease and full-service leasing will continue as our customers’ first choice for business mobility.

Irrespective of IFRS 16, leasing’s impacts on balance sheet, risk positioning and incorporated asset responsibilities are still lower than ownership of cars.

With leasing, the customer avoids potential investment in additional internal asset management resources required by wholly-owned vehicles, for example purchasing, servicing, quarterly asset risk assessments and remarketing.

Businesses that turn away from leasing also risk losing competitiveness when negotiating with supplier networks. As one of the top four leasing companies in Europe, Alphabet can leverage economies of scale and expertise in purchasing, services and remarketing that enable us to offer highly competitive prices.

Activating purchased vehicles will have a greater impact on balance sheets than leasing them because the full list price of the car will always be higher than its reporting value as a right-of-use asset.

With leasing, the asset risk and residual value risk remain with the leasing company whereas companies that own vehicles assume the risk themselves.

Cash in lieu of cars

It has been suggested that companies affected by IFRS 16 might consider cashing out their company drivers, so the businesses no longer provide cars for mobile employees.

In effect, companies that took this step would be increasing their dependence on grey fleet to deliver competitive business mobility.

Grey fleet’s drawbacks are well documented, especially in terms of its hidden costs and duty-of-care liabilities. Given that the underlying purpose of IFRS 16 is to clarify the way leased assets are accounted for, it would be paradoxical if listed companies’ responses to it included making their employees’ essential mobility more opaque and harder to manage.

The consumer credit market also looks set to tighten over the next 18 months or so, and this will affect the quality of vehicle employees can afford. The Bank of England warned (again) in April 2017 that personal debt is rising dangerously fast and the Financial Conduct Authority is specifically monitoring trends in private car finance. While cash-in-lieu-of-car policies almost invariably compromise the quality of business-use vehicles – the average grey fleet car is seven years old – liability for occupational road risk remains with the employer.

The first prosecution for vehicle-related corporate manslaughter took place in 2015. It cost the driver’s employer £900,000 in fines and costs plus the imposition of ‘public shame’ conditions. Although the vehicle involved was an HGV, not a car, the case emphasises the need for companies to be constantly vigilant around duty of care for drivers.

Looking to leasing

UK businesses expect lease-based finance arrangements to account for an ever-growing share of their vehicle funding, Sewells Research & Insight also reported in May 2017.

Sewells’ report said: “Companies anticipate an increase in the proportion of company cars they lease, rather than outright purchase over the next 12 months. These findings indicate that the fundamental advantages of leasing outweigh the negative effect of imminent changes to the way that companies have to account for leased assets.”

Overall, 36.5% of companies told Sewells that any new cars added to their fleets in 2017 will be funded by contract hire, compared to 31.7% for outright purchase, 25.6% for hire purchase and 24.6% for finance lease.