Maritime sector must absorb balance sheet implications of new lease accounting standard

A new international accounting standard dealing with leases could have major implications for companies in the shipping and offshore maritime sectors, and particularly for time charterers.

The new standard, IFRS 16, is effective for periods beginning on or after 1 January 2019, although early adoption is allowed. It covers all leases, whether the company acts as a lessor or a lessee. Michael Simms, a partner in the shipping and transport group, says, “In general, the changes for lessors and for lessees with existing finance leases are fairly minor. But those who have operating leases as a lessee, for example many of those with shorter-term time charters, will be most affected.
“IFRS 16 removes the distinction which previously existed between finance and operating leases. As a result, companies which previously leased in vessels under arrangements identified as operating leases will now find that, under the new standard, they have to recognise their interest in the vessel as an asset in the balance sheet. At the same time, they will also be required to record a liability for their future payments under the charter, to the extent that they relate to the vessel.”

Where a lease is recorded for the first time under the new rules, this will not always have a major effect on reported net assets. But it may make a substantial difference to gross assets and gross liabilities, changing ratios that are based on these figures. Where companies have loan covenants based on total debt levels, this may lead to breaches simply due to the accounting change.

There will also be some effect on reported profit, although this will vary between companies. Total lease costs will be more front-loaded, with higher charges in the earlier years and lower charges in the later years. The effect of this will be felt most by those companies with just a few – or even only one - substantial charter, while those with a number of charters may at various stages find that, even though the charges on each one might change, the overall charges remain broadly the same.

Michael Simms notes, “Time charters cover the provision of both a vessel and related services to the charterer, but it is only the asset element of the contract that falls within the scope of the lease standard. The service element will continue to be dealt with separately and, as was the case previously, no liability will be recorded until the services have been provided. Under the new standard, an allocation of total amounts payable will need to be made between the amounts attributable to the lease and those attributable to the service. Charterers will need to apply judgement in making this allocation.

“The new model for all leases is broadly similar to the old model for finance leases. For existing finance leases, a lessee needs to determine the interest rate that should be applied to the lease to determine the amount at which both the asset and the initial liability is recorded. The same basic idea will apply to all leases in the future. Ideally, the interest rate inherent in the lease should be used, as it currently is with a finance lease. In practice, this amount will often not be known to the lessee. Where this is the case the amount will have to be estimated by reference to the lessee’s incremental borrowing rate, which is likely to involve some judgement.”

There are exemptions under the new standard. In particular, an asset and liability need not be recorded in respect of short leases, those of less than a year. To avoid this being used too widely, there are provisions covering leases with variable terms which may last for more than a year. Very short-term charters will be excluded, although those with extension clauses will have to be considered in great detail.

Michael Simms concludes, “The new standard has been a long time coming, and it will be a few years yet before the first financial statements are published which have to comply with IFRS 16. Nevertheless, many companies in the shipping and offshore maritime sectors will need to consider the effect on their financial statements quite soon. Some will see major changes to their balance sheets, and a certain amount of change to their reported profits. Companies will need to consider the effect that the changes will have on compliance with the terms of loans which include covenants. And where breaches of covenant are likely, or reasonably possible, talking to lenders before the change hits the accounts will be crucial.”