In brief...
- IFRS 16 is a new accounting standard effective as
of 1 January 2019.
- The new standard removes the distinction
between an operating lease and a finance lease,
bringing operating leases onto the balance sheet.
- Future rent will become debt on the balance sheet
and current rent will be characterised as interest
and depreciation.
- Companies that have significant operating lease
portfolios (and so which have in the past been off
balance sheet) will be significantly affected.
- A company’s operations and cash flow should not
be affected. The change is to the presentation of
financial statements.
- Financial ratios (based on net debt and EBITDA)
and basket permissions in a company’s
loan agreement may be stretched or even
breached if the company switches to the new
reporting regime.
Background and scope of application
In January 2016, the International Accounting
Standards Board (IASB) introduced a new accounting
standard, IFRS 16, which applies in respect of
annual accounting periods beginning on or after
1 January 2019. It applies mandatorily to listed
companies, and non-listed companies may choose
to adopt it. Companies reporting under UK Generally
Accepted Accounting Principles (which are contained
in the Financial Reporting Standard 102 (FRS 102)),
will be unaffected by IFRS 16. It is unclear whether or
when FRS 102 will be amended to reflect IFRS 16, but it
seems unlikely to be before 2022 at the earliest.
Updating the lease accounting regime had been on
the agenda for IASB for many years. The previous
International Accounting Standard 7 regime provided
for two distinct accounting categories for operating
leases and finance leases, which operated entirely
different accounting models. Sir David Tweedie
(former chairman of IASB) had commented “One of
my great ambitions before I die is to fly in an aircraft
that is on an airline’s balance sheet.” IFRS 16 was
developed by IASB to improve financial reporting for
leases, provide greater transparency as to financial
performance of a company and ensure companies
provide a more faithful representation of their assets
and liabilities.
The new accounting treatment of leases
The new accounting standard removes the distinction
between an operating lease and a finance lease and
replaces the dual approach with a single approach,
which is fundamentally the same as currently exists for
finance leases. Under a finance lease, the right to use
an asset is considered to be economically similar to
purchasing it with debt and therefore the asset would
appear on the lessee’s balance sheet, with the present
value of any future rentals appearing as a capitalised
liability, with a corresponding depreciation charge going
through the profit and loss statement. An operating
lease is simply a right to use an asset and has no impact
on the balance sheet, with the entirety of the lease
rental (without any depreciation charge) going through
the profit and loss statement.
IFRS 16 may provide an initial shock to investors
in companies that are impacted, particularly those
with material operating lease portfolios in sectors
(among others) such as infrastructure, construction and
transport (in particular airlines) and consumer goods
and retail (such as multiple retailers). The new standard
should have no economic impact on a company from
a cash flow perspective or how it operates, although it
is likely to impact:
- the way companies make decisions, for instance,
negotiating lease terms to meet certain exemptions
in order to remain off balance sheet or whether to
purchase a capital asset as opposed to leasing;
- how a company presents its balance sheet and profit
and loss statement, including the classification of cash
flows from lease contracts; and
- financial ratios and additional reporting requirements
to lenders under loan agreements.
Broadly speaking, if the presentation of a company's
accounts changes to follow IFRS 16, all its operating
leases would be brought onto the balance sheet,
except where certain limited exemptions are met
(for example, if the lease term is less than 12 months or
if the underlying asset is a low value asset of USD5,000
or equivalent).
As a result of IFRS 16, the financial statements of a
company will change, although the extent of the change
will depend on the characteristics of the company's
individual lease portfolio, including its average life.
If a leased asset is brought onto the balance sheet,
a corresponding liability will also be shown equivalent
to the outstanding principal balance. The profit and
loss statement will reflect depreciation on a straight line
basis and an interest expense on a reducing balance
basis in respect of the leased asset and liability.
The impact on loan agreements
A company with significant operating lease liabilities is
likely to find that, if its accounts are presented under
IFRS 16, its debt level would increase dramatically,
with the potential to have significant consequences for
any financial ratios; for instance, EBITDA is likely to be
higher, because operating lease payments that were
previously deducted from the profit and loss statement
will be added back, and net debt is likely to increase as
future lease payments will be brought onto the balance
sheet. Having said that, if the transition to IFRS 16
occurs during the life of a loan, the significance of the
effect on any accounting-based ratios will be limited,
provided the loan agreement contains an applicable
frozen GAAP concept requiring the borrower to deliver
its accounts both under IFRS 16 and under original
GAAP. However, a frozen GAAP clause is unlikely to apply
to any basket levels in definitions such as permitted
financial indebtedness, and if the difference between
the old and new treatments is significant, basket levels
based on the amount of its financial indebtedness
may be inadequate, because financial indebtedness
would, by applying IFRS 16, include on-balance sheet
future lease liabilities that did not exist under the old
accounting treatment. In such a case, a borrower may
have to seek an amendment.
The impact of IFRS 16 is yet to be seen since most
companies are still in the transition period of
preparing accounts on the new standard, which largely
depends on when their accounting period begins in
2019, but we are certainly seeing an ever increasing
amount of queries on the matter from companies
and lenders alike.
Approach to loan agreement drafting
How this will be dealt with in future years remains
to be seen. We think it is likely that lenders will wish
to measure covenants on a pre-IFRS 16 basis, so as
to monitor debt and EBITDA consistently. However,
given that companies in scope will be required to
prepare audited accounts in full compliance with current
IFRS, reporting additionally to lenders on a “pre-IFRS
16 basis” to preserve more common financial ratios will
be an additional cost. Companies are therefore likely to
resist having this additional reporting audited, which we
suspect will remain a point for negotiation.