- 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.