Accounting for Leases - IFRS 16
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Introduction The International Accounting Standards Board (IASB) published on 13 January 2016 the final version of the new international accounting standard on leases (IFRS 16) as part of a joint project with the Financial Accounting Standards Board (FASB which is the US equivalent responsible for US GAAP). This project started some 10 years ago and there have been numerous twists and turns. Although the project concerns an international accounting standard rather than UK GAAP, it is expected that UK GAAP will be amended so as to replicate elements of IFRS 16 or will converge with it. IFRS 16 is effective for annual periods beginning on or after 1 January 2019. Earlier application is permitted for certain entities. There are detailed transitional rules dealing with existing off balance sheet leases of a lessee company held at the beginning of the first period to which IFRS 16 applies. Summary The accounting model for lessors stays substantially the same (subject to some additional disclosure requirements). The finance lease vs. operating lease distinction remains for lessors. The accounting model for lessees will change. All leases for lessees will be on balance sheet (other than low value (under $5k) or short leases (under 12 months)). This means lessees will have to recognise a right-ofuse asset and a liability for most leases in their balance sheet and a depreciation expense and interest expense in their profit and loss account. The changes in accounting standard are likely to change lessee behaviour and may result in: • lessees requesting shorter leases; • lessees requesting break clauses in leases; • lessees preferring variable rents (linked to RPI and/or turnover) rather than fixed or stepped; • sale and leaseback transactions no longer being carried out solely for accounting reasons; • businesses preferring to buy rather than lease assets; and • leases being restructured as contracts for services only which do not constitute or include a lease for accounting purposes. Key performance indicators of clients will change as a result of this accounting standard which may impact on the market’s perception of our clients and also impact on financial covenant tests in contracts. Historically, off-balance sheet treatment of leases has been desirable for certain businesses as it allowed them to report lower debt levels than would otherwise be shown in their accounts. This accounting treatment has been a key driver for a number of transactions (such as sale and leaseback transactions). The proposed changes in accounting standards will result in off balance sheet treatment no longer being available to lessees. Classification of leases IFRS 16 mainly affects lessee accounting. As you know, at the moment, a lease (including a lease of real estate, aircraft or rolling stock) is generally for accounting purposes either a finance lease or an operating lease. ACCOUNTING FOR LEASES IFRS 16 The current position If a lease is a finance lease, the lessee will show the lease as an asset on its balance sheet as if it actually owned the asset and will also show a discounted amount of the future rental liability as a loan liability. The lessee will charge to profit and loss account each period: • the proportion of future rental that is in effect the discount as it accrues; and • depreciation of the asset. If a lease is an operating lease, then, it is in effect ‘off balance sheet’ as no asset or associated loan liability is recognised and there is no depreciation. Instead only accruing rental is charged to profit and loss account (typically on a straight line basis if the rental is stepped). In contrast, where the lease is a finance lease, the effect is to front load charges to the profit and loss account because the discount or ‘interest’ will be higher in the early years of a lease. You will no doubt appreciate that, based on the current accounting model for tenants, classification of leases and the consequential accounting impact will affect: • the timing of recognition of a lessee’s profits each year (as well as the amount of its distributable profits for dividend purposes); • its perceived financial strength (or weakness) as shown by its accounts. However, much information may be contained in notes to the accounts; • its financial covenants (whether contained in loan documents or leases), although much will depend on how they are drafted; • its taxation position; and • the benefits of sales and leasebacks. What is a lease for accounting purposes? IFRS 16 defines a lease for accounting purposes - “A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration”. This definition with accompanying explanations and guidance differs in a number of respects from the meaning of ‘lease’ for the purposes of IAS 17 (the previous lease accounting standard). In the majority of transactions it will be obvious what constitutes a lease but IFRS 16 provides guidance for some difficult situations. The important point here is that IFRS 16 applies to leases as defined for accounting purposes and not to leases within the usual legal meaning. IFRS 16 does not apply to a limited number of classes of leases such as leases to explore for or use natural resources (e.g., minerals, oil, natural gas and similar non-regenerative resources). Operating leases come on balance sheet The main change introduced by IFRS 16 is that it largely removes the finance lease/operating lease classification for lessees. It introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. Accordingly, all leases to which IFRS 16 applies will be accounted for as if they were finance leases in effect. In short the lease is both an asset and a liability on balance sheet, each measured on a present value basis. Accordingly, rents and other non-cancellable payments will be discounted back at an appropriate rate. Where rents are inflation linked or variable (e.g. by reference to turnover or on rent reviews to market rates) there are special rules. Where there is an option to extend a lease or indeed break a lease, the extension or break is taken into account only if it is reasonably certain to occur. The charge to profit and loss account for depreciation and also the accruing interest or discount is, as explained above, the same as for finance leases. The IFRS 16 changes, especially to leases that would have been classified as operating leases, are significant and, accordingly, the removal of the classification for lessees will impact on: • the timing of recognition of a lessee’s profits each year (as well as the amount of its distributable profits for dividend purposes); • its perceived financial strength (or weakness) as shown by its accounts; • its financial covenants; • its taxation position; and • the benefits of sales and leasebacks. Lessor accounting IFRS 16 substantially preserves for lessors the lessor accounting requirements in the existing applicable standard, IAS 17. Accordingly, a lessor continues to classify its leases as operating leases or finance leases and to account for those two types of leases differently. IFRS 16 also requires enhanced disclosures to be provided by lessors that will improve information disclosed about a lessor’s risk exposure, particularly to residual value risk. Ramifications IFRS 16 could have the following ramifications: • lessees may want shorter leases so as to reduce the amount of liabilities shown on their balance sheets (shorter leases will result in less committed rentals to discount back and recognise); • lessees may want break rights so as reduce the committed rentals to discount on the basis that only rents up to the break date will be treated as committed provided that in short an exercise of the break right is reasonably certain; • lessees may prefer rents to be variable (linked to RPI and or turnover) rather than fixed or increasing at fixed levels as this will reduced the amount of lease liabilities to be recognised on balance sheet; • businesses may prefer to buy rather than lease assets; and • leases may need to be restructured as contracts for services only which do not constitute or include a lease for accounting purposes. This list is non exhaustive. EBITDA and financial covenants Whilst the application of IFRS 16 will not directly change the actual cash flows of a lessor or lessee, the presentation of the payments and indeed the obligations in the accounts of the lessees will be different because, in the case of leases that would have been operating leases, the expenses charged to profit and loss account will be shown in part as financial expenses rather than operating expenses and the cash outflows in the cash flow statement shown under financing activities rather than operating activities. See the table below. IAS 17 IFRS 16 Finance leases Operating leases All leases Revenue x x x Operating costs (excluding depreciation and amortisation) ---- --- EBITDA

Depreciation and amortisation Depreciation --- Operating Profit
Finance costs Interest --- Profit before tax  Single expense Depreciation Interest If for any purpose (e.g. financial covenants) EBITDA (earnings before interest, tax, depreciation and amortisation) or EBIT (earnings before interest and tax) is relevant, the movement in the accounts of the rental expense from operating expense in the calculation of earnings to depreciation and finance expense will have the effect of increasing EBITDA and EBIT. These are often based on financial metrics tests using figures from the accounts. The position of each lessee will be different (depending on its overall business and its portfolio of leases) but, in principle, if one takes a lessee with one operating lease that under IFRS 16 is on balance sheet, then, ignoring the effect of transition to IFRS 16 and drafting, the following results are expected: Financial metric Calculation Explanation Leverage Liabilities/equity Leverage will increase because the lease liabilities will be on balance sheet as debt Interest cover EBITDA/interest expense EBITDA will increase (see previous paragraph) and also interest will increase resulting in a different coverage ratio Profit or loss (after depreciation and interest but before tax) Because depreciation is straight line and the interest on the lease liabilities will be higher in the earlier period of the lease than the later period, the costs are effectively front loaded and will reduce profits (or increase losses) to a greater extent in the earlier period which effect will reverse in the later period ROCE (return on capital employed) Earnings before interest and tax/equity plus financial liabilities EBIT will increase (see previous paragraph) and also financial liabilities will increase resulting in a different rate of return Lessees should review their existing financial covenants in leases and also in their finance documents. They may find that the covenants either already include adjustments for off balance sheet leases . Other possible mitigants often found in finance documents are as follows: Many loan agreements contain what are termed “frozen GAAP provisions”. Examples can be found in the LMA Leveraged, Investment Grade and Real Estate Finance facility agreements as an option. The effect of these clauses is effectively to freeze the accounting standards for the purposes of financial covenants to the way they stood at the inception of the loan agreement. That may save a borrower from being put into breach by a change in accounting standards. However the borrower has to go to all the time, trouble and expense of preparing two sets of financial statements. One to satisfy the new accounting standards and one in accordance with the old so that the parties have the requisite information to know that the covenants have been complied with. Some loan agreements have a requirement that if accounting standards change the parties must get round a table and negotiate in good faith consequential variations to the financial covenants. Wording was agreed between the LMA and the Association of Corporate Treasurers at the time of the transition to IFRS dealing with this point. However, whatever the position, it is expected that some lessees (or lessors or indeed financial institutions) will need to renegotiate the covenants given by them or those given in their favour. Financial institutions which are themselves lessees may need to consider the regulatory capital impact of IFRS 16 because if they have material off balance sheet leases coming on their balance sheet it is expected that this will increase their assets and liabilities on balance sheet (but not necessarily in equal measure) and reduce their equity. Sale and leasebacks The IASB expects the number of sale and leaseback transactions to decrease with the implementation of IFRS 16. This is because IFRS 16 reduces the incentive for companies to enter into such transactions by requiring the recognition of assets and liabilities arising from the leaseback and restricting the amount of any gain recognised on sale of an asset. This note provides a general summary only. It is neither intended to be comprehensive nor legal or accountancy advice and should not be relied upon.