IFRS 16 - Leases: new financial reporting standard
Potential implications for lenders
“The new financial reporting standard for leases will significantly impact many corporates’ reported earnings, assets and liabilities, and will change the classification of expenses and cash flows, such that reported results, and the associated impact on covenant tests, may well vary materially.
Whilst IFRS 16 is only applicable to periods from 1 January 2019, lenders and their corporate borrowers should start evaluating the potential impact of this now, to avoid surprises when the standard is implemented. It may have a bearing on current negotiations regarding future covenants, cash sweep mechanisms, management incentive structures and the like.
We anticipate that the new standard will have the greatest impact on businesses with large portfolios of short-leasehold property, such as retailers, pubs/restaurant chains, or other sizable assets under operating leases (eg aircraft/shipping fleets).”
Matt Smith, Restructuring Services Partner
Following the release of an exposure draft in 2010, the International Accounting Standards Board (IASB) has finally released IFRS 16, a new standard on lease accounting.
This standard, which is mandatory for periods commencing on or after 1 January 2019, will require lessees to account for all leases on their balance sheets, including those which had previously been treated as operating leases and accounted for in the P&L account as an “in-year” expense. This will include leases of retail and commercial property, equipment and vehicles. Accordingly, affected corporates will see:
- The assets and liabilities on their balance sheets increase significantly, with a potentially material impact on covenant calculations;
- The cost profile of their income statements change, with costs skewed towards the early years of leases and greater volatility due to the frequency of recalculation;
- The nature of costs in the income statements change, with a positive impact on EBITDA, but a greater weighting to finance costs and depreciation, again potentially impacting calculations of covenants. Depending on the wording of finance documents, this could also have an impact on cash sweeps, management bonuses and the like;
- The accounting benefits of sale and leaseback transactions could be negatively impacted; and
- The financial reporting benefits of ‘OpCo/PropCo’ structures may be challenged.
IFRS 16 applies to all companies applying IFRS and will filter through to companies applying UK GAAP if they convert to IFRS/FRS 101 Reduced Disclosure Framework, rather than FRS 102.
Currently, under IFRS and UK GAAP, leases are treated in one of two ways, depending on the balance of risk and reward of ownership of the underlying asset under the lease contract:
- Finance lease: when substantially all the risk and reward transfers to the lessee, the present value of lease payments is recognised as a liability on the balance sheet with a corresponding asset;
- Operating lease: when significant risk and reward remains with the lessor, the lessee recognises the rental or lease expense in the profit and loss account, as it falls due, with no balance sheet impact.
Under current practice, most non-specialised property leases are classified as operating leases, with no liability arising on the occupier’s balance sheet, and only “in-year” lease costs (ie rent and service charges) are recognised in the income statement.
IFRS 16 – Leases
The new leasing standard released by IASB removes the distinction between finance and operating leases for lessees. For lessees, all leases will be recorded on the balance sheet as liabilities, at the present value of the future lease payments, along with an asset reflecting the right to use the asset over the lease term.
Two possible exemptions are available for leases with a maximum term of twelve months or less and leases of low value assets (something in the region of c£3,000 or less, irrespective of how many such leases there are). If these exemptions are taken the current service contract type accounting may continue.
The lease liability will reflect initial indexation or rate (eg RPI, and interest) linked payments and take account of renewal options and break clauses, but not contingent rents. The liability (and asset) will be remeasured when changing indices amend the payments; as a result, unless an entity has portfolios of similar leases, it is likely the liabilities will need to be calculated on a lease-by-lease basis, and a significant degree of judgement will be required. This is discussed further below.
Rent expense will be replaced with depreciation and interest expenses. As rent is currently reported as an operating expense, whilst neither depreciation nor interest are taken into account when measuring EBITDA, reported levels of EBITDA could be materially increased. This will have a bearing on banking covenants (both absolute measures of EBITDA/EBIT, and also ratios such as gearing and interest cover), and also any other items such as bonuses, which may be linked to these measures of profitability.
As demonstrated by the worked example below, in the initial years of a lease, the new standard will result in an income statement expense which is higher than the straight-line rent expense typically recognised under the current standards, falling to a lower cost mid-way through the lease as the interest cost reduces.
On implementation, existing leases will be treated in a similar fashion, resulting in increases in assets and liabilities of lessees of large estates, and impacting on reported earnings as above.
As a simple example, a company taking out a 20 year lease at an annual rental of £1 million, with no break clauses, and an illustrative incremental borrowing rate of 6% will recognise a right to use asset (ignoring related costs) and a matching financial liability of £11.5 million, being the discounted value (at 6% pa) of future lease payments.
In the first year of the lease the company will recognise in its income statement expenses of:
- £573,000 for depreciation of the asset (on a straight line basis over 20 years)
- £688,000 of interest cost on the liability at 6%
It can be seen that this will result in a year one income statement cost of £1.26 million, an increase compared to the rental cost of only £1 million which would be recognised on a simple operating lease under current standards.
At the end of year one, there will also be a mis-match between the value of the lease asset and the associated liability, with the liability being higher and thus impacting on overall net assets. The asset will be reduced from £11.5m to £10.9m (£11.5m less c.£0.6m depreciation), whilst the liability will decrease from £11.5m to £11.1m (£11.5m less c.£0.3m “loan repayment” (being the £1m real rent payment less c.£0.7m interest)).
Over the life of the lease, income statement expenses will generally be higher than under the current standards towards the start of the lease period, and lower towards the end, as shown in the graph below, based on the simple example above:
Lease options and breaks
The example above is based on a simple lease with no options, breaks or other complications which will often be seen in reality. The new standard requires companies to calculate the liability on initial recognition, reflecting the longer lease term if it is “reasonably certain to be longer” in relation to break options and options to extend, and variable payments related to an index such as RPI or a benchmark interest (reflected at the current index value). Other variable factors (such as turnover related rent) are not initially recognised, but are charged to profit in the period incurred. In the future the liability, and asset, will be adjusted as a changing index changes the payments or in some circumstances the likely exercise of a break clause is reassessed.
For instance, if there is a significant change in circumstances such that the expectation in relation to the likely exercise of a break clause changes, then there will be a matching change in the value of the asset and liability recognised. For companies such as retailers, pubs or restaurants, with a large leased estate, the need to remeasure the liability after initial recognition is likely to be onerous in terms of finance team resources and could result in material changes in the levels of assets and liabilities recognised in each year.
The revised definition of a lease may change those contracts considered to be a lease, but otherwise for lessors the finance / operating lease distinctions will remain and IFRS 16 also contains a specific exemption for lessors which value investment properties at fair value, in line with IAS 40. Consequently the proposed IFRS is not expected to impact on the majority of landlords.
There are some new requirements for sale and lease back transactions, with the leaseback giving rise to an asset, and only a portion of the sale gain reflected. There is also additional guidance for lessees that sublease: the headlease will give rise to a right of use asset and lease liability, and the sublease will be assessed as finance or operating and the right of use asset retained or derecognised based on the extent to which risks and rewards of the right of use asset have been transferred.
Considerations for lenders
For companies with any leased assets IFRS 16 will result in changes to reported profits, and assets and liabilities, and these changes are likely to be material for corporates with large leased estates, such as certain distributors, manufacturers, retailers and hotel and leisure operators.
These changes could impact covenant calculations, and current covenant definitions may be inadequate to encompass the proposed changes, resulting in ambiguity and the potential for disagreement between lenders and corporates on treatment.
Areas to consider in relation to each of the primary financial statements include:
The example below shows the impact on the income statement of an entity applying IFRS 16 with an estate of 10 properties leased for 20 years each at £1m per annum, with a mix of remaining terms ranging from 18 years to 1 year:
Overall there is a limited impact on reported profit before tax, but EBITDA and EBIT are increased materially, with property lease costs now being shown as depreciation and interest expenses.
This will impact on banking covenants and leverage ratios derived from standard income statement measures such as EBITDA and EBIT. Lenders should revisit the definitions used for such covenant calculations, and ensure they are re-worded as necessary to take account of the forthcoming changes in accounting standards.
Based on the example above, the balance sheet impact of the same leased estate is shown below:
Adoption of IFSR 16 results in a material increase in assets and liabilities, but with a net increase in liabilities, resulting in a move from an overall net asset position to a net liability position.
Lease liabilities will be classified as financial liabilities, and therefore will impact reported financial indebtedness, balance sheet ratios and covenants.
Cash flow statements
IFSR 16 will have no impact on net cash flows, but in the presentation of cash flow statements is likely to lead to an increase in operating cash inflows, with a matching increase in financing cash outflows.
Principal payments on leases will be classified as financing activities, and under IAS 7 interest can be classified under operating, investing, or financing cash flows.
Following the example above, key financial ratios are likely to be materially impacted, as shown below:
It can be seen from the above that the definitions of financial ratios will be key in determining the impact of IFRS 16. In order to avoid unintended covenant breaches, or the creation of excessive headroom which could mask real underperformance, definitions should be reviewed in advance of the implementation of IFRS 16.
The above is intended to provide an overview of the impact of IFRS 16 for restructuring market participants, it is not intended as advice for preparers of financial statements. For more detailed and technical information and analysis, including industry specific publications, please visit our IFRS 16 Resources page.