The effects of IFRS 16 on financial statements

Replacing previous leasing standard IAS 17, the new IFRS 16 / AASB 16 standard is set to shake-up the way entities manage their financial statements.

Under IAS 17, a lessee classified a lease as either finance or an operating lease depending on whether or not the lease is economically similar to purchasing the underlying asset. However, under IFRS 16, a lessee will no longer be able to make the distinction between operating and finance leases, and all leases will largely be treated as finance leases subject to certain exemptions. If lease payments are made over time, a company also recognises a financial liability representing its obligation to make future lease payments.

• An identifiable asset; 
• for which the lessee obtains economic benefits; and
• the lessee directs the use of the asset (control).

Additionally, the revenue recognition rules for customer contracts have changed. IAS18 is now IFRS15 and essentially brings long-term customer contracts on the balance sheet in a manner related to critical milestones.

What are the exemptions of IFRS 16?

Two significant exemptions make the standard easier to apply as they don’t appear on balance sheets, including short term leases under 12 months and the leases of low-value items under a materiality threshold. This threshold is generally accepted as being circa USD$5000 but there is no brightline test of this amount. The low-value items apply on a per-item basis; it doesn’t matter how many items under USD$5000 are listed on a lease. 

Likewise, specific criteria present the opportunity for current “leases” not to be “leases under IFRS16”, and hence not on the balance sheet. 

• assets may not be specifically identified;
• The lessee or the lessee can’t direct use of the asset.

• substantive substitution;
• splitting between a lease and non-lease components (must either be split or all lease);
• exclusion of variable payments.

What is the impact and effect of IFRS 16 on financial statements?

The introduction of IFRS 16 / AASB 16 will lead to an increase in leased assets and financial liabilities on the balance sheet of the lessee. Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) of the lessee increases as well. As a result, companies with material off-balance sheet lease commitments will encounter significant changes in their key financial metrics such as the leverage ratio, return on invested capital (ROIC) and implied valuation multiples. 

Below we have outlined the critical impact IFRS 16 will have on financials and ratios, and the effect this will have on valuations:

The Effect on Financials and Key Ratios

From a business valuation perspective, the equity value or market value of the company should not change with the implementation of IFRS 16 as there is no change to the underlying cash flows being generated by the business. However, adopting IFRS 16 will result in the company’s net debt and EBITDA increasing, which is likely to complicate the comparability of valuation multiples, particularly in the short term. 

This new accounting treatment will likely cause the following:

1. Create an increase in net debt with the recognition of incremental lease liabilities. 
2. A higher EBITDA with lease expenses effectively flowing through the income statement as a depreciation and finance charge. 
3. A higher invested capital for the lessee, which generally lowers the Return Of invested Capital (ROIC). 

Moreover, it is also likely that organisations will observe an increase in net debt/EBITDA ratios. This impact is mainly reliant on the remaining duration of the lease and current leverage ratio. The incremental net debt/EBITDA on the lease liability will likely be high at the start of the lease term, then gradually decreasing to zero at the end of the duration of the lease. 

The Effect on Valuations

The introduction of IFRS 16, should not in principle change the fundamental equity value of an organisation, although the enterprise values of companies will potentially increase. Accounting for a lease as either operating or finance in nature does not alter the economics and cash flow generating capacity of the business. However, as IFRS 16 / AASB16 impacts the implied financial metrics of a company (primarily EBITDA, net debt and therefore indicated enterprise value), adjustments and additional considerations are required in the most commonly applied valuation methodologies: (i) Discounted Cash Flow (DCF) approach; and (ii) Market approach based on market multiples. 

As IFRS 16 will likely increase the implied enterprise value of companies as net debt will increases, the equity value (market capitalisation) should remain the same. In the DCF approach and assuming a Free Cash Flow to Firm (FCFF) model, enterprise values are assessed based on the net present value of expected free cash flows, and the impact of IFRS 16 will be indicated in the following manner:

• The future FCFF will be higher over the remaining lease period, as rental expenses are excluded from EBITDA.
• The depreciation charge relating to the new finance lease asset is a non-cash item and consequently does not negatively impact FCFF.
• The lease payments are reflected in the cash flow statement through interest payments and redemptions of the lease obligation; however, these are financing items and also do not impact FCFF.

Ultimately, the introduction of IFRS 16 adds a level of complexity in valuations. Companies should consider how this will influence lease obligations, as well the average remaining lease term of the target should be analysed, with lease expenses should be treated as an operating cash outflow or adequately reflected in net debt. Likewise, when using EBITDA multiples, net debt should appropriately be adjusted, or an EBITA multiple should be considered.