Since January 2019, the IASB (International Accounting Standards Board) has mandated a new standard regarding leasing, namely IFRS 16 (what is IFRS?). The biggest change of this new standard is that companies must include all lease and rental contracts on the balance sheet, as a right-of-use asset (ROU). For this reason, this can have major consequences for companies that lease or rent a lot.
Because these contracts are now on the balance sheet, financial ratios, net profit and solvency, among other things, are affected. But how does IFRS 16 actually work? What’s the difference with the old way? In this article, I explain what the IFRS 16 standard entails, and discuss the effects of this new standard.
What is IFRS 16?
IFRS 16 – Leases require companies to include all lease and rental contracts (> 12 months) on the balance sheet, regardless of the type of lease. For all lease contracts, there will be an asset versus a liability with the present value of the lease contract on the balance sheet.
Prior to the introduction of IFRS 16, only financial leases were included on the balance sheet, but now also operational leases. This can have major consequences for companies that lease or rent a lot, such as airlines or shops. For example, about 30% of the aircraft at various airlines were kept off the balance sheet because they were (operationally) leased.
Before IFRS 16
Before this new standard became mandatory, companies had to comply with IAS 17 (International Accounting Standard 17). This standard had a separate way of reporting the two types of lease contracts; financial and operational lease. Below I briefly explain the difference between the old way and IFRS 16.
Operational lease
In IAS 17, all operational leases were recognized as costs. This cost was recognized in equal parts over the period of the lease contract. This was because with operational lease you do not own the asset yourself, but there is a purchase option at the end of the contract. With operational lease, you rent the asset, as it were, without being the owner.
Financial lease
Under the old rules, you had to put financial leases on the balance sheet (as well as under the new IFRS 16). With financial lease, you are the owner of the asset from the start of the contract. This ensures that the lease contract is seen as a liability, the leasing company only takes care of the financing.
After IFRS 16
IFRS 16 has ensured that the operational lease contracts must now also be capitalised on the balance sheet. The effect of this can be significant, because operational lease contracts are no longer recorded as costs, but are also capitalised. This creates a so-called ‘right of use asset’ or an ROU asset. In addition, you book the debt or ‘lease liability’ as the present value of the contract.
To determine the present value, and thus the value of the lease liability of the lease contract, the implicit interest rate determined by the lessor is used. Otherwise, the incremental borrowing rate is used. The incremental borrowing rate is the interest rate that lessee would have to pay if he wanted to take out financing to buy the asset.
Example of the valuation of the lease contract
The method for calculating the value of a lease contract is as follows:
Suppose you want to lease a machine and this will cost 20,711.11 per year for the next 5 years. You then calculate the present value of the lease contract with the implicit interest rate which is 4%. You calculate this as an annuity and end up with 95,890.35 (20,711.11 x 4.62990) This amount is booked as a ROU asset versus a lease liability:
Right of use asset: 95,890.35
Lease liability: 95.890,35
After this, you write off the lease liability every year according to an amortization schedule of 5 periods with 4% interest, where the interest costs decrease more and more. You also write off the asset every year by gradually depreciating it over the 5 years. As a result, the costs are accelerated in the beginning compared to the old method. This is because the interest rate starts high and ends lower, and the depreciation costs remain the same.
The effects of IFRS 16
This new way of reporting operational leases can have a huge impact on various KPIs (Key Performance Index) such as EBITDA (Earnings Before Interest, Tax, Deprecation and Amortisation) EPS (Earnings Per Share) and operating cash flow.
As indicated, operational leases are now capitalized on the balance sheet, and the former ‘rental costs’ are divided into depreciation and interest. As a result, these costs are no longer included in the EBITDA, which therefore increases the EBITDA.
For example, there are still a number of ratios that are affected by the change in IFRS 16. In short, the new method has negative effects on ratios, the leverage ratio goes up and the current ratio and asset turnover decrease. This is because debts or liabilities and assets are given a higher value.
Furthermore, the operating cash flow increases because part of the previous costs are now seen as interest expenses, which belongs to the finance department.
Below you can see all the changes in a row, published by the IASB.
Why from IAS 17 to IFRS 16?
Now, you’re right to wonder why the IASB has adopted this new approach to reporting leases. The IASB indicates that it improves overall financial reporting, and that IFRS16 increases comparability between different companies.
Better Financial Reporting
By putting (almost) all lease contracts on the balance sheet, transparency about the debts of companies increases, which ensures that investors get a more realistic picture of a company’s financial position. Prior to IFRS 16, debts were valued about 30% lower than actual debts.
In the old way, there would only be rental costs, which could have a distorted picture, because there is actually a debt attached to it. Investors knew this and used different techniques to assess debt, but other investors did not.
Better comparability
There is a higher comparability between companies because every company now has to use the same method for every lease. In other cases, a company might have a lot fewer assets due to the many operational leases, compared to a company that had a lot of financial leases. In this case, this is equalized, which improves comparability.
However, IFRS 16 is expected to make determining the conclusion of lease contracts a more strategic ‘game’. Whether or not to enter into a lease contract now has greater potential consequences and has thus become a more specialized task.
Summary
In summary, IFRS 16 ensures that all lease contracts must now appear on the balance sheet as an asset and as a lease liability. As a result of this change, companies’ financial statements can be significantly affected. In particular, EBITDA and KPIs such as leverage and asset turnover can give a significantly different picture of a company.
IAS 17 would not give a realistic picture of a company’s situation because sometimes huge leases were not on the balance sheet. As a result, assets and liabilities were undervalued by as much as 50% in some cases.
IFRS 16 has also made it easier for investors to compare companies with each other. This is because every company now has every lease or rental contract (> 12 months) on its balance sheet.
Furthermore, in this publication of the IFRS you will find everything about the costs and revenues in their impact analysis on IFRS 16.