Written by Denise D. Bright
IFRS 16 Leases becomes effective for annual reporting periods beginning on, or after, January 1, 2019. Consequently, entities with a December 31 year end, who did not adopt the new standards early, will report financial results utilizing IFRS 16 for the first time in their March 2019 quarterly financial statements. While entities have already been evaluating the impact of IFRS 16 on their financial statements, many have yet to fully consider its impact under various agreements, including, in particular, their financing agreements. It is important to note that the Financial Accounting Standards Board is also implementing similar rules (ASC 842) resulting in entities who report utilizing US GAAP needing to consider many of the same issues.
This article focuses on the impact of IFRS 16 on a lessee since lessor accounting remains similar to current practices. Under IFRS 16, the definition of lease is very broad, being "a contract or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration." Consequently, agreements that are not typical leases may include an embedded lease. Under IFRS 16, the "embedded lease" part of an agreement will be subject to the same analysis and accounting treatment as a typical lease. Any lease modifications or changes to the term will generally require the lessee to consider the lease as a new lease to which the applicability of IFRS 16 will need to be assessed.
To determine if a lease is present, a lessee will consider: whether there is a specified asset; who has the right to use and direct the use of such asset (i.e., control); any substitution rights; the period of use or term (which may be time or based on another identifiable factor (i.e., production)); and, whether it obtains substantially all of the economic benefits. It should be noted that the value of the lease payments as compared to the value of the asset, and the term of the lease as compared to the assets’ useful life are not relevant considerations to the IFRS 16 lease determinations except to the extent the lease would fall in the exceptions stated below. Consequently, it is likely that IFRS 16 will effectively eliminate the off balance sheet treatment of many leases that were historically classified as operating leases. As a result of IFRS 16, many operating leases of big ticket items such as real estate, aircraft, trains, ships, large equipment, cars and cell towers will now be on the balance sheet. Readers are reminded that IFRS 16 does not include the term or concept of 'capital lease', but in most cases those leases formerly known as capital or finance leases are likely leases under IFRS 16.
The application of IFRS 16 excludes a number of specific types of leases, including leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources, and certain licenses for intellectual property and intangibles. In addition, there are two other significant exclusions from lease accounting: short-term leases (generally those with a term of less than a year without a purchase option) and low-value leases, both as defined in the standard.
Historically, lessees recorded finance leases (often still referred to as capital leases) on their balance sheet as if the assets were owned and financed. Alternatively, operating leases were not recorded on the balance sheet but were disclosed in aggregate amounts in the notes to the financial statements. Lessees under IFRS 16 will recognize a right-of-use asset and a lease liability associated with leases.
Entities which have significantly utilized operating leases in the past will likely, as a result of IFRS 16, now have a higher balance for assets and increased liabilities on their balance sheet. In addition, the expenses related to the former operating leases, which are now leases under IFRS 16, will be accounted for as operating expenses, depreciation and interest expense, as opposed to operating expenses. Consequently, many ratios and financial calculations for an entity where operating leases are reclassified as leases under IFRS 16 are likely to be impacted. Ratios impacted include, but are not limited to debt to equity ratios, asset turnover ratios, interest coverage, current ratios and any ratios which utilize EBITDA or EBIT.
If IFRS 16 has an impact on an entity's financial statements, then it should evaluate it's financing agreements and other agreements to determine:
- Is GAAP Fixed or Floating?
If GAAP or the applicable definitions (i.e., operating lease or finance/capital lease) are fixed at a point in time (usually on or prior to December 31, 2017) then reporting and compliance under the agreement will not change post-implementation of IFRS 16; however, the amounts attributable to leases reported or utilized for the purposes of such agreement may be different from those reported in the financial statements which will require the maintenance of two sets of data to assess future compliance and provide the required reporting under the agreement.
- How Are Leases Defined and Treated If the Definitions Are Not Fixed?
The definitions of finance or operating leases in the applicable agreement is important in assessing the implications of IFRS 16. As an example, the definition of debt or indebtedness often includes any amounts that would be included on the borrower's consolidated balance sheet as a liability. As a result of the application of IFRS 16 debt, as defined, may increase liabilities due to the recognition of leases due to the reclassification of operating leases to leases under IFRS 16. An alternate definition of debt or indebtedness includes indebtedness for borrowed money as stated on the balance sheet and adjusts for certain items which often include the amounts attributed to finance (capital) leases. Since it is likely that many leases previously included as operating leases will now be leases under IFRS 16, the debt amount will increase under such a definition. Entities should also assess whether the current definitions continue to be applicable due to the finance lease, capital lease and operating lease distinctions not being utilized under IFRS 16. Balance Sheet related definitions which may be impacted include "Attributed Debt", "Capital Leases", "Debt", "Indebtedness", "Operating Leases", "Permitted Indebtedness", "Permitted Liens", "Total Assets" and any baskets associated with or including capital/finance and operating leases.
- Does Any Income Measure or Ratio Adequately Adjust for Changes as a Result of IFRS 16?
Under IFRS 16, the calculation of EBITDA and EBIT will increase as expenses attributable to former operating leases which are now being reported as leases under IFRS 16 will now be recorded as operating expenses, interest expense and depreciation rather than operating expenses. Therefore calculations, covenants, or earnouts based on EBITDA or EBIT should be re-evaluated.
- Does IFRS 16 Impact the Calculation of Other Financial Ratios?
Under IFRS 16, amounts attributable to assets may increase as the right of use assets are recognized. Short-term liabilities and long-term liabilities will also increase as the lease liabilities attributable to leases are recorded. Any calculation of current ratio will be affected as short-term assets will not increase but short-term liabilities will. The increase in liabilities may result in an increase in indebtedness or debt (as discussed above), and any debt or indebtedness based calculation may be impacted. Often lenders utilize lease baskets to limit the ability of a borrower to finance assets by way of a lease and the impact of the right of use assets and lease liabilities attributable to IFRS 16 should be assessed in conjunction with such baskets. In addition, under IFRS 16, as operating leases are reclassified as leases under IFRS 16, there will be an increase in both depreciation and interest expense and any ratios, such as interest coverage, calculated utilizing such expenses should be reassessed. Expenses relating to leases under IFRS 16 tend to be front-end loaded such that total lease expense (depreciation and interest) will be greater in the early years notwithstanding cash rentals are consistent through the term which may further impact calculations. Few calculations are based on cash flow but it should be noted that IFRS 16 will also impact cash flow moving some expenses from operating to financing cash flows. Finally, the characterization of a lease as on balance sheet may have an impact on the cross default provisions.
Currently entities are utilizing one of the following approaches to address the implications of IFRS 16:
- Frozen GAAP. Many entities are amending their agreements to include static or "frozen" GAAP definition for operating and capital leases which in effect carves out the application of IFRS 16, this effectively freezes GAAP until the full impact of IFRS 16 can be quantified or where the impact is not material. While freezing GAAP may be a quick and easy solution, consideration should be given as to the impact of keeping adequate records to produce accounting records in compliance with IFRS 16 and also providing covenant calculations and disclosure excluding the impact of IFRS 16.
- Triggering Amendment Provisions. Many credit agreements (but few bond/note indentures and agreements) provide for a mechanism where the borrower can provide notice to the lenders to trigger an amendment process with specific parameters which is often the intention to put the parties in the same position that they would have been absent the change.
- Amendment to Agreements Utilizing IFRS 16 Treatment. It is likely that once the full impact of IFRS 16 on the entity's financial statements is calculated, companies will renegotiate the definitions, covenants, baskets and ratios to reflect the new IFRS 16 financial realities.
The foregoing is a general summary of some of the likely significant impacts of IFRS 16 on lessees. However, the actual impact of IFRS 16 on any entity will be dependent on both the entity's utilization of leases, the categorization of leases under the new rules and the actual provisions of any agreement which is impacted by the changes.
The members of the Bennett Jones Financial Services team are familiar with the various implications of IFRS 16 on various aspects of our clients' business and operations. Please contact us if you would like to discuss the specific implications to your business and agreements.