Consequences of the implementation of “IFRS 16 Leases” on Key Performance Indicators
“One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet…” (Sir David Tweedie, former IASB Chairman, April 2008)
IFRS 16 was published by the IASB in 2016 and is effective in the European Union since 1st January 2019. In short, lessees are no longer obligated to account for lease transactions as operating or finance leases; instead, they have to recognize a so-called right-of-use asset and a mostly corresponding lease liability for almost all lease agreements. Subsequently, the right of use asset is usually amortized using the straight-line-method and the lease liability must be compounded. A first impression of potential impacts of a first time capitalization could be off-balance leasing liabilities.
Relief: short-term leases, where the non-cancellable duration of the agreement is less than 12 months, and lease agreements under which the underlying assets are low of value do not need to be capitalized.
Considering the capitalization requirement for almost all leases since 2019, the question is whether the new IFRS 16 leasing standard will have a negative impact on the attractiveness of leasing arrangements. Particularly in the case of investments such as real estate or financing of large machinery, off-balance accounting has been one of the main advantages of the leasing relationship for the lessee, but at the same time it has been the most frequently discussed point of criticism of leasing Accounting.
With regard to the lessor, the accounting remains largely unchanged, i.e. as under IAS 17.
So what are the KPI consequences for the lessee due to the application of IFRS 16, beginning with the interim financial statements 2019?
First of all the lessee has to prove whether an agreement contains a lease. Three criteria have to be checked for this purpose:
- Is the object of the agreement an identifiable asset?
- Does the lessee have the right to obtain substantially the majority of the benefits over the period of use?
- Does the lessee have the right to direct the use of the asset?
If all three criteria are met, the lease contract needs to be recognized in the financial statements. Furthermore, it must be verified that the lessor does not have a substantive substitution right of the asset. Then he must separate the components of the contract into lease and non-lease components. Furthermore, the lessee has to define the lease term. The difficulty is that the lease has a different term depending on the individual non-cancellable period of lessee and lessor and may be influenced by the different measurement of a short-term lease.
As a result of implementing IFRS 16, the following KPI changes are expected:
- Total capital increases as previously unrecognized assets are now recognized in the balance sheet as right-of-use assets as well as the related lease liabilities.
- Expenses will be higher in the beginning and lower at the end, because previously annual lease payments of the same amount will be replaced by the amortization on the right-of-use asset and interest expense on the lease liability.
- Due to the balance sheet extension the equity ratio will be reduced. The debt ratio increases.
- In addition, the increased total capital also reduces the return on investment (ROI) and the asset turnover. EBIT, EBITDA and the operating cash flow increase due to the effect of the new on-balance-sheet treatment on the income statement.
The compliance with loan covenants, effects on credit ratings, borrowing costs and EBIT based incentive systems shall be analyzed.
It remains to be seen what impact IFRS 16 will have on the leasing business model and whether the implementation of IFRS 16 will result in the main objective of IFRS 16, i.e. that companies conduct less accounting policy through lease agreements.