On paper, the new lease accounting standard (ifrs 16) is a non-cash adjustment that does not change much. However, this new standard will have a significant impact on financial aggregates and ratios as well as on the perception of risk shifting.
EBIT (earnings before interest & tax) margins are artificially inflated, EV/EBIT multiples distorted, EPS adjusted upwards or downwards and balance sheets are overwhelmed by assets and liabilities relating to leased property. The purpose of this article is therefore to clarify the concrete impacts of ifrs 16, both financial and operational, and to identify the sectors most affected by this new accounting system
At the beginning of 2018, it is time to forecast and understand the debates that will shake the financial world. As the valuation of listed companies reflects the expectations and valuations of operators, there is no doubt that the new ifrs 16 standard will be one of the topics of this financial year.
Published in January 2016, the new ifrs 16 standard on leases will be applicable from 1 January 2019. In short, this new IASB standard transforms off-balance sheet commitments, operating leases, into assets and liabilities. This new accounting rule is a real earthquake since, according to PWC, one out of two listed companies would be affected, which would represent nearly 3000 billion euros of off-balance sheet commitments related to rental contracts.
The assets concerned are real estate assets, vehicles, plants, equipment and production tools. The consideration of these former off-balance sheet commitments is therefore a major issue and has already been the cause of bankruptcy. In 2011, the U.S. bookstore Borders had $2.8 billion in off-balance sheet commitments related to its store leases, which was seven times the amount of debt recorded on the balance sheet.
Explanation of IFRS 16 and impact on the financial statements
For lessors, the distinction in IAS 17 between finance leases and operating leases is maintained and their recognition substantially unchanged.
IFRS 16 is a major change for lessees (tenants). Previously, rents related to operating leases were recorded off-balance sheet and impacted the income statement through rent charges and the balance sheet on cash.
From now on, tenants will recognize most leases directly on the balance sheet using the finance lease accounting model (also known as leasing or capital lease). Only rentals of less than 12 months and properties of low unit value (less than 5000 euros) may be exempted. Thus, a lease is finally considered as an asset purchase contract with a finite life generating a debt to purchase it.
What are the impacts of this change on the lessees’ financial statements?
- Balance sheet
For the balance sheet, payments due under operating leases (currently recorded as off-balance sheet commitments) will be recorded directly in the balance sheet at their discounted value in the form of financial debt.
In return, the lessee will recognise as an asset a right to use the asset corresponding to the financial debt related to the lease of the asset plus any pre-contract payment and/or costs related to the dismantling and restoration of the asset. The asset in question will be amortized on a straight-line basis and the debt will be reduced by the payments of the due dates provided for in the contract.
According to Pierre Phan Van Phi, partner at EY, “About 85% of the lease contracts will now appear on the balance sheet in the form of this debt and asset,…, and can reach up to 20% of the balance sheet total depending on the sector”. We can already see the obvious impacts on debt ratios, asset efficiencies and capital employed ratios as well as the implications this may have on the income statement.
- The main consequence of IFRS 16 is to change the nature of the expenses and their recognition rate. Old rent charges, corresponding more or less to the cash payment of rents to the lessor, become depreciation charges (related to the recognition of a new asset on the balance sheet) and financial interest charges (related to the increase in financial debt).
Thus, the EBITDA margin (earnings before interest, tax, depreciation & amortization) finally becomes the EBITDAR margin (R for rent). The elimination of rent charges therefore mechanically inflates the EBITDA margin.
Amortization expenses will be increased by the amortization of the right of use, which should remain stable for the entire life of the contract unless it is renegotiated.
The EBIT margin is also artificially increased since it is no longer reduced by full rental expenses but only by the depreciation part. As the financial charges come later, they increase substantially at the beginning of the contract but will decrease as the rents are paid.
Finally, the impact on profits, the bottom line, will not be equal depending on the company’s profile. Indeed, growth companies, which significantly increase their number of leases, will see their profits reduced in the short term while mature companies, which see their number of contracts decrease or mature, will see their profits increase.
Cash flow statement
Finally, the impact on cash flows is simple to understand. Operating cash flows will increase due to higher EBITDA or depreciation charges, while cash flows will be reduced by the additional interest expense.
Impact of IFRS 16 on financial analysis and valuation ratios
IFRS 16 has no direct “cash” impact, the amounts paid to the lessor remain intact. The study of the consequences on the three financial statements has already shown that EBITDA and EBIT margins are artificially increased. But what about the other ratios and aggregates?
First of all, it is clear that the debt of the companies concerned is likely to increase significantly. Thus, the liquidity and leverage ratios (Gearing, net debt/EBITDA) will deteriorate sharply in the first years of the contract and then begin a phase of improvement throughout its life cycle thanks to the gradual reduction of the debt linked to the payment of rents.
The question here is whether this increase does not jeopardize the company’s financial stability and solvency in the early years of the lease agreements. This significant increase in debt could, for example, lead companies to postpone certain investments or rethink their capital allocation policies. In addition, the interest expense coverage ratio is also expected to deteriorate in the early years of the contract, but less significantly as the EBIT margin will also increase.
On the operational efficiency ratios, several impacts can be observed. The turnover ratio of assets measuring revenue per euro of assets used will deteriorate due to the increase in assets related to the right of use recognised.
Similarly, ROCE (return on capital employed), which measures the effectiveness of capital allocation, will be degraded in the early years of lease contracts given the disproportionate increase in capital employed compared to the increase in EBIT. Thus, these newly restated ratios will more accurately show the efficiency of companies that use leasing on a massive scale.
In terms of valuation, the EV (enterprise value) will increase according to the debt generated by the leases. Thus the EV/CA of companies using rental will be clearly assessed. As far as the EV/EBITDA ratio is concerned, the situation is much less clear. This ratio will depend on the rent/EBITDA ratio and the rental period. To illustrate this point, here are two extreme cases:
The company has a high Rent to EBITDA ratio and a short contract term. EBITDA will increase significantly, EV will increase slightly so the EV/EBITDA ratio will be reduced
The company has a low Rent to EBITDA ratio and a long contract term. EBITDA will grow slightly. The EV will increase significantly. Thus the EV/EBITDA ratio will increase
With regard to the PER, the impact of IFRS 16 is relatively small. However, this ratio will depend on the company’s situation. In the case of mature companies, the PER will be slightly lower due to the partial increase in profits as indicated above.
Industries impacted by IFRS 16 and potential operational implications
It goes without saying that the areas to look at carefully are those where renting is a common and important practice. The food and non-food retail sectors will crystallize the interest of the financial community.
But these are not the only sectors. The aeronautics sector (in particular airlines), the transport sector in general, the hotel industry and the retirement homes sector will be strongly affected by this transformation.
Thus, there is a significant derating risk for players in its industries with low margins, long leases and balance sheets that are already “raised”. This does not suit an actor such as Steinhoff who is already caught up in an accounting scandal and full of debt.
The possible operational implications are multiple. Today the advantage of leasing is that the asset is fully available for the company’s business but remains mostly off balance sheet. This advantage disappears completely with IFRS 16. In order to reduce their financial leverage, some players will be forced to sell assets.
One can imagine, for example, in the supermarket distribution sector, a movement of store sales. But other players with controlled leverage could take advantage of this to buy back assets. The same applies to hotels and retirement homes. This impact could be acceptable to commercial real estate developers hurt by the rise in interest rates.
As far as the duration of the contracts is concerned, it is highly likely that a renegotiation of the rental contracts will take place. Longer-term contracts will generate greater debt and therefore higher financial charges at the beginning of the contracts.
The variance in the impact of long-term contracts will be greater on the income statements. Thus, contracts will probably be shorter in order to limit the size of financial charges. Companies will probably also renegotiate their borrowing terms with their bank to ensure that their covenant is not breached.
However, not everything is lost for companies. One way to circumvent the impact of this standard is to transform certain leases into service contracts that are still off-balance sheet commitments.
Thus, even if this new IASB standard has no cash impact, it is synonymous with upheaval for several industries. This big bang balance sheet will have to be analysed with the greatest attention and the leverage of companies will once again be at the heart of the debates, especially in retail, transport, aeronautics, hotels and retirement homes.
1] Pichelot.N (2017), “IFRS 16 standard: when USD 2,800 billion of leases are recognised in the balance sheet” Les Echos 13/07/2017
2] EY (2017), “IFRS 16, How to prepare for its application? ” (online), EY