The International Accounting Standards Board (IASB) has published a new standard on leases, IFRS 16, which will be effective for reporting periods beginning on or after 1 January 2019. This new standard replaces the previous standard IAS 17.
Background to leases
Under current accounting rules when a company leases an asset, the lease can be classified as either an operating lease or a finance lease. An operating lease is often referred to as off-balance-sheet because the asset does not appear on the company’s books. Instead, the lease payments are expensed in the income statement and the lease is disclosed in the notes to the accounts. Finance leases, however, appear on the company’s balance sheet in the form of a lease asset and a lease liability. The asset is depreciated and interest on the lease liability is charged to the income statement instead of the lease payment. This treatment captures the true substance of the leasing arrangement i.e. the lessor providing long term finance to the lessee.
Analysts use the notes to the accounts to make adjustments for operating leases so as to ascertain the company’s lease commitments that, in essence, represent long term liabilities (debt). British Airways, for example, has operating leases with terms of up to 12 years for aircraft and 128 years for ground leases; although not on the balance sheet, the substance is a long term financial commitment.
One of the driving forces behind IFRS 16 was that the IASB felt that disclosure of operating leases was not sufficient to allow a transparent view of the leased assets that a company controlled and the lease payments that it could not avoid.
New single lessee accounting model
IFRS 16 significantly changes the manner in which leases are accounted for as it introduces a single lessee accounting model where almost all leases will be treated as finance leases. Exceptions include leases with a term of one year or less and low value assets such as office equipment and computers.
Implications for financial analysis
For companies with significant operating leases, IFRS 16 will result in an increase in assets as off-balance-sheet leases are brought onto the books and an increase in liabilities as lease commitments are recognised. Asset turnover will therefore decrease, and financial gearing will increase. In addition, measures such as EBITDA will improve as operating lease payments will no longer feature as an operating expense. Operating cash flow will also appear healthier under IFRS 16 because the entire lease payment will no longer be deducted as an operating cash flow. Instead, part of the lease payment will appear in the financing section of the cash flow statement.
The IASB has indicated that companies within the airline, retail and travel and leisure industries are likely to be affected the most as they have a significant amount of off-balance-sheet operating leases – close to 30% of assets. The accounting by lessors, however, remains largely unchanged.