As more and more financial reports discuss the topic of IFRS 16 – Leases adoption and how its affects their reporting, I decided it is time to get a better understanding of the scope of IFRS 16 and how it affects reporting items within Balance Sheet, Income Statement and Cashflow Statements. In conclusion, I am going to describe some effects on Financial Ratios as well as giving an outlook on implications on Net Debt and Valuation Concepts.
Scope of IFRS 16 – Leases
In general all leasing contracts are to be handled accounting-wise according to IFRS 16 – Leases by the lessee. Exemptions are possible for lease contracts of (i) low value, and/or (ii) contracts with only a short contract term remaining. The new accounting concept is close to as if the company takes on debt for financing the purchase of a specific (long term) asset, that can be used for a certain time period, equal to the period during which the loan is payed back and the assets gets depreciated.
According to IFRS 16, taking on new leases the balance sheet total increases, since on the asset-side there is a right-of-use or RoU-Asset to be capitalized. On the liability-side leasing-liabilities are booked accordingly, representing future lease payments discounted with an appropriate discount-rate as illustrated below. Both balance sheet items decrease in value over the lease contract period.
Within the income statement, leasing expenses are booked as depreciation below Ebitda and before Ebit of the RoU-ssset and as interest expense below Ebit and before Ebt.
The periodic depreciation is calculated based on the shorter term of either economic lifetime of the asset or term of the lease contract. Interest expense is claculated as current liability times applicable interest rate. Frontloading-effect: Regular periodic depreciation is constant, but interest expenses are decreasing towards later periods, since liability is lower at later point in time.
The adoption of the new accounting regime does not change the cashflows between lessee and lessor, but the allocation concept within the cashflow statement is different now. Under IFRS 16 Leases, interest- and redemption-share of the lease-payment are allocated to financing cashflow (CFFF).
Ratios and Metrics
Ebitda and Ebit increase after IFRS 16 adoption, since interest expenses as part of leasing expenses are not included anymore.
Ebt can be higher or lower, compared to pre IFRS 16 (frontloading-effect).
FCF is higher, since CFFF items and thus lease payments are only included in CFFF.
Since 2019 the financial reporting is much more aligned with the above mentioned view on net debt / leases. With net debt increasing, both leverage ratio (increasing) and EQ Ratio (decreasing) look worse after IFRS 16 adoption. ROCE is declining.
Adoption of IFRS 16 Leases will have far reaching effects on net debt, which is increasing under the new reporting standard. There are many quirks handling net debt and valuation which will be discussed in another post.
Outlook: Implications on Valuation Concepts
When using IFRS 16 reported numbers, lease payments are presented differently within Income Statement compared with pre-IFRS 16 adoption. I believe it is only reasonable to treat leasing expenses as reported under IFRS 16, arguably as if the assets were purchased and financed with financial debt, which would be …
- Depreciation has a decreasing effect on the capitalized RoU-Asset.
- Repayment of debt, included in CFFF
- Interest payments for debt, included in CFFF
However, this new reporting regime brings some challenges when valuing a business, i.e.
… the NPV of free cashflows to the firm (“FCFF”) are expected to be higher resulting in a higher Enterprise Value (“EV”). The higher NPV of FCFF are a result of a higher EBITDA and lower WACC …AccountancyAge (link)
Additionally, the net debt from lease contracts only captures the currently existing contracts until they are ending. How to capture lease payments into perpetuity will also be discussed in another post.
Net debt as well as valuation considering IFRS 16 Leases will follow…
And a happy new year 2020!