EBITDA up, EBIT up, EPS? … well it depends. The impact of lease capitalisation under IFRS 16 on key company metrics in 2019 is complex and depends on several variables, including transition options chosen by companies.
We highlight what you should look out for and present a simple interactive model to help you understand the effects of IFRS 16 on profitability, growth rates, return on capital and leverage.
In the coming months companies reporting under IFRS will include the effects of the new lease accounting standard, IFRS 16, in their financial reporting for the first time. For some companies the capitalisation of previously off-balance sheet operating leases will have a significant effect on their financial statements.
Prior to these results being released companies should be communicating with investors about the likely impact. Indeed, IFRS requires that companies explain the effect in financial statements published prior to the adoption of a new standard. The disclosure is of “known or reasonably estimable information relevant to assessing the possible impact that application of the new IFRS will have on the entity’s financial statements in the period of initial application” – IAS 8 para. 30(b).
Unfortunately, all too often in practice the IAS 8 explanations are not very informative. You will probably find some companies will say something like ‘we are still evaluating the potential impact of IFRS 16 on our financial statements’ when they publish their 2018 results. We think that it is important that investors get an early indication of changes due to new standards. It is not difficult to do this for IFRS 16 and we think there is little excuse for non-compliance with IAS 8.
However, if you don’t see adequate disclosures by the company, it is still possible to estimate the impact of IFRS 16 based on prior disclosures about leases reported under the old accounting. We have built a simple model to help you. But first some explanation about what determines that impact.
Impact of IFRS 16 on key metrics
While the effect of lease capitalisation under IFRS 16 on certain metrics, such as EBIT or EBITDA, is clear and easy to understand, the impact on others can be much more complex. For example, the effect on net income and earnings per share depends not only on the significance of leasing to the company, but also on the growth in use of leasing and, therefore, the maturity of the lease portfolio. The impact on return on capital also depends on pre-IFRS 16 returns and the discount rate applied to lease liabilities. In addition, all metrics are impacted by transition choices made by the company, especially how the right-of-use asset is determined upon transition to the new standard.
The front-loading effect on net income
To understand the impact of IFRS 16 on key metrics it is necessary to appreciate the front-loading effect of lease capitalisation. When an individual lease is capitalised, the rental expense is replaced in profit and loss by depreciation of the asset and interest accretion for the liability. The previous operating lease rental expense and the new depreciation are generally recognised on a straight-line basis over the lease term. However, interest on the lease liability would be higher in the early stages of the lease. Treating the operating lease rental as a debt repayment means the liability decreases over time and with it the interest expense. The effect is that the sum of depreciation and interest for a capitalised lease is higher than the previous operating lease expense in the early stages and lower in the latter stages of each individual lease.
While for individual leases the expense is front-loaded, this does not mean that net income necessarily falls as a result of IFRS 16. The impact of IFRS 16 on net income depends on the average age of lease contracts. If the use of leasing has not changed over time, and hence equal numbers of leases are in their early and latter stages, then the front-loading effect averages out to zero. However, if the use of lease financing has been increasing, either due to business growth or perhaps a recent switch from asset ownership to leasing, then more leases would be in their early rather than later stages. This will result in a reduction in net income when IFRS 16 is implemented.
One way to think of this, and the question to ask a company is how mature the lease portfolio is. If the average age of leases is 50% of the total lease term then the portfolio is mature with no growth and equal numbers of leases in the early and later stage. A younger average age of leases would produce a larger reduction in profit and loss on transition to IFRS 16.
The magnitude of the effect of IFRS 16 on net income is determined not only by the size and maturity of the lease portfolio, but also by the discount rate and average lease term. A higher discount rate and longer lease term increase the amount of interest relative to depreciation and hence the magnitude of the front-loading effect. Both these effects are illustrated by the model below.
Shareholders’ equity almost certainly down
Related to the front-loading effect, the balance sheet value of the lease liability generally declines less rapidly than the right-of-use asset. Only at the start and end of an individual lease does the right-of-use asset equal the lease obligation. At all other stages of a lease the effect of capitalisation is to reduce net assets and hence equity. All companies will therefore experience a reduction in shareholders’ equity as a result of IFRS 16. Companies with large portfolios of long-term leases are particularly impacted.
A further complicating factor to look out for is where lease payments vary over the term of a lease. This can further change the impact of IFRS 16 on financial statements. If, for example, a company’s leases have significant rent-free periods at the start of each lease, or escalating rental payments during the lease, then this could contribute to a higher reduction in net income than would be anticipated from simply considering average lease maturity.
Transition choices affect transition metrics
One of the challenges for investors regarding IFRS 16 is that the standard offers various options to the company regarding transition. We explained more about transition in our earlier article ‘Leasing transition options can affect your analysis’. The key choice for companies affects the carrying value of the right-of-use asset at transition, which then impacts EBIT, net income and also profit growth in subsequent periods. In our model we show the impact on key metrics under two transition scenarios, firstly with full retrospective application and secondly with the modified retrospective approach applied to all leases and the transition right-of-use asset set equal to the liability.
Interactive model: IFRS 16 transition impact
Note: This model includes simplifying assumptions and is for illustrative purposes only. See below for further explanations and instructions. The model applies to IFRS reporters only. Although US GAAP also changes in 2019 to bring more leases on balance sheet, the impact on key metrics is quite different due to the use of the ‘single lease expense’ approach.
The input values included when you first load the model are designed to illustrate the effect of IFRS 16 on a retailer with a large and growing (hence immature) lease portfolio. The resulting impact on key metrics is higher than would be the case for most companies.
About the model inputs
To identify the impact of IFRS 16 on transition year metrics all model inputs should relate to that transition year (2019 for most companies) but should be before considering the effects of IFRS 16. In other words, if you use 2019 forecasts that are based on old lease accounting as inputs, the model will then show you the estimated impact on 2019 metrics of applying IFRS 16. One could alternatively use 2018 figures as inputs on the basis that these are a proxy for 2019 and probably good enough to give an indication of the transition effects.
- Return on capital employed: Defined as EBIT / shareholders’ equity plus net debt finance.
- Growth in use of lease financing: This is the average historical growth in the use of lease financing. We also show the implied average maturity of the lease portfolio that is consistent with the selected lease growth rate.
- Lease rental payments as a percentage of EBIT: This is the current operating lease payment expressed as a percentage of the pre-IFRS 16 EBIT. The model assumes that all operating lease payments will be capitalised under IFRS 16.
- Depreciation as a percentage of EBIT: Used to calculate the effect of IFRS 16 on EBITDA.
- Leverage: This is leverage measured as balance sheet debt divided by shareholders’ equity.
- Average lease term: This is the average term of leases when originated. It is not the average remaining term of leases present in the balance sheet which will be lower (about one half if leasing activity is constant). The model assumes that all leases have the same lease term. In practice this will need to be an estimate based on information given in the current operating lease rental commitments note.
- Lease liability discount rate: The rate applied to measure the new lease liability. The model assumes that this rate is also the average cost of existing debt finance.
Interpreting the model results
Rather than show the effect of IFRS 16 on the financial statements themselves (which would require additional inputs) we have expressed the results of the model as percentage changes in key metrics. For absolute profit metrics and shareholders’ equity the result is expressed as a percentage change in that metric. For changes in rates of growth, rates of return and coverage ratios the result is the absolute change in that metric. In other words, if return on capital increases from 10% pre IFRS 16 to 12% post IFRS 16 the result is given as +2% not +20%.
All results relate to the transition year when IFRS 16 is first applied (generally 2019). For balance sheet figures the changes are a comparison as at the end of that period. This explains why shareholders’ equity is impacted, even where the transition option is chosen to align the right-of-use asset with the transition lease liability. At the beginning of the transition year this would result in no change in shareholders’ equity, but at the end of that year the lease asset and liability would by then have started to diverge due to the differences in subsequent accounting.
One interesting aspect of the transition is the effect on future profit growth. Where the transition asset is calculated retrospectively the model shows no change in growth. This, in part, reflects the simplifying assumptions and, in practice, the result will not necessarily be non-zero, although any difference is likely to be small.
However, where the transition option to set the right-of-use asset equal to the liability is chosen, the company will benefit from an inbuilt growth enhancement over the duration of the leases present at transition. The model result shows the growth enhancement in the first year after transition; the effect in subsequent years would decline as the old leases gradually roll off the balance sheet. This growth enhancement arising from transition does not represent a change in economic growth.
Using the model
- Help you gauge the likely impact of IFRS 16. An accounting change does not change the underlying economics of a business, but better accounting (and we think IFRS 16 is a significant improvement in accounting) can help you better and more accurately understand those economics.
- Test the disclosures provided by companies. If their disclosed impact of IFRS 16 is very different then you might want to question the company further. Is there something else going on? Maybe the company has taken the opportunity of the transition to a new standard to include other effects such as impairments to lease assets that were not previously recognised as onerous lease contracts, with the objective of enhancing future profitability.