In 2019 you will see a significant change in the financial statements of many companies due to the adoption of IFRS 16 on lease accounting. In addition to understanding the new accounting, it is also important that investors are aware of the transition options selected by companies and their impact.
We explain how IFRS 16 transition works and the impact transition options will have on key metrics. Early adopter Air France KLM has already selected the full retrospective approach; we examine some of the effects on its financial statements.
Many of you will be aware of the imminent application of new lease accounting under IFRS 16. The standard will increase reported fixed assets and debt financing by applying current finance lease accounting to (nearly) all leases from 2019. Key performance metrics such as EBIT and EBITDA are affected, as may be profit and loss, shareholders’ equity and rates of return on capital. Airlines, hotels and retail sectors are all likely to be particularly impacted, as will any company with significant property leases or long-term leases of equipment. As a quick guide, all you need to do to determine whether IFRS 16 will matter for companies you follow is to identify the current operating lease expense – if this is material then IFRS 16 is also likely to affect your analysis.
In this article, we focus on transition and how transition choices made by companies could further impact key metrics and affect comparability between companies. We also examine whether there are any adjustments you could make to improve comparability.
IFRS 16 transition – Air France KLM
Air France KLM adopted IFRS 16 early in 2018 and has applied the full retrospective approach to transition. But what is the impact of full retrospective and what would have been the difference had they applied the alternative modified retrospective approach?
Below is an extract from the Air France KLM interim financial statements for the 6 months to June 2018 showing the transition impact of IFRS 16 at 1 January 2017, the start of the comparative period. This clearly shows the new ‘right of use’ leased assets and additional lease debt reported on the balance sheet and that their impact is highly significant.
Extract from Air France KLM June 2018 interim report
It is the impact on shareholders’ equity that is, perhaps most notable in this case, with the restatement due to IFRS 16 reducing the previously reported amount by 72%. A reduction in equity will be a common feature of the IFRS 16 transition. It arises because of the different accounting for the lease asset and the liability following their initial recognition. Generally, lease assets will decline linearly over the lease term, given the common application of straight line depreciation. However, lease liabilities tend to fall less in the early stages, even if rental payments are the same each period, simply because the interest component of rentals is naturally higher during the early stages of repayment. The effect of the declining interest expense over the lease term is sometimes referred to as the front-loading of the total cost of a lease compared with the way in which operating lease payments were previously expensed.
In the case of Air France KLM neither the depreciation (due to componentisation of the asset) nor the payments related to the lease (due to the maintenance component) will be exactly straight line. However, the effect of the front-end loading of the total cost of leases under IFRS 16 can still be clearly seen at transition. The newly recognised right of use asset of €5,805m is significantly lower than the new lease and related return obligation of €6,830m (€5,656m + €1,174m)
The total liability arising from the Air France KLM aircraft leases includes a so-called return maintenance obligation. Although the maintenance obligation is presented separately with other ‘provisions’, it largely arises from the application of IFRS 16 and we regard this as just as much debt finance as the reported lease debt. We explain more about this peculiarity of aircraft leases below.
Firstly however, what about transition? How does it work and what are the choices available?
IFRS 16 transition options
Companies have a number of transition options available to them when adopting IFRS 16. The main choice is between the full retrospective, which is what has been applied by Air France KLM and modified retrospective approaches – one or other of these must be applied across the entity as a whole. For each approach there are further options which may be applied on a lease by lease basis.
Full retrospective approach
The default transition approach under IFRS involves adjusting financial statements based on the assumption that the new accounting had been applied since the inception of all leases currently held. Prior periods reported as comparative amounts are restated and the opening balance sheet at the beginning of the earliest comparative period presented is adjusted. The application of the standard to leases at transition is the same as for leases that will originate in future periods.
This approach is clearly most useful for investors as both years presented in the financial statements will be comparable. It also ensures that there is no legacy transition impact on subsequent periods, which is not the case for the modified retrospective approach.
Remember that full retrospective only means retrospectively applied to the comparative periods reported in the year the new standard is adopted. There is no requirement to restate earlier periods. If you are relying on time series data, particularly of EBITDA, operating profit, leverage and return on capital, then you need to be aware of a potential significant discontinuity.
Modified retrospective approach
Because the full retrospective approach may be difficult and costly to apply, IFRS 16 provides companies with the option of a simpler alternative. The modified retrospective approach still applies IFRS 16 to all leases present at transition (it does not grandfather old accounting), but there is no restatement of comparatives and the application of the new standard has further optional simplifications. The key features of this approach are:
- Comparatives: Prior year figures must not be restated, which obviously makes it more difficult to interpret the current period. However, some companies may choose to provide supplementary disclosures to show how the comparatives would have been impacted; if you do get this then use it.
- Lease liability: While the future lease payments used to measure the balance sheet obligation are the same as under the full retrospective approach, the discount rate may not be. There is an option to discount at the incremental borrowing rate at the date when the standard is initially applied rather than being determined for each lease based on when that lease first originated. In one sense, the result will be better for investors as the liability is more up to date and the subsequent interest expense a better reflection of the current economic cost. However, the downside is one of comparability; if rates have changed since leases were originated a liability measured using this option will not be comparable.
- Right of use asset: Companies have a choice of measuring the right of use asset in a way that approximates what it would have been had the full retrospective approach been applied or setting it equal to the transition lease liability (adjusted for previous lease prepayments and accruals, although generally these are not significant). This particular option can be applied on a lease by lease basis and will likely have the largest impact the reported balance sheet amounts at transition, with knock on consequences for future profitability and profit growth.
Setting the right of use asset equal to the lease liability would almost always produce a higher asset value at transition and hence higher shareholders’ equity. For Air France KLM it would probably have meant there being little or no reduction in shareholders’ equity at all, although a currency translation effect for this company would still have resulted in some change. However, the effect of this would be to produce higher depreciation (and possibly impairment) charges in subsequent periods. Operating profit and net income would be reduced until all leases present at transition have terminated. Profit growth over this period will, as a consequence, be higher since profitability will be unaffected by transition once all these leases have expired.
For those companies that elect to measure leased assets equal to the new lease liability at transition it would be possible for you to make adjustments to approximate what the asset would have been with retrospective application, as long as you know the approximate average lease term. However, forecasting that adjustment in subsequent periods would require some effort and should probably only be attempted if the amounts involved are particularly large and comparability of the related key metrics is important.
In practice the asset measurement choice we identify may not be too much of a problem for you. We anticipate that relatively few companies will opt for the higher asset value at transition, given the immediate effect on profits, and those that do will be those with smaller portfolios and/or shorter-term leases where the effect is far less. Indeed, we will probably see companies apply the two approaches selectively to different types of leases because the choice can be made on a lease by lease basis. We cannot be sure since some may well prioritise the boost to profit growth and accept the immediate profit hit as a price worth paying.
Other options available in IFRS 16
There are some further transition options applicable to both the above approaches. Companies may, for example, elect to grandfather their past classification of leases. Although the definition of a lease does not change under IFRS 16, the application might. However, in most cases we would not expect the impact of this to be significant to your analysis. In addition, there are options regarding leases close to the end of their life and the ongoing choices to be made regarding the separation of non-lease components and the treatment of short term and low value asset leases. However, in most cases we believe these choices will generally have much less impact than the full versus modified retrospective alternatives at transition.
A note on the Air France KLM lease aircraft maintenance provisions
We said above that the additional aircraft maintenance provision arising from IFRS 16 and recognised at transition by Air France KLM, should, in our view, be regarded in the same way as the lease debt. This is because the obligation also arises from the lease contract, is measured, accreted and repaid in a manner that is similar to the lease obligation and is also added to the right of use asset at inception.
Many leases stipulate that the asset must be returned to the lessor at the end of the lease in a particular condition. For real-estate leases it could be removing building modifications and for aircraft leases removing branding or performing maintenance. Such payments are effectively part of the overall lease cash flows and should, therefore, be included in the initially recognised liability and asset, even if separately measured and accounted for under a different standard.
We note that Air France KLM does not include the maintenance provision related to leased assets as debt in its net debt calculation. Our preference would be to include this liability as a component of net debt. While the obligation and the related interest accretion should indeed be reported separately from the lease liability, in our view it has characteristics similar to debt finance.
Insights for investors
- The IFRS 16 transition choices selected by a company can have a significant impact on how the new additional lease capitalisation will impact key metrics. It is important you understand these options and are aware of their impact.
- Identify how the transition right of use asset has been measured. This could have significant impact on post adoption profitability and profit growth.
- Pay particular attention to whether comparatives have been restated and consider the impact on trends.