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Introduction – What is IFRS 16?
IFRS 16 brings in a requirement which provides a single lessee accounting model.
- Requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value.
- A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.
Notes – IFRS 16 is effective for annual reporting periods beginning on or after 1 January 2019.
- Eliminates the classification of leases as either operating leases or finance leases for a lessee.
- Leases are treated in a similar way to finance leases under IAS 17.
- IFRS 16 will have a significant impact on companies that have relied on off-balance sheet financing in the form of operating leases, particularly in the airline, sector.
Right of Use
Under IFRS 16 a lessee is required to recognize:
- A right-of-use (“ROU”) asset representing its right to use the underlying leased asset; and
- A lease liability representing its obligation to make lease payments. Lessors’ accounting for leases will remain largely unchanged.
Impact of IFRS 16 on lessee financial statements
- The recognition of a right-of-use asset and a lease liability. (Companies that have previously had significant off-balance sheet leases will now show higher assets and higher liabilities.)
Profit and loss statement
As a result of implementing IFRS 16, operating expenses will be lower, interest expenses will be higher, and EBITDA and EBIT will be higher.
Cashflow Statement
- The total cashflow of a company will not change as a result of implementing IFRS 16. However, IFRS 16 is expected to impact the classification of cash flows generated through operating and financing activities.
- The increase in cash from operating activities will be offset by a decrease in cash from financing activities as cash outflows related to principal repayments and interest (interest can be recognised under financing activities under IFRS) on lease liabilities will be recognised under cash from financing activities.
Valuation Considerations
The introduction of IFRS 16, should not in principle change the fundamental equity value of a company, although the enterprise values of companies will increase. Accounting for a lease as either operating or finance in nature does not alter the economics and cash flow generating capacity of the business.
However, IFRS 16 impacts the implied financial metrics of a company (primarily EBITDA, net debt, and therefore implied enterprise value).
- Note – EBITDA, which means earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an alternative to the net income in some circumstances.
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