IFRS 16: How this new accounting standard will affect companies and your stock investments

In the April 2008 edition of the Empire Club of Canada forum, former chairman of the International Accounting Standards Board (IASB) Sir David Tweedie famously said: ‘One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.’

This quote, likely said in a jocular manner, is frequently mentioned in any conversation about IFRS 16 – a new amendment to the International Financial Reporting Standards that radically changes the method in which operating leases are dealt with.

Making this point using the airline industry is understandable, given that it is common practice for airlines to operate aircraft under short-term leases that are not reflected on their balance sheets. As IFRS 16 took effect on 1 January 2019, Sir Tweedie has finally realised his lifelong desire. Companies will now have to recognise the financial commitment that accompanies lease agreements on their balance sheets.

Undoubtedly, this complicates matters for investors, causing otherwise unexplainable changes in popular metrics like the debt-to-equity ratio and operating profit. However, this technique of dealing with operating leases serves to increase transparency on the financial statements, revealing the full extent of a firm’s financial commitments. In this article, I will walk you through exactly what has changed, and how this will impact the companies’ financials.

IAS 17: The former standard

Under the former standard, IAS 17, the expenses associated with operating leases were simply recorded in the income statement as an operating expense. That was it. There would be no signs of the lease in the other financial statements, even though the company may have committed to a multi-year lease.

This presented a large problem for investors analysing companies with a large portfolio of leases. Take Chico’s FAS, a U.S.-based apparel retailer. At the end of fiscal year 2017, the company had shareholder’s equity of US$656 million and had US$247 million more in current assets than current liabilities. Coupled with the US$101 million the company generated in 2017, it seems like the company has a rock-solid financial position.

However, deeper research reveals company had committed to a total of US$931 million of retail leases over the next five years, with US$191 million due in one year or less.

Source: Chico’s FAS 2017 annual report

To be clear, I did not cite this example to criticise Chico’s current financial position. Rather, it serves to emphasise that under former accounting standards, Chico’s balance sheet did not portray the full extent of its short and medium-term liabilities.

IFRS 16: Operating leases as debt

IFRS 16 changes a lot of that. Under the revamped accounting standard, a firm’s operating lease commitments will be expressed in the balance sheet as either short-term or long-term debt, depending on when payment is due. At the same time, a corresponding right-of-use lease asset will be recorded on the asset side of the balance sheet.

As a result, lease payments are amortised based on the value of the asset, and reclassified as depreciation expenses and interest payments. I will not go into the details of how amortization figures are calculated, but it is similar to the way auto loan or mortgage loan payments are computed. In the following sections, I’ll go through the changes that will take place on the companies’ financial statements.

The income statement

After IFRS 16 takes effect, operating lease payments will be reclassified and recorded under the ‘Depreciation & Amortization’ and ‘Interest Payments’ line items. 

While popular metrics like EBIT and EBITDA will experience a significant boost as a result of this new accounting standard, the increase in debt for most companies outweighs the impact of this boost. This ultimately increases the value of popular ratios like EV/EBIT and EV/EBITDA, making the company look more overvalued than before.

Luckily, the net income figure will not change significantly as most costs are simply shifted down the income statement. This means that net profit-based ratios such as the price-to-earnings ratio will not be affected too significantly.  

The balance sheet

On the liabilities side of the balance sheet, an ‘operating lease liabilities’ line item will be added to represent the total amount of operating leases a company has committed to paying, discounted to its present value. At the same time, a corresponding asset, commonly named ‘operating lease right-of use asset’ will be recorded on the asset side of the balance sheet. The value of the asset and the liability should be equal at the onset, but the two values can diverge over time due to the concept of straight-line depreciation.

The image below shows the balance sheet of Microsoft which chose to adopt IFRS 16 in 2017, two years ahead of time:

Given that operating lease liabilities are now classified as a type of long-term debt, metrics such as the debt/equity ratio, debt/capital ratio, and the interest coverage ratio will be affected heavily. Companies with a large portfolio of leases will see these ratios increase heavily.

At the same time, it is noteworthy that this change will also increase the level of invested capital in a company, given the increase in total assets. This means that measures of profitability such as return on invested capital (ROIC) may take a hit if the increase in operating capital outweighs the increase in EBIT.

The cash flow statement

In the cash flow statement, operating lease payments — which used to be classified as an operating expense — will now be recorded as a financing expense. This means that net cash flows will not change, but metrics like operating cash flow and free cash flow will increase for a company with a large portfolio of leases.

IFRS 16’s impact on companies you own

The impact of this new accounting standard varies for different industries, and as one might expect, companies that need to maintain a significant portfolio of leases will feel the greatest impact.

As seen below in a table extracted from a PwC report, the median increase of debt and EBITDA for a U.S. company is 22% and 13% respectively. For retailers that need to rent brick-and-mortar stores to reach customers, the median increase in debt and EBITDA is substantially higher, at 98% and 41% respectively.

Source: PwC

The fifth perspective

The IFRS 16 change is one of the most significant accounting standard changes in years. While some may feel that this makes it difficult for investors to compare some widely-used financial metrics across time periods, the benefits that accompany this method are manifold and should be embraced.

After all, most of the dirty work — such as restating of financials — will be done by the companies’ accounting departments, with investors simply on the receiving end of that data.

In summary, you can refer to the table how IFRS 16 will affect a financial metric or ratio:

Financial Metric/RatioImpact of IFRS 16
EBIT, EBITDAHigher
EarningsNo change
Total AssetsHigher
Total LiabilitiesHigher
Total DebtHigher
Operating Cash FlowHigher
Free Cash FlowHigher
EV/EBIT, EV/EBITDAHigher
Price/EarningsNo change
Debt/Equity, Debt/CapitalHigher
Interest Coverage RatioLower
Return on Invested CapitalHigher
Price/Operating Cash FlowLower
Price/Free Cash FlowLower

Happy investing!

Kang Wei has been an investor since he was 15 and is intrigued by the stock market and anything related to business, finance and economics. He favours on dividend-paying aristocrats, high quality stocks and mispriced stock opportunities, and primarily focuses on the U.S. markets.

10 Comments

  1. thebearprowl

    March 19, 2019 at 9:01 am

    Great insights overall – we like to point out that whilst it is meaningful to inform your readers that earnings should not take a hit, it is not conceptually accurate.
    As a consequence of implementing the initial transition, depending on the transition option of choice, there will be an initial downwards adjustment to equity which will lead to a cumulative post-transition P&L positive impact arising from leases existing as at adoption of IFRS16, until the expiration of aforecited lease contracts .

    • Ong Kang Wei

      March 19, 2019 at 11:23 am

      Hi thebearprowl,

      Thanks for pointing that out! That is indeed something I didn’t mention in the article.

      Just to provide some context & explanation about your point to other readers:

      So as a result of IFRS16, interest payments on the lease assets are higher in the initial period of the lease, and lower towards the end of the lease due to the concept of straight line amortisation,. As a result, earnings seem to take a hit at the beginning of the lease term, but will then be boosted towards the end of the lease term.

      Hence, for companies that have many leases that are nearing expiration, adoption of IFRS16 will cause a positive impact on earnings because they are benefitting from the boost that comes at the end of the lease term. But as IFRS16 was adopted midway of the lease term, the negative impact of the lease would ultimately not get recognised.

      For most companies with diversified lease portfolios, this positive impact on profits will be offset, either partially or fully, by new lease contracts and existing lease contracts that have recently be renewed, but on a cumulative basis, there will be a positive impact on net profit.

  2. alex

    March 19, 2019 at 12:38 pm

    Can i check what’s the impact to reits? Especially for hospitality, that have management contracts.. Where they managed hotels for the owners? Will this affect their gearing ratio since it might be classified as those managed properties might be classified as leased assets?

    • Ong Kang Wei

      March 19, 2019 at 3:07 pm

      Hi Alex,

      Thanks for leaving a comment. From an accounting point of view, the impact of IFRS16 on REITs should be negligible. REITs own a portfolio of property, and generate their income from leasing these properties out to tenants. Same concept for hospitality REITs, which lease their hotel properties under master lease agreements to the operator.

      One possible impact of IFRS16 on REITs is that tenants may negotiate shorter weighted average lease expiries (WALE) so that they have less leases on their balance sheet. But the likelihood of something like this happening seems slim, given that the bargaining power lies with the REIT most of the times.

      But of course, this is just a general view. Different companies have styles of operations, and if you are worried about the impact of this accounting change on one of your holdings, its advisable to consult the investor relations team of that company as well.

  3. YK

    March 19, 2019 at 5:27 pm

    Pls clarify on how IFR16 affect on the cash flow statement, if the lease is moved from op expense to financing expense, the effect would be netted out and the free cash flow should be unchanged. This is because the op cash flow will increase, the financing cash flow will decrease by same amount. Am I missing something?

    • Ong Kang Wei

      March 20, 2019 at 11:39 am

      Hi YK,

      Thanks for leaving a comment. You are right that part of the lease expense is moved from being an operating expense to a financing expense. As a result, the net change in cash for the company will not change.

      However, given that FCF is the cash left over after a company pays for its operating expenses and capital expenditures, FCF is calculated by subtracting CAPEX costs from operating cash flows (OCF). This means that FCF will increase as OCF increases.

      Do note that FCF is not the same as change in net cash. Hope this reply helps!

      • YK

        March 20, 2019 at 2:20 pm

        tks for sharing about the definition of FCF. You are right in this sense.

        Some other people define free cash after includes financial and invest cash flow.

  4. Steve Cooper

    May 31, 2019 at 9:16 am

    Interesting article and comments on IFRS 16. The capitalisation of leases has always presented challenges regarding free cash flow. In the past this was limited to finance leases but now with increased lease capitalisation it is a greater issue for investors. The solution is to include new lease assets in FCF as capital expenditure. Here is an explanation of how … https://www.footnotesanalyst.com/free-cash-flow-amazon/

  5. vndv

    June 4, 2019 at 2:57 am

    You mentioned ratios like EV/EBIT and EV/EBITDA might decrease thanks to the boost to both EBIT and EBITDA, but should the increase in EV (resulting from the increase in debt) not make up for it?
    Thanks!

    • Ong Kang Wei

      June 4, 2019 at 1:40 pm

      Hi vndv,

      Thanks for pointing that out- that is indeed something I overlooked. It depends on how the magnitude of each increase, but in most cases the increase in EV offsets the boost to EBIT/EBITDA. We will be making an amendment to the article shortly.

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