IFRS 16- Practicalities

Applying IFRS 16 leases requires identifying all your leases, completeness of lease information, getting all the documentation, doing estimates, using the portfolio exemption, modifications, modelling and transition.

Challenges in applying IFRS 16 leases relate to obtaining all of the necessary information to determine lease assets and liabilities, both at transition and thereafter.

The standard in brief

For lessees, IFRS 16 requires all leases to be recognised on the balance sheet, subject to some exemptions for short term and small ticket leases. The process for this is broadly to identify all lease contracts, where you must:

• Estimate the lease term;

• Calculate the lease liability by discounting the lease payments at the interest rate implicit in the lease; and

• Recognise a right-of-use asset.

There are some circumstances in which revisiting the carrying value of either the lease liability or the right-of-use asset is required, generally the lease liability is carried at amortised cost and the right-of-use asset is amortised over its useful economic life.

Areas of practical challenge

Identifying all of your leases

IFRS 16 contains a slightly revised definition of a lease but in practice this is likely to only cause differences at the margins. Where previously there were difficult judgements as to whether a contract contained a lease, those past conclusions may need to be revisited.

However, while the definition might lead to very similar conclusions, it could still cause problems in practice, e.g., whether a contract was an operating lease or a contract for services did not make a big difference under IAS 17; the expense was generally recognised straight line over the term of the contract. Under IFRS 16 however, if it is a lease, it will impact the balance sheet.

IT contracts could be troublesome, e.g., software service contracts might contain leases of equipment, such as a dedicated fibre optic connection. Finding and reviewing all these contracts and then applying the standard’s definition of a lease could be time consuming.

Completeness of lease information

Gaining comfort over the completeness of lease information could be resource intensive and complex. Groups with numerous subsidiaries – especially multinational groups – often apply different accounting systems and processes across the group.

Getting all the documentation

The next step will be gathering all the actual contracts to analyse. This requirement should not be underestimated; even in simple groups, the actual contracts themselves might be held by numerous different teams within the business.

Property, IT, finance or even legal teams, for example, might hold all or some of the relevant contracts; assuming they are not in storage somewhere!

There are technology solutions that can help that reads a contract document in PDF or word format, and provide an output of contract data points that are relevant for IFRS 16 in a format which can be used for modelling an impact assessment calculation.

Judgement in estimates

The standard requires judgement for estimates to be made, from stand-alone selling prices of lease and non-lease components; the length lease term where the lessee has either an extension or termination option; the interest rate implicit in the lease; and amounts payable under residual value guarantees.

For example, a lease contract might contain both the right to use a floor in a property, the lease component, and a payment for services such as cleaning and reception services, the non-lease component.

The practical expedient provides, by class of underlying asset, an election not to separate lease and non-lease components. If selected, this election requires all payments to be capitalised as though the entire contract was a lease.

Estimating the interest rate implicit in the lease is problematic. If the interest rate implicit in the lease cannot be determined readily, the standard does allow the incremental borrowing rate to be used but estimating this can be a nightmare.

When the entity’s incremental borrowing rate is used, it is not simple to use the entity’s WACC or overall incremental borrowing rate, which is supposed to be asset specific, i.e., what rate would be obtained to borrow the same amount as the right-of-use asset over a similar term and with the same security.

Practically this could mean estimating different incremental borrowing rates for:

• Different types of underlying asset, for example property, plant and equipment;

• Different locations, e.g., property in London versus property in West Midlands;

• Different lengths of lease, for example two-year, three-year, five-year…;

• Different group entities: May have very different credit ratings and this may need to be reflected in the incremental borrowing rate.

Using the portfolio exemption

While IFRS 16 is applied to leases individually, it does allow application at a portfolio level if the impact is not materially different.

Selecting a discount rate for groups of similar assets – for example, all property in London with a lease term of 10 years – is likely to be a situation where the portfolio approach is acceptable. However, it is a matter of judgement which should be discussed with auditors.

Modifications

Modifications are accounted for as either separate leases or as an increase or decrease to existing lease liabilities and right-of-use assets with a gain or loss recognised in the income statement.

Determining the treatment requires obtaining information about whether the modification increases the scope of the lease by adding the right to use one or more underlying assets and whether the consideration for the lease modification represents the stand-alone sales price for the modification.

When the standard is applied fully retrospectively, obtaining this information for all previous modifications will be tough work.

Transition options/ expedients

Financial impacts on Company Valuations

IFRS 16 should in principle have no impact on fundamental valuations, since the substance of the lease does not change the economics and cash flow generating capacity of the business.

DCF Methodology:

IFRS 16 will increase the enterprise value of companies as net debt will increase, while equity value should remain the same. In DCF models – in which enterprise values are assessed based on the NPV of expected Free Cash Flows (FCF) – this will generally be reflected via the following two effects:

• Following IFRS 16, leverage ratios of companies, which are used to estimate the target capital structure in the WACC, will increase. A higher leverage, with unchanged observed levered beta’s, will lead to a lower WACC and a higher net present value of FCF’s; and

• After IFRS 16, the future FCF’s will be higher over the remaining lease period, as rental expenses are excluded from EBITDA and hence FCF. The depreciation charge is a non-cash item and consequently does not negatively impact FCF. The lease payments are reflected in the cash flow statement via interest payments and repayments of the lease obligation, however, these are financing items and also do not impact FCF.

The increase in enterprise value should in theory be exactly offset by the increase in net debt (representing the NPV of the remaining lease obligation) of the company that is being valued. Hence, this would theory result in the same equity value.

Market Approach:

Valuations based on market multiples are also likely to be affected by the switch to IFRS 16, as it influences valuation multiples. EV/EBITDA multiples are impacted because:

• Enterprise Values increase under IFRS 16 compared to IAS 17, due to capitalisation of the present value of future lease payments (expressed by the higher financial debt); and

• EBITDA increases, due to the removal of operational lease expenses.

When the ratio NPV lease obligation / current operating lease expenses (referred to as ‘lease multiple’) is lower than the current EV / EBITDA trading multiple, the EV/EBITDA trading multiple decreases following the introduction of IFRS 16. Conversely, when the lease multiple is higher than the current valuation multiple, the EV/EBITDA multiple will increase.

Key take-aways for business valuations:

• Gain proper insight in the lease obligations and average remaining lease terms;

• In DCF analyses, be sure not to simply set Capex equal to the depreciation that relates to the current lease agreements (as this is already reflected in the net debt);

• In DCF analyses, properly incorporate the negative value effect of the required continuation of leasing after the lease agreements expire (either in the future free cash flows or by separately adjusting net debt);

• Assess the comparability in ownership of assets and the remaining lease terms between target – and peer group companies; and

• Do not simply use EV/EBITDA multiples without further considering: ‒ Adjusting the net debt related to financial leases; and / or ‒ Use EV / EBITA multiples.

Round up

While the basic premise of the standard is simple to understand – all leases are on the balance sheet – the real challenge in the application is data completeness. Obtaining all of the information needed to apply the standard takes time and effort.

If you have not started your implementation programme or need help get in touch with Kothari Partners.

Dee Singh Kothari is a senior partner in Kothari Partners Ideas expressed and/ or methodologies in this article are solely of the authors. The author nor Kothari Partner’s accept any liability for the incorrect application of these ideas either used by companies, employees or other individuals alike.

At Kothari Partners, we have worked with various UK and overseas listed and PE/ VC backed clients across various industries to consider how their business and finance services can bring them both cost reductions and performance improvement. Our approach is to help our clients understand their current situation, identify the value and decide on the scope, vision and set of strategies for what they could achieve for their business. We help plan their implementation and support them and deliver the solution/ change needed, so it is properly and permanently embedded in their organisation. We aim to help past and future clients by delivering high-quality work to their organisation, generate real efficiencies and free up time to support better business decisions. For a confidential discussion please free to contact us, via our corporate website: https://www.KothariPartners.com