/IFRS 16 – Beautifying balance sheets is over

IFRS 16 – Beautifying balance sheets is over

The almost 20 years old Standard IAS 17, which regulated leasing expenses on your balance sheet, is being replaced. From January 2019 IFRS 16 becomes applicable to all leased assets. The main difference: Leasing must appear on your balance as a liability and will no longer be treated as operational costs. A change leading to more unpleasant balance sheets and worse financial ratios on one hand, but more transparency on the other.

The old Standard is treating expenses associated with leasing contracts as operational costs, even though common sense might implicate that leases should be handled as liabilities. This leads to confusion for external shareholders, when reading the balance sheet and makes a company’s financial situations harder to evaluate. It particularly applies to enterprises like airlines, which are operating most of their aircrafts on a lease contract’s basis, but might also be relevant for smaller companies with a fleet of leased cars.

Therefore, the new IFRS 16 is trying to solve this problem now. From 2019 on, all leasing contracts, which do not form an exception, must appear on the balance as a liability at the amount of the Net-Present-Value of all future leasing payments. The two cases which do form an exception are short term leasing contracts under 12 months and those with a small amount of underlying value. Beside the liability, an asset will be activated at the same amount. The interest on the financial obligation combined with the straight depreciation of the activated asset, will form the new lease repayment per period.

The following example should help to make the impact more comprehensible. For the calculation it is assumed that a company has a fleet of 25 cars, leased over 3 years at a monthly average payment of 320 Euros and discounts at a rate of 1.2 % p.a.. The given numbers lead to a Net-Present-Value of 11.320 Euros per car to be activated in the balance sheets. Looking at the total fleet this gives over 283.000 Euros of additional liability in the first period. Applying this calculation to an airline with multiple aircrafts on lease, should give a feeling of the possible impact in different industries.

Besides new positions on the balance sheets, financial key ratios will adapt to the change, which might give a few CFOs quite a headache. In the following one important ratio should be looked at under the change of the IFRS 16. The equity ratio, which describes the relative proportion of equity used to finance the company’s assets, is especially used in Central Europe and Japan. Activating the leased goods as assets in the balance sheets, increases the total amount of assets. Whereas the amount of equity remains untouched. This leads to a worse equity ratio for the venture. A similar financial indicator, with widespread practice in the US, would be the debt-to-equity ratio. Both are important to external stakeholders, especially when it comes to a company’s financial leverage and therefore a ticket to new capital.

The two sides of the new accounting standard should be clear. From an external perspective, a venture’s financial situation becomes more transparent and makes a banker’s life easier. Even though the negative effects on the other side might be overwhelming in the first place, it should trigger a change in the thinking on leasing products. As the American author Robert Collier once said: “Supply always comes on the heels of demand.”