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How the leases standard is impacting company balance sheets

Victor Chan

International Director, Global IFRS Services, Ernst & Young Global Limited

5 minute read 14 Jun 2021

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Companies involved in air travel, retail and transportation have been the most affected by a major change to lease accounting.

In brief

  • A major change to lease accounting is particularly affecting companies from certain sectors.
  • IFRS 16 has resulted in most leases being recognized on the balance sheet.
  • Transparency and comparability have been improved, with companies most affected providing more extensive discussion in the management commentary.

The introduction of the IFRS 16 accounting standard – described as the most significant change to lease accounting in more than 30 years – has impacted company balance sheets across a range of sectors.

An EY survey shows that companies involved in airlines, retail and apparel, and shipping and transport, have seen their total assets rise by an average of 14% as a result of the introduction of the new standard. A fourth sector, telecommunications, saw an average 6% increase in total assets.

IFRS 16 requires most leases – including those for property, equipment and vehicles – to be “capitalized” by recognizing both “right-of-use” assets and lease liabilities on the balance sheet. The change affects lease accounting for all companies that report under International Financial Reporting Standards (IFRS), and the only exemptions are for leases with terms of less than 12 months without purchase options or where the underlying asset is of low value.

Previously, leases were classified either as operating leases, which did not appear on the balance sheet, or finance leases, which did. For reporting periods starting on or after 1 January 2019, this distinction no longer applies where companies report under IFRS.

Increased transparency and better comparability

By reducing the number of leases that are off balance sheet and allowing users of financial statements to make more informed comparisons between companies in particular sectors, the result is greater transparency. The financial statements will now more faithfully reflect economic reality.

For instance, some airlines choose to lease and some to buy their fleet of aircraft. Under the previous approach, an airline that preferred to use operating leases for its aircraft could look very different to a competitor that had borrowed to buy most of its fleet, even when, in reality, their financing obligations might be similar.

IFRS 16 results in an increase in assets, liabilities and net debt where leases are brought on to the balance sheet, and can also affect key accounting and financial ratios impacting a company’s attractiveness to investors and its ability to raise finance.

 

By reducing the number of leases that are off balance sheet, users of financial statements will be able to make more informed comparisons between companies in particular sectors. The financial statements will now more faithfully reflect economic reality.

The EY survey reviewed the financial statements and reports of 58 companies drawn from the 2020 Fortune Global 500 list across 12 sectors. As well as the 14% increase in total assets, the survey found that liabilities had grown by more than 20% on average across the airline, retail and apparel, and shipping and transport sectors.

At the other end of the scale, the least affected sectors were power and utilities, real estate and construction, and financial services. Total assets grew by a maximum of 1% and liabilities by a maximum of 2% in these sectors.

How EY can help

These figures are in line with a previous EY survey that took place before the introduction of IFRS 16 that examined the expected impact of the standard. However, the results are averages and there is a wide range within some sectors. For example, within the shipping and transport sector, the percentage increase in assets varies from 1% to 34% (producing a 14% average).

 

Making more use of management commentary

The survey confirmed that the more significant the effects of IFRS 16 on the financial statements, the greater the level of disclosure and explanation in the management commentary about the first-time adoption of the standard.

 

Most of the companies surveyed did not restate the comparative information in their financial statements as they applied the “modified retrospective” approach on transition to IFRS 16. Instead, many of those in the sectors particularly affected by IFRS 16 tailored their disclosures in the commentary to explain the changes.

 

This included adding columns of financial information, either to present comparatives restated to include the impact arising from the adoption of IFRS 16 or presenting current year information both “with” and “excluding” the effects of adopting the standard.

 

There were also changes in the use of Alternative Performance Measures (APMs) such as EBITDA (earnings before interest, taxes, depreciation and amortization) and EBITDAR (which also excludes rent).

 

EBITDA is likely to rise under IFRS 16 for companies that have large-scale lease arrangements, as the majority of the former rental expenses will be reflected in depreciation and interest. The survey showed that some companies have adjusted EBITDA to include depreciation of right-of-use assets and interest expenses on lease liabilities to keep the basis of measurement consistent across the years.

 

IFRS 16 requires companies to reclassify cash outflows for lease payments from operating to financing activities in the statement of cash flows. The survey showed that some companies changed their definition or calculation of “free cash flow” to become, for example, “free cash flow after leases,” as they adjusted free cash flow for repayment of lease liabilities.

 

IFRS 16 has also had an impact on debt, as additional liabilities are recognized for leases that were previously off balance sheet. Some companies, especially those in the airline sector, previously added a multiple of operating lease expenses to net debt to present an APM called “adjusted net debt” to better reflect the level of indebtedness. Since the adoption of IFRS 16, this is no longer necessary as these companies can present net debt from the balance sheet (which includes lease liabilities).

 

Overall, the survey suggests that companies most affected by the implementation of IFRS 16 have communicated to investors the impact of the first-time adoption of the standard with transparency and have provided additional management commentary where necessary to explain any changes. 

Summary

Adoption of the IFRS 16 accounting standard for leases is starting to impact balance sheets for companies that choose to lease rather than buy assets. As a result, almost all leases are on the balance sheet. The EY survey shows that companies in the air travel, retail and transportation sectors have been most affected and are facing implications in terms of the financial statements, management commentary and use of alternative performance measures.

About this article

Victor Chan

International Director, Global IFRS Services, Ernst & Young Global Limited

Develops insights on applying IFRS to emerging accounting issues. Focuses on leases, crypto-assets, investment property and latest standard-setting activities. Enjoys relaxing with family.

Related topics

Assurance
IFRS
Financial accounting advisory services
CFO agenda
Future of corporate reporting

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.