IFRS 16 and its impact on EBITDA/debt and financial covenants

IFRS 16 – the new lease accounting standard – will take effect from 1 January 2019.

IFRS 16 introduces a new lease accounting model, removing the distinction between operating and finance leases. Currently operating leases are off balance sheet items, whilst finance leases (those with the characteristics of economic ownership) are on balance sheet items. Under IFRS 16 all leases of more than 12 months will have to be recognised on a lessee’s balance sheet except for some limited exceptions.

Why does this matter?

Numerous reasons. The addition of leases to the balance sheet will mean that many companies will experience a corresponding increase in their debt levels. But different industry sectors will experience this impact in different ways, depending upon whether they are heavy users of what are currently treated as operating leases or not. Retailers, airlines and professional service industries are all expected to suffer badly because of their common reliance upon property or equipment leases which currently qualify as operating leases. By contrast, those which operate in the entertainment, transport, wholesale and telecommunications sectors are all expected to be less affected.

The impact doesn’t stop there. EBITDA numbers (those which calculate earnings before interest, tax, depreciation and amortisation) are also expected to go up for many businesses. In particular, currently operating leases which are off balance sheet give rise to rental expenses which typically go through the P&L account and are included within EBITDA. By contrast, under the new rules all leases will effectively be capitalised so that going forwards the expenses they result in will be solely depreciation and interest - both of which are excluded from EBITDA. Consequently under the new lease standard EBITDA numbers are also expected to go up, again in particular for those which are heavy users of what are currently operating leases.

Overall, debt numbers are expected to increase by more than EBITDA numbers, and also the increase will often be by a higher multiple than typical leverage ratios, so adversely affecting leverage levels for the purposes of financial covenant compliance. Even where borrowers have adopted frozen GAAP covenants (for example allowing them to calculate covenant compliance on the basis of existing IAS 17 accounting standards), the accountants will still have to manage two sets of books which is not ideal.

Practical difficulties

As we already mention, financing arrangements without frozen GAAP covenants and which contain financial covenants which refer to EBITDA and debt levels will likely be adversely affected so that covenant compliance might become harder to achieve particularly for heavy uses of leases.

But the potential difficulties don’t stop there. In addition, there will be the practical problems associated with assessing the impact of operating leases located in multiple places, often in different languages and currencies. Unexpected outcomes may occur as a result of corporate deals, remuneration, bonus plans and employee schemes which include targets which refer to EBITDA numbers – these may need to be re-engineered. And tricky calculations will have to be made where agreements contain a combination of service and property elements (for both lessees and lessors). Depending upon how the lease payments are made, for example whether they are variable or fixed, the duration of the lease, and whether the agreement contains any option to purchase the asset - all of these are factors which will affect how big the liability is which is brought onto the balance sheet.

Scope of IFRS 16

All common leases – equipment and property leases – which convey a right to use an asset for a period of time in exchange for consideration are expected to fall within the scope of IFRS 16. There are some specific exceptions, quite esoteric in nature – examples include leases of intangible assets, rights held by lessees under certain licensing agreements (motion picture films, copyrights etc.). It’s a tricky question and accountants will we expect have many a cold towel moment as they determine what are and what aren’t leases within the scope of IFRS 16. The notes to the new standard also include an exemption for lessees who may choose not to apply the new rules in respect of certain ‘low value’ assets.

Impact on loan agreements

Borrowers will need to think carefully about the impact of the new accounting standard for leases so far as their financial covenants are concerned. The impact doesn’t end there – many general undertakings such as financial indebtedness and negative pledge restrictions also refer to borrowing levels, so that those restrictions might become more restrictive than currently if operating leases get included in the future. Events of default may in turn be more easily triggered which can have tangential effects where other contractual arrangements contain cross default provisions.

We encourage borrowers to start modelling their financial covenants to assess what impact IFRS 16 will have on their loan documentation. Relevant considerations are the size of the borrower’s affected operating lease portfolio, the duration of their loan arrangements and applicable covenant testing dates. Borrowers should think about whether they have adopted frozen or floating GAAP provisions and also what existing headroom they have under their financial covenants and, if very little, what financial covenant cure rights (if any) are available to them.

As always, early dialogue with lenders is always to be encouraged where borrowers foresee any requirement to re-set financial covenant levels because of these new changes.