The new IFRS 16 Leases accounting standard comes into effect on 1 January 2019. This note will help you prepare for it.

What will change

Currently only finance leases are required to be recognised on a balance sheet. IFRS 16 Leases will extend this requirement to operating leases, removing the current distinction in treatment and rendering the terms operating and finance lease obsolete.

This will affect:

  • financial covenants (including leverage-based pricing and restrictions and ratios incorporating EBIT/EBITDA numbers)
  • restrictions on financial indebtedness, and
  • baskets or other allowances based on total assets.

The changed accounting standard will have a broad range of impacts on lessees' reported financial position and performance. It will increase an entity's assets (now including the "right of use" of leased assets) and liabilities (the present value of rentals and any residual at the end of the lease). P&L is also impacted, with rental expense replaced by depreciation and interest expenses, which are front-loaded to the early period of the lease.

Financial covenants

Operating leases are often excluded from financial covenant tests either explicitly or through the use of GAAP references. Under the new IFRS 16 standard, they may now be included in the calculations. Depending on the borrower's business, this change could affect both balance sheet and income statement items - assets, liabilities, expenses and revenue.

Facility agreements will generally state, in the case of a change to GAAP, whether the covenants continue to be calculated on the basis of existing GAAP or are amended to reflect the change. These clauses commonly contemplate the parties negotiating in good faith for a period to agree a revised approach, with a fallback to the prior position (i.e. "frozen GAAP") if agreement can't be reached.

As such, any changes to the covenants are likely to require a negotiation between borrower and lender. Alternatively, the borrower may have to provide reconciliations between their financial statements and the covenant calculations if these are inconsistent.

If the covenants are calculated on the basis of GAAP as amended, the covenant levels may need to be adjusted to ensure ongoing compliance.

Financial indebtedness

Bank facility agreements typically define financial indebtedness to include debt, which would be treated by GAAP as a finance lease. When this term becomes redundant with the change to IFRS 16, will all leases be caught or will they all be excluded?

The answer to this will depend on the drafting of the particular facility agreement and wider factors of contract interpretation – such as the intent of the parties, what makes common sense and what is reasonable. However, this is not a recipe for certainty, as the financial modelling underlying the ratios will not be transparent on the face of the facility agreement and will not necessarily even have been shared among the parties.

What to do

Borrowers and lenders should review existing facility agreements to see how operating leases have been treated and what the impact of IFRS 16 will be. Amendments may be needed before January 2019 to avoid defaults, ambiguity and in some cases additional reporting.

Early engagement is recommended as the two parties may have different views of the implications for their contract of the new Leases standard.

The information in this article is for informative purposes only and should not be relied on as legal advice. Please contact Chapman Tripp for advice tailored to your situation.