IFRS 16: Leases; Liquidity and Cash Flow

What is IRS 16 and how will recognising operating leases in the balance sheet affect perceived liquidity and cash flows.

 New Standard for Leases

The International Financial Reporting Standards body (IFRS 16) has drawn up revised rules regarding the recognition of operating leases in the balance sheet. This is not as routine a matter as it sounds.

At present there are two principal types of leasing agreement connected with fixed assets that are used to enable or support a company's operations. These are dealt with in the balance sheet as follows:

Finance Lease

A contract with an undertaking or option to purchase an asset at the end of the term defines a finance lease. As this assumes that the asset will be acquired, its values (outstanding repayments) have to be included in the balance sheet.

Operating Lease

The absence of an agreement or option to purchase the asset describes an operating lease. That makes it a "right of use asset" (ROU) making them an "off balance sheet" item. As these are have not been included in the balance sheet, they have had no effect on reported liquidity or net cash flow.

This is set to change for all ROU assets such as vehicles, plant and machinery, and perhaps most significantly of all, for leasehold business premises. All will now be capitalised, being included among fixed assets and both current and long term liabilities. Interest costs will not be capitalised though.

Calculating Lease Assets and Liabilities

Take for example a company leasing its business premises with 36 months left to renewal at a rent of £20,000 p.a. 

The residual value will be £60,000 and this will be added to fixed assets. The annual payments due will be reported as £20,000 current liabilities (i.e. payable within the next 12 months) with the balance of £40,000 reported as long term assets;

This first example below shows how this would change the balance sheet

Balance Sheet Example
  @ Present IFRS 16
Fixed Assets 15,000 75,000
Current Assets 45,000 45,000
Total Assets 60,000 120,000
Current Liabilites 30,000 50,000
Long Term Liabilities 10,000 50,000
Total Liabilities 40,000 100,000
Net Assets 20,000 20,000

With net assets unchanged this may seem innocuous but it is the calculations that are derived from balance sheet figures for working capital (liquidity) and perceived borrowings (Financing Loans) where the problems can arise as follows:

Liquidity: Cash Flow and Financing
  @ Present IFRS 16
Working Capital 15,000 -5,000
Working Capital Ratio 1.50 0.90
Borrowings 10,000 70,000
Debt to Asset 66.7% 83.3%
Debt to Equity 50% 350%

With working capital ratio falling below 1, increased debt to assets close to 100% and debt to equity (net assets) beyond 100%, what were once acceptable descriptions of liquidity and cash flows now appear to be close to or beyond crisis levels.

This is why operating lease liabilities between those currently in force and those planned between now and January 2019 need to be reviewed or reconsidered, notwithstanding their details being specifically reported in notes to the accounts.

IFRS 16 Exemptions

Leased intellectual property rights such as licences for character merchandise derived from movies or videos and plays or for the use of copyrights and patents will be exempt from IFRS 61. 

The rental for small value items, e.g. laptops or items of furniture and leases where the term does not exceed 12 months and either agreement or option to purchase is absent, will only require  rental payments charged to profit and loss.

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