LMA Webinar: IFRS 16 The practical impact of new lease accounting standards on loan agreements Avni Mashru and Annalie Croney, PwC
Agenda 1. Why does this matter? 2. What s the size of the problem? 3. Impact on loan agreements 4. Practical considerations 2
1. Why does this matter? 1 3
IFRS 16 will impact some sectors more than others Industry Median increase debt 1 % Median increase BITDA % Median change leverage 2 Median decrease in solvency 3 Before standard After standard Before standard % After standard % All companies 22 13 2.03 2.14 35 32 Retailers 98 41 1.17 2.47 41 28 Airlines 47 33 3.26 3.63 25 19 Professional services 42 15 0.53 0.96 40 37 Healthcare 36 24 2.11 2.92 22 19 Wholesale 28 17 2.04 2.31 31 29 Transport and infrastructure 24 20 2.21 2.52 36 30 Entertainment 23 15 1.78 1.30 30 25 Telecommunications 21 8 1.65 2.00 23 21 Source: PwC Global Lease Capitalisation study of 3,199 listed IFRS reporters. Notes: 1 Interest-bearing debt 2 Net debt/ebitda 3 Equity less Intangibles/Total Assets 4
Covenants might be a problem Company A s financial covenants are: Total Borrowings: EBITDA not to exceed 3.5:1 EBITDA: Net interest not to be less than 5:1 Company A takes on a lease with rental cost of 5m which gives rise to additional EBITDAR of 7m. Before lease IAS 17 IFRS 16 RoU asset 36 Debt (100) (100) (137) EBITDA 30 32 37 Finance cost (6) (6) (8) Depreciation (4) Borrowings: EBITDA 3.3 3.1 3.7 EBITDA: Net interest 5.0 5.3 4.6 Are your covenants on frozen GAAP? If so, will you need to prepare different numbers? 5
Existing arrangements will need to be considered Financing arrangements (e.g. covenants) Split of service and property elements (for both lessees and lessors) Examples Supply arrangements Lease payments not in functional currency Remuneration, bonus plans and employee schemes 6
and the changes might influence future decisions Structuring arrangements as a service rather than lease of an asset Different payment types for leases no breaks, more contingent rentals, less fixed uplift rents etc. Examples Lease vs. buy decisions, including tax consequences Lease terms Inclusion of bargain purchase options in leases 7
2. What s the size of the problem? 2 8
Scope of IFRS 16 Lease = A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. All leases are in the scope of IFRS 16, except for: Lease to explore for or use non-regenerative resources Biological assets within the scope of IAS 41 Service concession arrangements within the scope of IFRIC 12 Licences of intellectual property granted by lessor within the scope of IFRS 15 Rights held by lessees under certain licensing agreements (motion picture films, patents, copyrights etc.) Other intangible assets Out of scope Out of scope Out of scope Out of scope Out of scope Policy choice for lessees 9
Identifying a lease Key judgement! 1 There is an identified asset No identified asset if supplier has substantive right to substitute asset and 2 Contract conveys the right to control the use of an identified asset Right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use and Right to direct the use of the identified asset throughout the period of use 10
Recognition and measurement exemptions Only available for lessees Short-term leases Lease term of 12 months or less Accounting policy choice (by class of underlying assets) Leases of low value assets Assets with a value, when new, of US$ 5,000 or less Accounting policy choice (lease-bylease basis) 11
Lessee accounting Initial measurement Right-of-use asset Lease liability Lease liability Lease payments Discount rate Lease payments made before or at commencement date Restoration costs Provision Initial direct costs 12
Discount rate Lease payments are discounted at the interest rate implicit in the lease if it can be readily determinable Rate at which Present value of lease payments Present value of unguaranteed residual value Fair value of underlying asset Initial direct costs If not readily determinable, use lessee s incremental borrowing rate 13
Incremental borrowing rate Key judgement The rate interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment 74% of audience likely to use IBR Most challenging implementation issue, according to practitioner panel ICAEW/IFRS Foundation Conference 7 October 2016 14
Lease term Key judgement! Non-cancellable period of lease + Periods covered by option to extend + Periods covered by option to terminate if if lessee is reasonably certain to exercise option lessee is reasonably certain not to exercise option 15
3. Impact on loan agreements 3 16
Current treatment of leasing Under current lease accounting standards only leases on the balance sheet and treated as debt i.e. finance leases (rather than operating leases) are particularly relevant for the key LMA facility definitions, general covenants, financial covenants and events of default etc. Common historic LMA definition: "Finance Lease" means any lease or hire purchase contract which would, in accordance with the Accounting Principles, be treated as a finance or capital lease. 17
Relevance of a Finance Lease currently Form part of Financial Indebtedness, Borrowings definitions which impact: Financial covenants measuring indebtedness and coverage e.g. Total/Net Debt, Leverage, Debt Service, Interest Cover General covenants restrictions on incurring Financial Indebtedness or Negative Pledge Events of default Cross Default 18
Relevance of a Finance Lease currently On-balance sheet nature of finance lease asset and liabilities impacts: Financial covenants measuring asset value e.g. minimum group/guarantor worth requirements Balance sheet Solvency representations and/or events of default Financial covenants measuring ratio of debt to assets i.e. gearing 19
Relevance of a Finance Lease currently Relevant for EBITDA and thus financial covenants driven by EBITDA such as leverage, interest cover and cashflow cover as: Expenses on operating lease assets currently deducted to reach EBITDA Depreciation charges and interest expense on finance lease assets added back in to reach EBITDA Early adoption of IFRS 16 is permitted but otherwise mandatory effective date is 1 January 2019 20
Impact of IFRS 16 Modelling on a case by case basis is needed to assess the impact of bringing operating lease assets and liabilities on-balance including the impact on costs/expenses and EBITDA Other considerations: size of the borrower s affected operating lease portfolio expiry of facility term and covenant testing dates existing definitions of Finance Lease, Financial Indebtedness etc. any existing carve outs of operating leases from financial or general covenants existing headroom in financial covenants and/or immediate cure rights relevant GAAP provisions Frozen or Floating 21
Impact of IFRS 16 Frozen GAAP adoption and continued application of GAAP in place as at set historic date (usually as per Original Financial Statements) Floating GAAP adoption of most up to date GAAP at relevant calculation/accounts production point, incorporating any new accounting standards 22
New LMA definition of Finance Lease "Finance Lease" means any lease or hire purchase contract, a liability under which would, in accordance with the Accounting Principles, be treated as a balance sheet liability [(other than a lease or hire purchase contract which would, in accordance with the Accounting Principles in force [prior to 1 January 2019] / [prior to [ ]] / [ ], have been treated as an operating lease)]. Updated June 2016 23
4. Practical considerations 4 24
Practical Considerations For facilities already in place: Financial covenant re-modelling to assess impact Check covenant cure options Consider viability of freezing GAAP in short term Reassess current Permitted Baskets Reassess current cross-default de minimis thresholds Seek amendments to definitions/tests/covenant levels For facilities with terms expiring post 1 January 2019 or those being entered into now or post 1 January 2019: Consider treatment of operating leases brought on balance sheet permanent exclusion from covenants? Fixed or Floating GAAP? 25
Contacts Avni is a director within PwC s Accounting Consulting Services (ACS) group which provides IFRS and UK GAAP accounting advice both internally and to external clients. Avni has supported a number of the firm s largest clients when dealing with significant acquisitions or disposals, significant areas of accounting change, most recently with leasing, and responding to enquiries from the UK regulator. Avni also has a particular focus on the Real Estate industry; she chairs PwC s global Real Estate industry accounting group and is a member of the British Property Federation accounting group. Avni joined PwC in 2000 and, in addition to working within ACS, she has completed a secondment to PwC USA, a secondment to the BBC as Head of Technical Accounting and has worked within the Consumer and Industrial Products and Services audit practice. Avnri Mashru, PwC - Accounting avni.r.mashru@pwc.com Annalie is a solicitor and director in PwC's Legal Banking and Finance team. In her time at PwC she has focused on advising borrowers on new financing arrangements, refinancings and bank consent requirements in connection with group reorganisations and restructurings. Annalie focuses on advising on general banking, property finance, development finance and leveraged transactions but is often also frequently involved in the establishment of cash pooling and other treasury management arrangements including setting up in-house banks. Her clients range from start-ups, entrepreneurs, family offices and privately owned business to sponsors, funds, in-bound businesses, large multinationals and PLCs. Being part of PwC's multi-disciplinary practice allows Annalie to advise her clients alongside PwC's specialists in tax, corporate finance, debt advisory, valuations, audit and consulting both in the UK and across the globe. Annalie Croney, PwC - Legal annalie.croney@pwc.com 26