Cracking the Code: How Lease Accounting is Redefining Balance Sheets

Sapna Malya

Anirudh Goel, Syed Shayan Mahtab and Saket Nayal

Accounting for Leases and Corporate Investment, The Accounting Review, 2023; Chen, C.-W., Correia, M., & Urcan, O.

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Cracking the Code: How Lease Accounting is Redefining Balance Sheets

Problem of Practice: Since 2016, accounting boards worldwide have advocated for greater lease accountingtransparency. However, it was not until 2019 that the implementation of new lease accounting standards, IFRS 16/Ind AS 116 (Indian standard), brought significant changes for companies. These changes have had far-reaching implications, affecting various parameters used to analyse corporate financial performance. A key question arises: ‘How can companies effectively incorporate the new lease accounting standards to ensure compliance while minimizing financial and operational disruptions?’

According to research by Ciao-Wei Chen, Maria Correia and Oktay Urcan, the adoption of these standards has macro- and micro-level implications that companies must navigate carefully.¹ At the company level, Chief Financial Officers (CFOs) and Chief Operating Officers (COOs) must reassess their operating assets and liabilities, as the new regulations limit the headroom for additional debt on balance sheets. These changes require organizations to implement strategic adjustments, enhance data management processes and improve internal coordination to meet compliance requirements, while ensuring business continuity. On a macro level, policymakers must recognize that compliance with these standards reduces financial flexibility, potentially impacting capital expenditures and debt management strategies

Decline of operating leases

The implementation of the new lease accounting standards, IFRS 16/Ind AS 116, has significantly impacted companies worldwide, particularly companies in capital-intensive sectors like technology, aviation, telecom, oil and gas and retail, which have huge assets on operating leases (see Table 1).

Table 1: Percentage of companies affected by the new lease standard across the globe

Region	Percentage of Companies Affected
North America	62%
Europe	47%
Asia/ Pacific	43%
Latin America	23%
Africa / Middle East	23%
Total future minimum payments for off-balance sheet leases (undiscounted)	US$ 2.86 trillion

Source: The International Accounting Standards Board (IASB)²

Leases are classified into two types: operating and finance leases. Operating leases were traditionally treated as off-balance sheet items, with lease payments recorded as operating expenses, making financial obligations appear lower and financial health better. In contrast, finance leases are recognized on the balance sheet, where leased assets and corresponding liabilities are recorded, reflecting the lessee’s ownership risks and rewards. Operating leases provided flexibility but distorted financial reporting, while finance leases offered transparency but increased reported liabilities.

Why does the change matter to a CFO of a capital-intensive company? Previously, operating leases for more than a year were recorded as operating expenses in the profit and loss account, meaning they had no impact on the balance sheet, allowing companies to appear ‘asset-light’. However, IFRS 16/Ind AS 116 mandates capitalization of nearly all leases onto the balance sheet. This change increases the company’s reported asset values by recognizing leased assets and, at the same time, raises liabilities due to the inclusion of future lease payments. A global survey of Fortune Global 500 companies across 12 sectors, conducted by Ernst & Young in 2020, indicated a 14% increase in total assets and a more than 20% rise in liabilities, with the airline, retail, apparel and shipping sectors being the most affected (see Figure 1).³

Figure 1: Impact on assets and liabilities of certain sectors due to IFRS 16 as of 2020

Impact on assets and liabilities of certain sectors due to IFRS 16 as of 2020

Source: Ernst & Young Global Limited, June 2021⁴

The lease liabilities are classified as long-term debts, which can negatively impact key financial ratios, such as the debt-to-equity ratio (financial metric that shows the amount of debt a company has compared to its assets) and reduce the company’s ability to take on additional debt (see Figure 2).⁵ A 2019 study by PWC, examining the impact of the lease accounting standard on NSE Nifty 50 companies, revealed that the average debt would rise by approximately 7% and the debt-to-equity ratio would increase by about 10%. For 32% of the companies, this ratio could surge by as much as 25%.⁶

Decline of operating leases

Figure 2: Effect of the new lease accounting standard on financial metrics

Metric	What it measures	Common method of calculation	Expected effect of IFRS 16	Explanation
Leverage (gearing)	Long-term solvency	Liabilities / Equity	Increase	Increase because financial liabilities increase (and equity is expected to decrease).
Current ratio	Liquidity	Current assets / Current liabilities	Decrease	Decrease because current lease liabilities increase while current assets do not.
Asset turnover	Profitability	Sales / Total assets	Decrease	Decrease because lease assets will be recognised as part of total assets.
Interest cover	Long-term solvency	EBITDA / Interest expense	Depends	EBITDA will increase applying IFRS 16 as will interest expense. The change in the ratio will depend on the characteristics of the lease portfolio.
EBIT / Operating	Profitability	Various methods—Profit that does not consider earnings from investments and the effects of interest and taxes	Increase	Increase because the depreciation charge added is lower than the expense for off balance sheet leases excluded.
EBITDA	Profitability	Profit before interest, tax, depreciation and amortisation	Increase	Increase because expenses for off balance sheet leases are excluded.
EBITDAR	Profitability	Profit before interest, tax, depreciation, amortisation and rent	No change	No change because all lease-related expenses are excluded.
Profit or loss	Profitability	As reported applying IFRS	Depends	Depends on the characteristics of the lease portfolio and the tax rate.
EPS	Profitability	Profit or loss / Number of shares in issue	Depends	Depends on the effect on profit or loss, which depends on the characteristics of the lease portfolio and the effects on tax.
ROCE	Profitability	EBIT / Equity plus financial liabilities	Depends	EBIT will increase applying IFRS 16 as will financial liabilities. The change in the ratio will depend on the characteristics of the lease portfolio.
ROE	Profitability	Profit or loss / Equity	Depends	Depends on the effect on profit or loss, which in turn depends on the lease portfolio—if there is no effect on profit or loss, then the ratio will be higher because reported equity will decrease.
Operating cash flow	Profitability	Various methods—Cash flow from operating activities does not include cash related to equity and borrowings	Increase	Increase because at least part of the lease payments (those payments relating to the principal) will be moved to the financing section of the cash flow statement.
Net cash flow	Profitability and liquidity	Difference between cash inflows and cash outflows	No change	No change No change because cash will not be affected.

Source: Source: The International Accounting Standards Board (IASB)⁷

In the profit and loss statement, lease rentals are no longer recorded as an expense. Instead, the financial statements now show depreciation of leased assets and interest costs, which leads to an improvement in EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), potentially giving a more favourable view of the company’s operating performance (see Table 2).⁸

Table 2: Percentage change in EBITDA after implementing the new Lease Standard in different sectors (as per IASB Report 2016)

Industry sector	EBITDA in millions of USD		Increase in EBITDA (percentage)
Industry sector	Before IFRS 16	After IFRS 16	Increase in EBITDA (percentage)
NNN	NNN	NNN	NNN
Airlines	51,652	73,849	43%
Retailers	2,70,403	3,47,716	29%
Travel and Leisure	50,299	63,279	26%
Transport	71,177	87,580	23%
Telecommunications	3,99,328	4,34,452	9%
Energy	6,88,370	7,45,273	8%
Media	1,18,156	1,28,959	9%
Distributors	29,350	35,047	19%
Information Technology	2,98,655	3,12,392	5%
Healthcare	2,54,616	2,65,181	4%
Others	11,62,512	12,28,643	6%
Total	33,94,490	37,22,371	10%

Source: Source: The International Accounting Standards Board (IASB)⁹

Dealing with the change

The research by Chen et al explores the real-world impact of lease accounting standards on businesses. It indicates that the new lease capitalization requirements have a significant effect on firm-level investment. To comply, companies must collect, analyse and report additional lease-related data. During this process, they may identify areas of overinvestment that could be reduced or eliminated. The new accounting rules can also negatively impact debt covenant ratios, prompting lenders to impose more restrictive loan terms. As a result, projects that previously had a positive Net Present Value (value of future cash flows discounted to the present) may become unviable, leading to a substantial reduction in capital expenditures for lease-heavy companies.

Companies with high lease obligations may also consider reducing their workforce to manage financial strain. The research also highlights that operating leases are now perceived as debt by credit rating agencies, creditors and investors, influencing debt covenants and risk premiums.

Adopting the new lease standard is a complex process that requires a deep understanding of the regulations and their implications. Careful planning is essential to ensure a smooth transition and maintain comparability of financial information.

Air France-KLM adopted IFRS 16 early in 2018 and has applied the complete retrospective approach to transition. Under the retrospective approach, a company applies the new standard to all leases and restates its prior financial information, recognising an adjustment in equity at the beginning of the earliest period presented. Figure 3 shows the extract from its interim report of 2018, when KLM adopted IFRS 16.¹⁰

Figure 3: Extract from Air France KLM June 2018 interim report

In € millions Balance sheet as of January 1, 2017	Published account	IFRS 9 impact	IFRS 15 impact	IFRS 16 impact – contracts capitalization	IFRS 16 impact – maintenance of leased aircraft	Restated accounts
Asset	–	–	–	–	–	–
Flight equipment	9,119	(26)	–	(94)	(241)	8,758
Other property, plant and equipment	1,480	–	–	(80)	–	1,400
Right-of-use assets	–	–	–	4651	1154	5,805
Deferred tax assets	176	6	32	289	86	589
Trade receivables	1,868	–	26	–	–	1,894
Other current assets	1,105	(1)	23	(52)	5	1,080
Equity and liabilities	–	–	–	–	–	–
Return obligation liability and other provisions (current and non-current term)	2,327	–	(106)	(1)	1174	3,394
Financial debt (current and non-current)	8,452	(4)	–	(175)	–	8,273
Lease debt (current and non-current)	–	–	–	5656	–	5,656
Deferred tax liabilities	(12)	–	(5)	–	–	(17)
Deferred revenue on ticket sales	2,517	–	122	–	–	2,639
Other current liabilities	2,775	–	146		(7)	2,915
Equity	1,296	(17)	(76)	(767)	(163)	273
* Holders of Air France-KLM	1,284	(17)	(76)	(766)	(163)	262
* Non-controlling interests	12	–	–	(1)	–	11

Source: Air France KLM First Half Financial Report Jan-Jun 2018¹¹

Walmart, on the other hand, used a modified retrospective approach to deal with the transition from the old standard to the new lease accounting standard. Under the modified retrospective approach, there is no requirement to restate the comparative financial information.

When it adopted the new standards, the following was mentioned in its annual report of 2020.¹² “…In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lease assets and liabilities to be recorded on the balance sheet. The Company adopted this ASU and related amendments as of February 1, 2019 under the modified retrospective approach and elected certain practical expedients permitted under the transition guidance, including to retain the historical lease classification as well as relief from reviewing expired or existing contracts to determine if they contain leases. For leases subject to index or rate adjustments, the most current index or rate adjustments were included in the measurement of operating lease obligations at adoption.

The adoption of this ASU and related amendments resulted in a $14.8 billion increase to total assets and a $15.1 billion increase to total liabilities in the first quarter $1.7 billion, respectively, of assets and liabilities related to financial obligations connected with the construction of leased stores. Several other asset and liability line items in the Company’s Consolidated Balance Sheet were also impacted by immaterial amounts. Additionally, the adoption resulted in a cumulative-effect adjustment to retained earnings of approximately $0.3 billion, net of tax, which primarily consisted of the recognition of impairment. The Company’s Consolidated Statement of Income and Consolidated Statement of Cash Flows were immaterially impacted. Accounting policies as a result of the adoption of this ASU are described below. Refer to Note 7 for additional lease disclosures…”

The transition phase of reporting is crucial for companies and, therefore, they need to consider the quantitative and qualitative factors to manage the stakeholder expectations. They need to understand the standard and assess the effects of the transition options on their financial reporting.

Embracing the change

Companies must adopt a proactive approach to comply with the new lease accounting standards and minimize potential risks. This includes the following key actions:

Stakeholder communication and training: Clear and effective communication with stakeholders is essential to ensure they understand the implications of IFRS 16/Ind AS 116. Companies should conduct training sessions and workshops for finance teams, executives, and other key personnel to build awareness and knowledge. Lenders should also be informed about changes in debt covenants resulting from the new lease accounting treatment. During the first year of transition, providing detailed comparative financial information — such as lease-adjusted leverage ratios and adjusted earnings (EBITDAR) — can help stakeholders better understand the impact.
Reviewing and assessing lease agreements: Companies should thoroughly review all lease agreements to identify those that fall under IFRS 16/Ind AS 116. This process requires collaboration across departments, including finance, procurement and legal teams, to gather relevant lease data and evaluate its impact on financial reporting. Engaging lease accounting experts can be beneficial in accurately analysing lease arrangements and ensuring compliance.
Upgrading data management and reporting systems: Organizations must assess their current data management and reporting systems to ensure they can handle the increased complexity and volume of lease data required by IFRS 16/Ind AS 116. This may involve upgrading existing software, implementing new reporting tools and strengthening data governance processes to improve accuracy, consistency and compliance with reporting requirements.

Mitigating potential risks

The adoption of Ind AS 116 and IFRS 16 represents a significant shift in lease accounting. Under the new framework, companies must recognize leased assets and corresponding liabilities on their balance sheets, even if they do not own them. This change has far-reaching implications for financial reporting, particularly for companies with substantial lease obligations, as it alters key financial ratios and impacts strategic decision making.

Figure 4: Requirements for adapting to changes in lease accounting

Requirements for adapting to changes in lease accounting

Source: Developed by authors

The research by Chen et al highlights that firms with high lease obligations may experience reduced capital expenditures, workforce downsizing and tighter debt covenants due to the new accounting standards. While the changes introduce challenges, they also present an opportunity for companies to enhance financial accuracy and comparability.

To adopt these changes effectively, organizations must implement proactive strategies such as stakeholder communication and training, thorough review and assessment of lease agreements and upgrading data management and reporting systems. By implementing these measures, businesses can mitigate potential risks and ensure compliance while minimizing financial and operational disruptions.

Ultimately, adapting to the new lease accounting standards is not just a regulatory requirement but an opportunity to improve financial transparency and operational efficiency in the long run.

About the author

Sapna Malya

Sapna Malya is Associate Professor, Finance & Economics at SPJIMR. She is also Deputy Programme Chairperson, Post Graduation Diploma in Management and Post Graduation Diploma in Management Business Management.

You can reach out to her at sapna.malya@spjimr.org

Anirudh Goel, Syed Shayan Mahtab and Saket Nayal

Anirudh Goel, Syed Shayan Mahtab and Saket Nayal were students from SPJIMR’s Post Graduate Programme in Management Class of 2024

References

1Ciao-Wei Chen, Maria Correia, and Oktay Urcan, “Accounting for Leases and Corporate Investment,” The Accounting Review 98, no. 3 (May 1, 2023): 109–33, https://doi.org/10.2308/TAR-2018-0406.
International Accounting Standards Board, “IFRS 16 Leases,” January 2016,
https://www.ifrs.org/content/dam/ifrs/project/leases/ifrs/pu blished-documents/ifrs16-effects-analysis.pdf.
Victor Chan, “How the Leases Standard Is Impacting Company Balance Sheets,” Ernst & Young Global Limited (blog), June 2021, https://www.ey.com/en_gl/insights/ifrs/how-the-leases-standard-impacts-company-balance-sheets.

Chan, “How the Leases Standard Is Impacting Company Balance Sheets.”

International Accounting Standards Board, “IFRS 16 Leases.”

PWC PWC, “A Study on the Impact of Lease Capitalisation: The New Leases Standard (Proposed),” March 2019, https://www.pwc.in/assets/pdfs/services/accounting-advisory/a-study-on-the-impact-of-lease-capitalisation.pdf.

International Accounting Standards Board, “IFRS 16 Leases.”

International Accounting Standards Board.

“Air France KLM First Half Financial Report Jan-Jun 2018,” 2018, https://www.airfranceklm.com/sites/default/files/2022-09/rfs_2018air_franceklmva.pdf.

“Air France KLM First Half Financial Report Jan-Jun 2018.”

Walmart Inc., “Walmart Annual Report, 2020,” 2020, https://s201.q4cdn.com/262069030/files/doc_financials/2020/ar/Walmart_2020_Annual_Report.pdf.

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Note: This is an open access article under the CC BY license (https://creativecommons.org/licenses/by/4.0/)

Examining Why and When Market Share Drives Firm Profit, Journal of Marketing, 2022; Bhattacharya, A., Morgan, N. A., & Rego, L. L.

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