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How Does IFRS 16 Affect Financial Statements That Audit Firms Prepare?

The new IFRS 16 / AASB16 standard replaces the IAS 17 leasing standard. It is designed to revolutionize the way  Dubai audit services and entities manage financial statements. A lessee can classify a lease under IAS 17 as either finance, or operating lease depending on how similar the lease is to the purchase of the asset.

IFRS 16 will make it impossible for a lessee to distinguish between finance and operating leases. All leases will be treated as finance leases with certain exceptions. A company in Dubai, UAE can also recognize a financial obligation if it makes lease payments over time. This is its obligation to make future leasing payments.

The following are the definitions of a lease:

  • A distinct asset
  • For which the lessee receives economic benefits
  • The lessee directs the asset's use (control)
  • The revenue recognition rules for customer contract revenue have also changed. IAS18 has been replaced by IFRS15. It essentially adds long-term customer agreements to the balance sheet, in a manner that is related to important milestones.

What Are The Exclusions From IFRS 16

Audit firms in Dubai can easily apply the standard because of two significant exemptions. These include short-term leases less than 12 months and leases of low value items below a materiality threshold. Specific criteria also offer the possibility for "leases" under IFRS16 to not be on the balance sheet.

  • This can be seen, for example, with service contracts.
  • Assets may not be identified.
  • The asset can only be used by the lessee or the lessee.

IFRS 16 also allows for exceptions to the following conditions:

  • Substantive substitution
  • Splitting between lease and non-lease elements
  • Variable payments are excluded

Read also: An Audit Firm in Dubai Explanation of the Impact of IFRS 16 on Financial Statements

What Are The Effects And Implications Of IFRS 16 For Financial Statements?

AASB 16 / IFRS 16 will result in an increase of leased assets and financial liability on the balance sheet. The lessee's Earnings before Interest, Tax, Amortization, and Depreciation (EBITDA), also increases. Dubai and UAE Companies with significant off-balance sheet commitments to leases will see significant changes in key financial metrics like the leverage ratio, return on invested capital, and implied valuation multiples. Below are the key implications of IFRS 16 on financials, ratios, as well as the impact on valuations.

The Financial Effect and Key Ratios.

The implementation of IFRS 16 will not affect the equity value or market valuation of the company. This is because there has been no change in the underlying cash flow generated by the Dubai company. Adopting IFRS 16 may result in net debt and EBITDA rising, which will make it difficult to compare valuation multiples, especially in the short-term.

The following will likely result from this new accounting method:

Acknowledge incremental lease liabilities and create an increase in net borrowing.

Higher EBITDA, with lease expenses flowing through the income statement as depreciation or finance charge.

Higher invested capital means lower Return on invested capital (ROIC) for lessees.

It is possible that organizations will experience an increase in their net debt/EBITDA ratios. The remaining lease term and the current leverage ratio are key factors in this impact. The incremental net debt/EBITDA of the lease liability will be likely to be high at the beginning of the lease term and then slowly decrease to zero at the end.

The Impact on Valuations

Although IFRS 16 will not affect the organization’s fundamental equity value, it could lead to an increase in the enterprise value. Accounting for a lease is not a change in the economics or cash flow-generating ability of the business.

However, IFRS 16 / ASB16 has an impact on the implied financial metrics of a company (primarily EBITDA and net debt, and thus indicated enterprise value), so adjustments and additional considerations will be required for the most common valuation methodologies: (i), Discounted Cash Flow approach (DCF) and (ii), Market approach based upon market multiples.

The implied enterprise value of companies will increase with IFRS 16, but net debt will rise. Therefore, equity (or market capitalization) should not change. The DCF approach assumes a Free Cash Flow To Firm (FCFF). Enterprise values are based on the expected net cash flows. The impact of IFRS16 will be shown in the following way:

  • Because rental expenses are not included in EBITDA, the future FCFF will be greater than during the remaining lease period.
  • FCFF is not adversely affected by the depreciation cost relating to new finance lease assets.
  • The cash flow statement includes interest payments and redemptions of lease obligations. However, these are financing items that do not affect FCFF.

The introduction of IFRS 16 creates additional complexity in valuations. The impact of IFRS 16 on lease obligations should be considered by companies. Company audit teams at audit firms in Dubai should also consider lease expenses. Net debt should also be adjusted when using EBITDA multiples. Alternatively, an EBITA multiple should not be overlooked.

Read also: How Audit Firms in Dubai De-risk Lease Accounting Modifications in IFRS 16

Ervee is a CPA with international experience in Tax and Accounting. He has over 12 years of experience in accounting and bookkeeping and over a year in VAT implementation, registration, and accounting in UAE. He regularly drives out inefficiencies in company operations and loves the challenge of helping clients find additional ways for an easier and improved compliance and verification of transactions.