IFRS 16 and IAS 36

how changes in lease accounting will impact your impairment testing processes

Right-Of-Use (ROU) assets are non-financial assets in the scope of IAS 361. Unless it is tested on a
standalone basis, an ROU asset is tested in combination with other assets in a Cash Generating Unit
(CGU). IFRS 16 may impact both the CGU’s carrying amount and the way the recoverable amount of
the CGU is measured. Elements to consider are: the cash flow forecasts, the discounted cash flow
models, the discount rate and the treatment of lease liabilities.

ROU assets are non-financial assets in the scope of IAS 36 the section on lease liabilities below for more details). If an
and generally need to be included in the carrying amount of entity uses a ‘free cash flow to the firm3’ valuation approach
Cash Generating Units (CGUs). to determine the RA, both the cash flows and discount rate
used are likely to differ under IFRS 16.
IFRS 16 may impact both a CGU’s carrying amount and the
way the recoverable amount of the CGU is measured. IFRS 16 replaces operating lease expenses in the income
statement with depreciation of the ROU asset and interest
Elements to consider include:
• the cash flow forecast and discounted cash flow models;
Cash Flow Statement IAS 17 IFRS 16 DCF
• the discount rate; and
• the treatment of lease liabilities. Operating Approach 1 Approach 2
lease
We discuss each of these areas below.
Operating activities ✔ ✘ ✔
Cash flow forecast and discounted cash flow models
Companies should ensure consistency between the Carrying Investing activities ✘ ✘ ✘
Amount (CA) and the Recoverable Amount (RA) of a CGU
in an IAS 36 impairment calculation. The CA will generally Financing activities ✘ ✔ ✘
include the ROU asset value and the lease liability2 (refer to

1
IFRS 16.33
2
While adding both the ROU asset and lease liability will have an offsetting effect, there would be a net impact to the CA as ROU asset and lease
liability are generally not of equal and opposite amount other than at commencement of the lease (and at IFRS 16 transition date under the modified
retrospective approach for those ROU assets measured at the amount equal to the lease liability [IFRS 16.C8(b)ii])
3
Free Cash Flow to the Firm (FCFF) is an economic measure of a business’ cash flows before any payments to/from providers of finance. The FCFF of
a business with leases will change as a result of the adoption of IFRS 16 which effectively changes the treatment of operating leases into financing
arrangements. Operating lease payments will no longer be recorded as part of operating costs (and therefore deducted in arriving at FCFF) but as
financing items which are not deducted in arriving at FCFF.

IFRS 16 and IAS 36

2 | IFRS 16 and IAS 36

on the lease liability. In the statement of cash flows, the lease in that respect from the indefinite term implied in the free
payments split into principal repayments of the lease liability cash flows used (in a ‘going concern’) when determining the
which are included in the cash outflows related to financing RA. In a going concern, the ROU assets would need to be
activities and an interest element whose classification as replaced by owned or new ROU assets after the lease term.
operating or financing cash flows depends on a company’s Discounted cash flow models should appropriately include
accounting policy4. The question arises how lease payments an element of additional operating cash outflows in relation
should be treated when determining the recoverable amount to the replacement of the ROU assets at the end of the lease
of a CGU post IFRS 16. term for both the forecast period and the terminal value.

In practice two main approaches could be applied in the In approach 2 the lease expenses would be classified (back)
discounted cash flow analysis, which, if applied correctly, as operating expenses. This would essentially reflect the way
should lead to the same estimate of the RA. These how impairment analyses prior to the introduction of IFRS 16
approaches are: would have been performed. The ‘old’ approach also assumed,
often in a non-conscious way, that new leases would be
1. follow IFRS 16 classification and treat lease payments as entered into by growing operating expenses (that included
cash flows to debt providers in the discounted cash flow lease payments) at a set rate. Going forward this approach
model, and subtract the fair value the lease liability from would result in a mismatch between management accounts
the outcome as applicable; or and model forecast. This mismatch should be carefully
analysed and reconciled to ensure consistency between
2. follow IAS 17 cash flow classification and continue management’s expectations versus impairment model
modelling the cash flows as before, treating the lease assumptions.
payments (including interest) as a cash outflow in the
determination of the free cash flow to the firm5. While either of approaches 1 or 2, should result in the same
Fair Value Less Cost of Disposal (FVLCD) if applied correctly,
Approach 1 requires changes to commonly used discounted IAS 36.78, provides that the carrying amounts of certain
cash flow models and/or the assumptions used when recognized liabilities should be deducted in a calculation of the
deriving the cash flows used in these models. The ROU asset RA under Value in Use (VIU), implying that approach 1 should
and lease liability reflect the actual leases in place on the be applied for VIU, but deducting the carrying amount of lease
measurement date. The lease terms are finite and deviate liabilities rather than their fair value6.

Modelled cash flow The change in cash flow classification of leases

1 2 3 4 5 ... TV
impact IFRS 16 triggers a significant increase in operating cash
flow.

The ROU asset balance and depreciation charge

Add back Lease only reflects the lease payments over the IFRS
expense 16 lease term - 3 years in the graph. Many
DCF models will require an update to include
replacement cash flows for ROU assets in the
Lease payments forecast period and terminal value (TV).
incorporated in Another difference may arise from ROU assets
carrying amount being measured excluding the interest implicit
in the payments.

4
Following IFRS 16.50 lease payments for the principal portion are classified as financing activities and payments for the interest portion are classified
in accordance with the company’s policy on classification of interest paid. In the ‘free cash flow to the firm’ valuation approach, interest payments are
cash flows to funding providers, and therefore are not part of the free cash flows to the firm.
5
As IFRS 16 eliminates the distinction between operating and finance leases this adjustment would be made for all lease payments, regardless of
whether the lease was classified as operating or finance lease under IAS 17.
6
In our view, IAS 36.78 applies to a lessee’s lease liability: “…the carrying amount of the liability is deducted in determining both the cash-generating
unit's value in use and its carrying amount”, i.e. the discounted cash flows will not include the cash outflows resulting from the lease payments to
avoid double counting. This is based on the guidance in IAS 36.78 and the IFRS Interpretations Committee discussion [IAS 36.29, 78. IU 05-16].

© 2019 KPMG Advisory N.V.

3 | IFRS 16 and IAS 36

Discount rate (WACC) In cases where the lessee concludes that the buyer would not
The way of determining the discount rate should be be required to assume the lease liability upon disposal of the
consistent with what is included in the cash flows. If the lease CGU, then the lessee excludes the lease payments from the
payments are not deducted from the free cash flows to the discounted cash flows used to measure the CGU’s VIU and, in
firm (approach 1 above), then the resulting net cash flows order to ensure consistency, excludes the lease liability from
include the cash that will be used to pay the lease obligation. the CA of the CGU. Similarly, the CGU’s FVLCD excludes the
In this approach the lease payments are treated as a financing lease liability when a buyer would not be required to assume
item to the firm. Therefore, to ensure consistency with the the lease liability.
cash flows, the capital cost of lease liabilities should be
reflected in the weighted average cost of capital (‘WACC’). Similar to what is discussed above with respect to approach 1,
due consideration needs to be given to replacement cash
Incorporating the capital cost of lease liabilities is expected flows for the ROU assets after the lease term and the
to result in a reduction of the WACC, relative to a rate implications of the possible change in composition of cash
measurement that uses only ‘traditional’ debt and equity7. flows to the discount rates used.

Combined impact on net present values due to changes Other considerations and further guidance
in cash flows and discount rate Changes to lease accounting also need to be considered
Under approach 1 above, the RA of a CGU, before when using historical information in impairment analyses,
consideration of lease liabilities, would increase due to to ensure the information is like-for-like. This applies both for
both higher operating cash flows (because of the exclusion trend analyses of the company’s own data as well as for peer
of IAS 17 operating lease payments) and from using a lower company information used (e.g. for asset beta or leverage
WACC. This increase in net present values may be offset by estimates, market multiples or profitability benchmarking).
inclusion of the lease liability.
Valuators continue to discuss the appropriate and practical
Lease liabilities approach to adoption of IFRS 16 in IAS 36 impairment testing.
Another topic for impairment testing post IFRS 16 relates to Standard practices and further guidance on the implications
the allocation of lease liabilities to CGUs. ROU assets are of IFRS 16 are expected to become available in the course of
non-financial assets in the scope of IAS 36 and generally need 2019, following the adoption of IFRS 16 by all IFRS reporters.
to be included in the carrying amount of the CGU unless they
generate independent cash inflows. The inclusion of the
corresponding lease liabilities in the carrying amount
depends on whether a buyer would assume the lease liability
in a disposal of the CGU.

Under IAS 36, the CA of a CGU does not include the CA of any
recognized liability, unless an entity needs to consider that
liability to determine the recoverable amount of the CGU [IAS
36.78]. This may occur when a buyer would be required to
assume the liability in a disposal of the CGU. In our view, this
guidance applies to a lessee’s lease liability associated with
ROU assets in the CGU. This is based on the guidance in IAS
36.78 and the IFRS Interpretations Committee discussion [IAS
36.29, 78. IU 05-16]. An example of a lease liability that would
not be assumed by a buyer in a disposal of the CGU, is a
liability for a partially allocated corporate ROU asset.

7
Under the assumption that the impact of IFRS 16 is similar for other market participants.

© 2019 KPMG Advisory N.V.

 How KPMG can help

Impairment testing remains a complex accounting topic. Transitioning to IFRS

16 was (and for some still is) a time-consuming and cumbersome process.
KPMG can help you to determine how IFRS 16 will change your impairment
testing and how to process these changes. We can help you to determine the
most practical approach on determining your CGUs’ CA and RA post IFRS 16.

The contacts at KPMG in connection with this publication are:

Gijs de Graaff Sander Mulder Janpiter Nijp

Director Director Manager
Capital Markets Accounting Valuations Capital Markets Accounting
Advisory Services Advisory Services
T: +31206 567757 T: +31206 568371 T: +31206 568074
M: +31 6 20000806 M: +31 6 12054982 M: +31 6 53671291
E: [email protected] E: [email protected] E: [email protected]

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely
information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without
appropriate professional advice after a thorough examination of the particular situation.

@ 2019 KPMG Advisory N.V., registered with the trade register in the Netherlands under number 33263682, is a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (‘KPMG International’), a Swiss entity. All rights reserved.