IFRS 16 Leases came into effect on 1 January 2019 and requires companies to report all leases on the balance sheet (except where exemptions apply). With the new requirements, in many cases, the lessee will recognise equal amounts of leased assets (also called right of use or RoU assets) and lease liabilities at initial recognition of the lease. The lease liability will be calculated as the present value (PV) of the future lease payments discounted using an appropriate rate. This calculation resembles that for finance leases as required in IAS 17 Leases, which IFRS 16 supersedes.
IASB(International Accounting Standards Board)expected this change to bring greater comparability and consistency in lessee accounting in its February Investor Update Newsletter. However, the statement of cash flows will still vary across companies, and IASB illustrated how leasing information provided under IFRS 16 can be used to adjust cash flow information to calculate adjusted FCF measure for lessees. This will allow for comparison with FCF measures of companies that own or purchase assets.

Comparison of financial statements
  Purchase of assets
(with borrowing)
Leasing of assets Implications for financial analysis
Balance sheet reflects
  • owned assets
  • borrowings
  • leased assets (right of use)
  • lease liabilities
ratios related to efficiency, return and leverage that make use of P&L and balance sheet are more comparable
P&L reflects
  • depreciation of owned assets
  • interest charge on borrowings
  • depreciation of leased asset
  • interest charge on lease liabilities
Cash flow statement reflects in the year of asset purchase
  • capital expenditure or capex (outflow in CFI*)
  • borrowing (inflow in CFF*)
in the year of initiating new lease of an asset
  • no capex in CFI
  • lease repayment in CFF (outflow)
measures such as FCF are less comparable
over life of loan
  • loan repayment (outflow in CFF*)
over lease term
  • repayment of lease liability (outflow in CFF)
Key non-cash adjustments depreciation on owned asset is added back in CFO* calculations depreciation on leased asset is added back in CFO calculations  

Investors and company managers generally view free cash flow (FCF) as excess cash generated by the company that is available for distribution or reinvestment into the business. Consequently, these measures are widely used in analysing companies’ financial health and intrinsic value. Free cash flow’ is not defined in IFRS Standards. In most cases, this measure (let’s call this version FCF1) is calculated as cash flow from operating activities (CFO) less capital expenditure (or capex). However,reported capex limits the usefulness of FCF1 (for lessees) in making crosscompany comparisons.

Chart 1 shows a comparison of the unadjusted FCF1 of Let’s-Lease (lessee) and the FCF1 of Big-Buy(purchaser) over a six-year period. IASB will elaborate on the mechanics of these calculations in the case study section. For now, it wants to highlight the comparability blind spot–the unadjusted annual FCF1 of Let’s-Lease is significantly higher than the annual FCF1 of Big-Buy, particularly from Year 1 to Year 4(see Chart 1). By the end of the six-year period, Let’s-Lease has a higher cumulative FCF1 than that of Big-Buy. Its proposed adjustment approach will bring the annual FCF1 of both companies in line for enhanced comparability.
Chart 1: FCF1—Measure of free cash flow defined as CFO less capex
Another approach commonly observed for computing and presenting FCF is CFO less capex and repayment of lease liabilities (we call this measure FCF2). This approach, unlike FCF1, takes into consideration the cash outflows (lease repayments) related to leasing activity, but spreads them over the life of the lease (unlike capex for Big-Buy, which is expensed upfront).
We can see from Chart 2 that the annual FCF2 of Let’s-Lease is higher than that of Big-Buy in early years but lower in later years. In contrast to FCF1, the cumulative FCF2 for Let’s-Lease equals that of Big-Buy over the sixyear period.
Chart 2: FCF2—Measure of free cash flow defined as CFO less capex & lease repayments
The reason why cumulative FCF2 over the six-year period for Let’s-Lease and Big-Buy is the same is because its calculations (discussed further in the case study segment related to cash flow statements) include the repayment towards lease liabilities thereby spreading out the capital cost towards the leased asset.
Some may view FCF2 as an improvement over FCF1, although it still exhibits shortcomings for the purpose of cross-company comparisons (see Comparison of FCF under FCF2 in Section III of the case study).

To make the appropriate adjustments that compensate for the comparability blind spot associated with FCF1, we make use of IFRS 16 disclosures on the addition to RoU assets (a requirement in the new Standard) via the following steps:

Step 1: Assess Let’s-Lease ’s addition to RoU assets.
Based on the information presented in Section I, Let’s-Lease has disclosed CU33,000 as addition to RoU assets in each of Year 1, 2, 3 and 4 in its IFRS 16 notes.

Step 2: Compute adjusted CFI by reducing reported CFI each year by the addition to RoU assets.

Step 3: Compute adjusted FCF1 as reported CFO less adjusted CFI calculated in Step 2.

Step 4: Add as a source of financing in CFF the increase in lease liability.

Other free cash flow measures

Although there may be agreement on what free cash flow means at a broad level (eg the cash left over after paying operating expenses and capex), there can be differences in the detail. We highlight other formulas for computing FCF measures that are commonly used by investors in financial analysis and valuation.

Free cash flows to firm (FCFF) = CFO3 + post-tax interest – capex
Free cash flows to equity (FCFE) = CFO3 – capex + net borrowings

These formulations of an FCF metric share the disadvantages that apply to the FCF1 metric that we previously discussed. Under both formulas, the capex figure for both FCFF and FCFE suffers from the blind spot related to leases.

Furthermore, it makes sense to make three adjustments:
(a) adjust the reported capex figure (as calculated for Let’s-Lease ) to account for the effect of the addition of leased assets;
(b) adjust the post-tax interest to include interest paid to lessors; and
(c) adjust the net borrowings (as calculated for Let’s-Lease in Section IV) by taking into consideration the addition of lease liabilities.

These adjustments can facilitate a more meaningful comparison between Let’s-Lease and Big-Buy’s FCFF, and FCFE.
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