While economically nothing has changed when entities adopt NZ IFRS 16 (i.e. it is just a change in accounting treatment), the adoption of NZ IFRS 16 can “mechanically” result in an immediate erosion of headroom - and consequentially, potentially give rise to impairment.
Differences between the WACC rate and the discount rate used under NZ IFRS 16
Prior to NZ IFRS 16, the lease payments were reflected in the DCF as operating expenses, and were therefore being discounted at the WACC rate.
Now, under NZ IFRS 16, these same lease payments are:
i. Removed from the DCF’s operating expense cash outflows (that are discount by WACC)
ii. Included in the determination of the RoU Asset recognised (that are discounted by the associated cost of additional debt).
This results in both an increase to the discounted net cash flows, and the asset carrying amounts to be supported.
However, because the net cash flows are discounted at a higher rate (i.e. the WACC rate, which incorporates the higher costs attached to equity (refer section 6. above))), the increase in discounted cash flows is lower than the increase in assets to be supported by those discounted cash flows.
||$10,000 per year
|Increase in free cash flows:
||$34,331 (PV of $10,000 over 5 years at 14%)
|Increase in assets:
||($39,927) (PV of $10,000 over 5 years at 8%)
ii. Method used to adopt NZ IFRS 16
If an entity has used the Modified Retrospective Method to adopt NZ IFRS 16, together with that added practical expedient to simply set the RoU Asset equal to the Lease liability at adoption date, then the RoU Asset will technically be artificially higher than it otherwise would be (refer to our previous Cheat Sheets for further information).
Adding to the asset base in this way will inherently erode into previous headroom, all other things being equal.
 The entity’s incremental borrowing rate (IBR).