Table of Contents
Type: Full Masters Dissertation | Subject: MSc Accounting | Level: Masters | Word Count: ~14,300 words
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Overview: This complete MSc Accounting dissertation examines how the adoption of IFRS 16 Leases changed the reported leverage of UK listed retailers. Using a before-and-after ratio design on an illustrative sample of ten anonymised retailers, it quantifies the lease liabilities and right-of-use assets brought onto the balance sheet and traces their effect on gearing, net debt to EBITDA and interest cover. The financial figures throughout are illustrative, constructed for teaching purposes, and are not the audited results of any named company.
The introduction of IFRS 16 Leases, effective for accounting periods beginning on or after 1 January 2019, abolished the long-standing distinction between operating and finance leases for lessees and required almost all leases to be recognised on the balance sheet as a right-of-use asset and a corresponding lease liability. For retailers, whose business models historically relied on large portfolios of leased stores held off balance sheet under IAS 17, the standard represented one of the most consequential reporting changes of the decade. This dissertation investigates the effect of IFRS 16 adoption on the reported leverage of UK listed retailers. Adopting a positivist philosophy and a quantitative, before-and-after research design, the study analyses an illustrative sample of ten anonymised UK listed retailers and compares their key leverage and coverage ratios immediately before and after transition. Three ratios are examined: gearing measured as net debt to equity, net debt to EBITDA, and interest cover. The findings show that recognising previously off-balance-sheet leases materially increased reported leverage across every sample firm. Mean gearing rose from approximately 34% to 249%, mean net debt to EBITDA rose from about 0.6 times to 2.5 times, and mean interest cover fell from roughly 24 times to just over 4 times, even though EBITDA itself increased by around half as rental charges moved below the EBITDA line. The magnitude of change varied widely and was greatest for firms with the largest lease portfolios relative to equity. A paired-samples test confirmed that the change in gearing was statistically significant. The dissertation concludes that IFRS 16 substantially altered the reported financial position of retailers without changing their underlying cash flows or economic substance, with important implications for covenant design, ratio benchmarking and the comparability of historical financial data. It recommends that analysts recalibrate sector benchmarks and that covenant frameworks be reviewed to avoid unintended consequences arising from a purely accounting-driven change.
Leasing has long been a central feature of corporate finance, allowing firms to obtain the use of productive assets without committing the capital required for outright purchase. In the retail sector in particular, the ability to occupy high-street units, shopping-centre anchors and out-of-town retail parks through leasing rather than ownership has historically been fundamental to expansion strategy. Under the previous standard, IAS 17 Leases, a lease was classified as either a finance lease or an operating lease. A finance lease, which transferred substantially all the risks and rewards of ownership, was recognised on the balance sheet. An operating lease, by contrast, was treated as an executory contract: the lessee simply recognised the rental charge as an expense on a straight-line basis over the lease term, and no asset or liability appeared on the statement of financial position (International Accounting Standards Board, 2016a). The consequence was that a retailer with hundreds of leased stores could carry obligations amounting to several times its reported borrowings entirely off balance sheet, disclosed only in the notes as future minimum lease commitments.
This treatment attracted sustained criticism. Standard-setters, analysts and academics argued that operating-lease accounting obscured real financial obligations, impaired comparability between firms that leased and firms that borrowed to buy, and encouraged structuring transactions to achieve a favourable accounting outcome rather than to reflect economic substance (Imhoff, Lipe and Wright, 1991; Beattie, Edwards and Goodacre, 1998). After a protracted development process, the International Accounting Standards Board issued IFRS 16 Leases in January 2016, with mandatory application for periods beginning on or after 1 January 2019. The standard introduced a single lessee accounting model under which, subject to limited exemptions for short-term and low-value leases, every lease gives rise to a right-of-use asset and a lease liability measured at the present value of the future lease payments (International Accounting Standards Board, 2016a). The off-balance-sheet operating lease, as a category for lessees, effectively ceased to exist.
The reporting consequences of this change are concentrated in sectors that lease intensively, and retail is among the most lease-intensive of all. The Board’s own effects analysis identified retailers, airlines and hotel operators as the industries most affected, estimating that retailers held some of the largest off-balance-sheet lease commitments of any sector (International Accounting Standards Board, 2016b). For a UK listed retailer, transition to IFRS 16 could add billions of pounds of lease liabilities to the balance sheet overnight, transforming headline measures of indebtedness without any change to the underlying contracts, cash flows or commercial reality. It is precisely this gap between a change in reported numbers and an absence of change in economic substance that makes the standard an instructive subject for academic study.
Financial ratios derived from the balance sheet and income statement are among the most widely used tools in corporate analysis. Lenders write loan covenants in terms of gearing and net debt to EBITDA; credit-rating agencies incorporate leverage metrics into their scorecards; equity analysts benchmark firms against sector peers; and boards monitor their own capital structure against internal policy. All of these uses rest on an implicit assumption that reported leverage reflects, in a reasonably stable and comparable way, the financial obligations of the firm. IFRS 16 disturbs that assumption. By bringing previously invisible lease obligations onto the balance sheet, the standard mechanically increases reported leverage for affected firms, and it does so to a degree that depends heavily on the size and structure of each firm’s lease portfolio.
The research problem addressed in this dissertation is therefore twofold. First, there is a measurement question: how large, in practice, is the effect of IFRS 16 adoption on the reported leverage of UK listed retailers, and how does that effect vary across firms? Second, there is an interpretive question: what does a change of this kind mean for the users of financial statements, given that it alters reported numbers without altering cash flows or the economic position of the firm? Although a substantial literature anticipated the likely direction of the effect through constructive capitalisation studies conducted before mandatory adoption, there remains value in a focused, sector-specific examination using the before-and-after framework that actual transition now makes possible. UK listed retailers provide an especially suitable setting because of their heavy reliance on leased property and their prominence in a market where leverage benchmarks are closely watched.
The overall aim of this dissertation is to evaluate the effect of IFRS 16 adoption on the reported leverage of UK listed retailers and to interpret the significance of that effect for the users of financial statements. To achieve this aim, the study pursues four objectives:
The objectives are operationalised through the following research questions:
The significance of this dissertation lies in its bridging of a technical accounting change and its practical consequences for financial analysis. For practitioners, it offers a structured demonstration of the scale of the leverage shift and a reminder that time-series and peer comparisons spanning the transition date must be treated with caution. For lenders and those who draft or monitor covenants, it highlights the risk that a purely accounting-driven increase in reported leverage could, absent appropriate carve-outs, trigger covenant pressure that bears no relation to any deterioration in the borrower’s actual position. For the academic literature, the study provides a focused, UK retail-specific application of the before-and-after method that complements the broader, cross-sectoral and pre-adoption constructive capitalisation studies that dominate prior work. Because the analysis isolates a change in measurement from any change in substance, it also contributes to the longstanding debate about whether, and how, accounting numbers that move for reporting reasons alone influence the decisions of their users.
The scope of the study is deliberately bounded. It concerns lessee accounting, not lessor accounting, because the lessee model is where IFRS 16 made its decisive change. It focuses on UK listed retailers, a population chosen for its lease intensity and the salience of leverage benchmarks within it. It examines reported leverage through three ratios chosen for their prominence in covenant and analytical practice, rather than attempting an exhaustive ratio inventory. The financial data analysed are illustrative figures constructed to be internally consistent and representative of the sector; they are used to demonstrate the method and the direction and approximate magnitude of the effect, and they are not the audited results of any identifiable company. This design choice is explained and defended in Chapter 3.
The remainder of the dissertation is organised into five chapters. Chapter 2 reviews the relevant literature and develops the theoretical framework. Chapter 3 sets out the research methodology, including the philosophy, design, sample, data and analytical procedures. Chapter 4 presents the findings, supported by worked financial tables. Chapter 5 discusses the findings in relation to the literature and theory. Chapter 6 concludes, revisits the objectives, draws out implications, acknowledges limitations and suggests directions for future research.
This chapter reviews the body of knowledge relevant to the effect of lease capitalisation on reported leverage. It proceeds thematically rather than study by study. It begins by tracing the evolution of lease accounting from IAS 17 to IFRS 16, establishing the technical mechanism through which the change affects the financial statements. It then examines the literature on off-balance-sheet financing and the constructive capitalisation of operating leases, which anticipated the effect of mandatory adoption. The chapter next develops the theoretical framework, drawing on positive accounting theory, agency theory, signalling and the debt-covenant hypothesis. It reviews the empirical evidence on the ratio effects of lease capitalisation, considers the particular sensitivity of the retail sector, and discusses the interpretation of the leverage metrics used in this study. It closes by identifying the research gap that the dissertation addresses.
The accounting treatment of leases has been contested for decades. The central difficulty is that a lease sits on the boundary between the purchase of an asset and the rental of a service. IAS 17 resolved this difficulty by drawing a line between finance leases, which were deemed to transfer substantially all the risks and rewards incidental to ownership, and operating leases, which were not. Finance leases were capitalised; operating leases were expensed. The classification turned on a set of indicators, such as whether ownership transferred at the end of the term, whether the lease term covered the major part of the asset’s economic life, and whether the present value of the minimum lease payments amounted to substantially all of the asset’s fair value (International Accounting Standards Board, 2016a). In practice, the boundary proved porous. Because the consequences of classification were so significant, preparers had both the incentive and the means to structure leases so as to fall just on the operating side of the line, keeping the resulting obligations off the balance sheet (Duke, Hsieh and Su, 2009).
Criticism of this arrangement was long-standing and came from several directions. Imhoff, Lipe and Wright (1991) demonstrated that the exclusion of operating leases from the balance sheet materially understated both assets and liabilities and distorted the ratios that users derived from them. Beattie, Edwards and Goodacre (1998) extended this argument in a UK setting, showing that constructive capitalisation of operating leases would change key ratios for a large proportion of listed firms. The underlying objection was conceptual: an operating lease creates a present obligation to make future payments in exchange for a right to use an asset, and that obligation and right meet the definitions of a liability and an asset in the conceptual framework. The off-balance-sheet treatment therefore failed to represent the economic substance of the arrangement.
IFRS 16 resolved the debate in favour of recognition. For lessees it removed the operating or finance distinction entirely and introduced a single model under which, at the commencement of a lease, the lessee recognises a lease liability measured at the present value of the lease payments not yet paid, discounted at the rate implicit in the lease or, where that is not readily determinable, the lessee’s incremental borrowing rate. Simultaneously, the lessee recognises a right-of-use asset, initially measured at the amount of the lease liability adjusted for prepayments, initial direct costs and any restoration obligations (International Accounting Standards Board, 2016a). Over the lease term the liability unwinds, generating a finance charge, while the right-of-use asset is depreciated, typically on a straight-line basis. Two exemptions remain: short-term leases of twelve months or less and leases of low-value assets may continue to be expensed. The net effect for a lease-intensive lessee is a substantial grossing-up of the balance sheet and a redistribution of expense from a single operating rental charge to a combination of depreciation and finance cost.
The standard permitted two transition approaches, and the choice between them affects the comparability of the figures examined in this study. Under the full retrospective approach, a firm restates its prior-year comparatives as if IFRS 16 had always applied, producing a consistent time series but requiring extensive historical computation. Under the modified retrospective approach, which most retailers adopted for its lower implementation burden, the firm applies the standard from the date of initial application without restating comparatives, measuring the lease liability at the present value of the remaining payments and the right-of-use asset either at an amount equal to the liability or as if the standard had always applied. A suite of practical expedients was also available, including the option to exclude leases with a remaining term of twelve months or less at transition, to rely on a previous onerous-lease assessment in place of an impairment review, and to apply a single discount rate to a portfolio of leases with reasonably similar characteristics (International Accounting Standards Board, 2016a). The prevalence of the modified retrospective approach means that, for many retailers, the first set of IFRS 16 figures was not accompanied by restated comparatives, which is one reason why a within-firm before-and-after design based on the reported transition adjustment, rather than a naive comparison of consecutive annual reports, is the appropriate analytical frame.
The reform also has an international dimension that bears on the comparability of the resulting numbers. The United States Financial Accounting Standards Board developed its own lease standard, ASC 842, in parallel with the Board, but the two standard-setters did not fully converge. Whereas IFRS 16 adopts a single on-balance-sheet model for all lessee leases, ASC 842 retains a dual model that distinguishes finance leases from operating leases, recognising both on the balance sheet but presenting the expense of an operating lease as a single straight-line charge rather than as separate depreciation and interest. The practical consequence is that a retailer reporting under IFRS and a comparable retailer reporting under US GAAP will show similar balance sheets but materially different income-statement geographies and therefore different EBITDA, operating profit and interest-cover figures for economically identical lease portfolios (Collins, Pasewark and Riley, 2012). This residual divergence is relevant to the present study because it limits the comparability of the leverage and coverage metrics of UK retailers with those of their US-reporting peers and is returned to in the discussion.
Because mandatory adoption of IFRS 16 occurred only in 2019, much of the literature on its likely effects was produced in advance, using the technique of constructive capitalisation. This approach takes the operating-lease commitments disclosed in the notes under IAS 17 and estimates the asset and liability that would appear if those commitments were brought onto the balance sheet. Imhoff, Lipe and Wright (1991, 1997) pioneered the method, developing procedures to estimate both the balance-sheet and the income-statement effects of capitalisation from disclosed data. Their work established that the effect on liabilities and on leverage ratios could be large and that the income-statement effect, while smaller, was not negligible and depended on the maturity profile of the lease portfolio.
Subsequent studies applied and refined the method across different jurisdictions. Beattie, Edwards and Goodacre (1998) found that, for a sample of UK listed companies, constructive capitalisation materially increased gearing and reduced interest cover for the majority of firms, with the effect concentrated in particular sectors. Fülbier, Silva and Pferdehirt (2008) reached similar conclusions for German listed firms, reporting pronounced effects on leverage and more modest effects on profitability measures. Fitó, Moya and Orgaz (2013) and Nuryani, Heng and Juliesta (2015) extended the evidence to Spanish and other settings respectively, consistently finding that capitalisation increased reported leverage. The refinement of the estimation method itself became a subject of study, with Morales-Díaz and Zamora-Ramírez (2018) proposing a methodological approach tailored to the specific requirements of IFRS 16 and demonstrating that the choice of estimation assumptions, particularly the discount rate and the assumed remaining lease term, materially affected the estimated impact.
The constructive capitalisation literature is valuable because it established, in advance, both the expected direction of the effect and its likely heterogeneity across firms and sectors. Its principal limitation is precisely that it is an estimate. Constructive capitalisation relies on assumptions about discount rates, lease terms and the pattern of future payments that the disclosed data do not fully reveal, and different researchers adopted different assumptions, producing a range of estimates for otherwise similar firms. The arrival of actual transition data under IFRS 16 allows the estimate to be replaced, in principle, by observation: the lease liability and right-of-use asset are now reported quantities rather than reconstructed ones. This dissertation adopts the before-and-after logic that transition makes possible, applying it within a single sector to sharpen comparability.
Several theoretical perspectives help to explain why a change in lease accounting matters even when it leaves cash flows unchanged. The first is positive accounting theory, which seeks to explain and predict the accounting choices of firms and the consequences of accounting regulation. Watts and Zimmerman (1990) articulated the debt-covenant hypothesis, which holds that firms closer to the limits of their debt covenants have stronger incentives to make accounting choices that relax those limits. Under IAS 17, the operating-lease classification was in part a product of these incentives: keeping obligations off the balance sheet helped firms preserve covenant headroom and present a more conservative leverage profile. IFRS 16 removes this avenue, and the debt-covenant hypothesis predicts that the resulting increase in reported leverage will have real consequences wherever covenants are written on reported figures without adjustment.
Agency theory provides a second lens. The separation of ownership and control, and of borrowers and lenders, gives rise to information asymmetries that accounting is intended to mitigate. Off-balance-sheet financing worsens these asymmetries by concealing obligations from those who rely on the financial statements. From this perspective, IFRS 16 is an information-improving reform: by recognising lease obligations, it reduces the scope for managers to present a misleadingly low picture of indebtedness, thereby lowering monitoring costs for lenders and shareholders (Lim, Mann and Mihov, 2017). A third perspective, signalling theory, considers how the change affects the information that financial statements convey. If users were already aware of operating-lease commitments through the notes and adjusted for them, the recognition of those commitments on the face of the statements conveys little new information and should have limited economic consequence. If, however, a meaningful proportion of users relied on headline reported figures without adjustment, then recognition conveys information and may change behaviour. The empirical question of which of these holds is central to interpreting the significance of the leverage effect.
Finally, the debate between recognition and disclosure underlies much of the theoretical discussion. Proponents of the view that disclosure is a sufficient substitute for recognition argue that sophisticated users already incorporate note-disclosed commitments and that moving them onto the face of the statements is cosmetic. The opposing view, reflected in the Board’s rationale for IFRS 16, holds that recognition and disclosure are not equivalent, that recognised items receive greater attention and are treated as more reliable, and that many users do not fully adjust for disclosed items (International Accounting Standards Board, 2016b). Giner and Pardo (2018) provide value-relevance evidence consistent with the proposition that operating-lease liabilities were already priced by equity markets to a degree, suggesting partial but incomplete adjustment by at least some users. This dissertation does not test market pricing directly, but the recognition-versus-disclosure debate frames the interpretive discussion in Chapter 5.
The empirical literature, whether based on constructive capitalisation or on post-adoption data, converges on a consistent set of findings. The first and most robust is that lease capitalisation increases reported leverage. Across jurisdictions and samples, gearing ratios rise, often substantially, because the lease liability adds to reported debt while equity either remains broadly unchanged or falls slightly on transition owing to the difference between the opening right-of-use asset and the lease liability (Beattie, Edwards and Goodacre, 1998; Fülbier, Silva and Pferdehirt, 2008; Magli, Nobolo and Ogliari, 2018). The magnitude of the effect is strongly related to lease intensity, so that sectors and firms that lease heavily experience the largest increases.
The second finding concerns the income statement and the measures derived from it. Because the former operating-lease rental charge, which sat above the EBITDA line, is replaced by depreciation and a finance charge, both of which sit below it, EBITDA rises mechanically on capitalisation (Öztürk and Serçemeli, 2016). Operating profit also tends to rise modestly, because in a steady-state portfolio the straight-line depreciation of the right-of-use asset is lower than the former rental charge by approximately the amount of the finance element. Profit before tax, however, can fall in the early years of a lease or a growing portfolio because the combined depreciation and finance charge is front-loaded relative to the straight-line rental it replaces. The combination of higher EBITDA and higher reported debt produces offsetting pressures on the net debt to EBITDA ratio, but the evidence consistently finds that the debt effect dominates, so that net debt to EBITDA rises on capitalisation.
The third finding concerns coverage ratios. Interest cover, measured as operating profit divided by finance costs, deteriorates sharply because the finance charge arising from the unwinding of the lease liability is added to the denominator, often increasing finance costs several-fold for a lease-intensive firm (Imhoff, Lipe and Wright, 1997; Morales-Díaz and Zamora-Ramírez, 2018). Return on assets tends to fall, because the grossed-up asset base in the denominator outweighs the modest improvement in operating profit in the numerator. The direction of these effects is not in serious dispute in the literature; what varies is their magnitude, which depends on lease intensity, portfolio maturity and the discount rate applied.
Beyond the mechanical effect on ratios, a further strand of the literature asks whether the recognition of lease obligations conveyed new information to capital markets or merely relocated information already disclosed in the notes. The value-relevance evidence is instructive here. Giner and Pardo (2018) report that operating-lease liabilities were associated with firm value before mandatory recognition, implying that at least some investors had already incorporated note-disclosed commitments into their assessments. If markets had fully adjusted, recognition under IFRS 16 should produce little price reaction and few economic consequences, consistent with the efficient-markets intuition underlying the strong form of signalling theory. Yet the same literature finds that adjustment was partial rather than complete, and surveys of preparers and users conducted before adoption anticipated real consequences, particularly for borrowing costs and covenant compliance (Beattie, Goodacre and Thomson, 2006). The balance of evidence therefore supports the Board’s position that recognition and disclosure are not perfect substitutes and that the standard was likely to matter to users in practice, a proposition that frames the interpretation of this study’s findings in Chapter 5.
A recurring theme in the literature is that the impact of lease capitalisation is highly uneven across sectors. The Board’s effects analysis singled out retailers, airlines, travel and leisure, and transport operators as the industries with the largest off-balance-sheet lease commitments, and therefore the largest expected transition effects (International Accounting Standards Board, 2016b). Goodacre (2003), in a study specific to the UK retail sector, documented the scale of operating-lease finance among retailers and argued that the omission of these obligations from the balance sheet gave a materially incomplete picture of the sector’s financial position. Sari, Altintas and Tas (2016) examined the retailing sector in another market and found that constructive capitalisation produced some of the most pronounced ratio effects of any industry studied.
The reasons for retail’s sensitivity are structural. Retailers require extensive physical selling space in locations whose value lies in their footfall and catchment, and they have historically preferred to lease rather than own that space, both to preserve capital for inventory and expansion and to retain flexibility as consumer patterns shift. The result is a portfolio of long-dated property leases whose aggregate present value can dwarf the retailer’s conventional borrowings. For such firms, IFRS 16 does not merely adjust the balance sheet at the margin; it can more than double reported net debt. This concentration of effect makes the retail sector the natural setting for a focused study, and it is the setting adopted here. It also means that cross-sectoral studies, which average the retail effect with that of asset-light sectors, may understate the significance of the change for retailers specifically.
The structural features that make retail so sensitive are also, in part, durable, which affects how the transition effect should be understood over time. A grocery or general-merchandise operator typically holds a mixture of long-dated anchor leases and shorter secondary units, so that the lease portfolio does not expire uniformly but rolls forward as leases are renewed or replaced. This means that the recognised liability does not simply unwind to nothing after a few years; it is replenished as new leases commence, so that a lease-intensive retailer that continues to trade will carry a substantial lease liability indefinitely. The transition effect documented in the present study is therefore not a one-off distortion that washes out quickly but the first observation of a persistently higher level of reported leverage that will characterise the sector for as long as its store-based model endures. At the same time, structural change in retail, including the shift of sales online and the periodic renegotiation of rents, means that the size and maturity of lease portfolios are themselves in flux, so that the reported leverage of a retailer in any given year reflects both the accounting model and the strategic choices the firm has made about its property estate. Disentangling these two influences is one of the interpretive challenges that the standard creates for users, and it is a theme to which the discussion returns.
Leverage can be measured in several ways, and the choice of metric affects both the apparent magnitude of the IFRS 16 effect and its interpretation. Gearing expressed as net debt to equity captures the balance between borrowed and owners’ funds and is sensitive both to the addition of lease liabilities to net debt and to any transition adjustment to equity. Net debt to EBITDA, widely used in covenants and by rating agencies, expresses indebtedness relative to a measure of cash-generative capacity; it is distinctive under IFRS 16 because both numerator and denominator move, the numerator rising with the lease liability and the denominator rising as rental charges leave operating expenses. Interest cover expresses the ability of operating profit to service finance costs and deteriorates most visibly under the new standard because the lease finance charge enlarges the denominator.
The literature cautions that these metrics are not interchangeable and that the IFRS 16 effect must be understood metric by metric (Morales-Díaz and Zamora-Ramírez, 2018). A further complication is the treatment of the lease liability in the definition of net debt itself. Some analysts and lenders include lease liabilities in net debt, consistent with the accounting; others explicitly exclude them, preferring a pre-IFRS 16 definition that treats leases as operating in nature. This divergence means that the reported effect of the standard on leverage depends not only on the accounting but on the analytical conventions adopted by the user. This study computes leverage on an IFRS 16 basis, including lease liabilities in net debt, which is the basis on which the standard requires the statements to be prepared, while recognising in the discussion that some users will apply adjusted definitions.
The review reveals a mature literature on the direction of the lease-capitalisation effect but a continuing need for focused, post-adoption, sector-specific evidence presented through the before-and-after framework. Much prior work is pre-adoption and estimate-based, relies on cross-sectoral samples that dilute the retail effect, or is situated outside the UK. There is scope for a study that concentrates on UK listed retailers, uses the before-and-after logic that mandatory transition now permits, and presents the effect through the specific leverage and coverage ratios that matter most in covenant and analytical practice, while explicitly interpreting what a measurement-only change means for users. This dissertation addresses that gap. Because the audited transition data for individual named firms are proprietary to those firms and their disclosure varies in granularity, the study uses an illustrative, internally consistent sample calibrated to be representative of the sector, a design choice justified in Chapter 3. The contribution lies in the structured demonstration of the method and in the interpretation of the results, rather than in a claim about any particular company.
This chapter has traced the transition from IAS 17 to IFRS 16, reviewed the constructive capitalisation and post-adoption literature, developed a theoretical framework drawing on positive accounting theory, agency and signalling perspectives, and established the sector sensitivity that makes retail the appropriate focus. The literature agrees that capitalisation increases reported leverage, raises EBITDA, and depresses coverage ratios, with the magnitude governed by lease intensity. It leaves open the interpretive question of how a measurement-only change should affect users, and it points to a gap for focused UK retail evidence framed through the before-and-after method. The next chapter sets out the methodology by which this study addresses that gap.
This chapter explains and justifies the methodological choices of the study. It sets out the research philosophy, the approach and design, the basis on which the sample was constructed, the nature and source of the data, the definition of the variables and ratios, the analytical procedures applied, and the steps taken to ensure reliability and validity. It also addresses ethical considerations and the limitations inherent in the chosen design. The methodology follows the logic of the research onion as a device for organising these layered choices from philosophy through to technique (Saunders, Lewis and Thornhill, 2019).
The study adopts a positivist philosophy. Positivism holds that reliable knowledge is derived from observable, measurable phenomena and that the researcher should remain detached from the object of study, testing relationships through structured and replicable procedures (Bryman and Bell, 2015). This philosophy is appropriate here because the research question is fundamentally one of measurement: it asks how a defined accounting change affects defined, quantifiable ratios, and it seeks an answer that is objective, replicable and free of the researcher’s interpretation of the underlying numbers. The accounting quantities involved, the lease liability, the right-of-use asset, net debt, equity, EBITDA and finance costs, are precisely defined by the reporting framework, and the ratios derived from them follow deterministic formulae. A positivist, quantitative stance is therefore well matched to the problem. The interpretive dimension of the study, concerning what the measured change means for users, is addressed in the discussion but does not alter the measurement itself.
The study takes a deductive approach: it begins from theory and prior evidence, which predict that lease capitalisation increases reported leverage, and tests whether that prediction holds for UK listed retailers and with what magnitude. The design is a quantitative, longitudinal, before-and-after comparison. For each firm in the sample, a set of leverage and coverage ratios is computed on two bases: an IAS 17 basis representing the position immediately before adoption, and an IFRS 16 basis representing the position immediately after adoption. Because the comparison is within firm, with each firm serving as its own control, the design holds constant the many firm-specific factors, such as size, business model and capital structure, that would confound a cross-sectional comparison of different firms. The change in each ratio is attributable to the accounting transition rather than to differences between firms. This paired, within-firm structure is the central strength of the before-and-after design and is the standard approach in the lease-capitalisation literature.
A quantitative design was preferred over a qualitative or mixed-methods alternative after consideration of the research question. The question is one of measurement and of the statistical comparison of defined quantities, for which structured numerical analysis is directly suited; a qualitative design, such as interviews with preparers or analysts, would illuminate attitudes and responses to the standard but could not quantify the ratio effect that is the study’s primary concern. A mixed-methods design combining ratio analysis with interviews was considered and set aside on grounds of scope and feasibility, since the interpretive questions it would address are examined here through engagement with the existing survey and value-relevance literature rather than through primary qualitative data. An alternative quantitative design, a cross-sectional regression of leverage on lease intensity across a large sample, was also considered; it was rejected in favour of the paired before-and-after design because the latter isolates the accounting effect within each firm and does not require the large sample that a regression with multiple controls would demand. The chosen design thus matches the measurement nature of the question while remaining tractable within the constraints of a master’s dissertation (Saunders, Lewis and Thornhill, 2019).
The population of interest is UK listed retailers, that is, retailers whose equity is listed on the London Stock Exchange and which prepare financial statements under IFRS. From this population an illustrative sample of ten firms was constructed to span the main retail sub-sectors: food and grocery, general merchandise and department stores, clothing and fashion, health and beauty, electricals, and specialist and do-it-yourself retail. The sample deliberately includes variation in size, lease intensity and pre-existing leverage so that the cross-sectional analysis in Chapter 4 can examine how the leverage effect varies with firm characteristics.
An important methodological decision concerns the nature of the financial figures used. Rather than reproducing the audited transition figures of named companies, which vary considerably in the granularity of their IFRS 16 disclosures and which would risk the inadvertent misstatement of a specific firm’s results, the study uses illustrative financial data constructed to be internally consistent and calibrated to the characteristics typical of the sector. Each firm in the sample, labelled R1 to R10, is assigned a plausible set of pre-transition figures, a lease portfolio consistent with its sub-sector and size, and transition adjustments derived from those inputs by the mechanical application of the IFRS 16 measurement rules. This approach has two advantages. First, it ensures that the arithmetic is fully transparent and reproducible, since every post-transition figure follows deterministically from the stated inputs. Second, it avoids any implication that the study reports the actual audited results of identifiable firms. The trade-off is that the sample is representative rather than actual, and the findings should be read as a demonstration of the method and of the direction and approximate magnitude of the effect rather than as a measurement of any particular company. The figures are not the audited results of any named retailer and should not be cited as such.
For each sample firm, the following pre-transition (IAS 17) quantities were specified: total equity, reported net debt (borrowings less cash), EBITDA, operating profit, finance costs, and the annual operating-lease rental charge together with the present value of the future lease commitments that would be capitalised on transition. The transition to the IFRS 16 basis was then computed by the application of the measurement rules. The lease liability on transition was set equal to the present value of the remaining lease payments. The right-of-use asset was measured at the lease liability adjusted for the modest differences that typically arise under the modified retrospective approach, such as previously recognised prepaid or accrued lease payments; the small excess of the liability over the asset was recognised as a reduction in opening retained earnings, net of deferred tax at the prevailing UK corporation tax rate. Net debt on the IFRS 16 basis was increased by the lease liability. EBITDA on the IFRS 16 basis was increased by the former rental charge, which no longer appears as an operating expense. The lease finance charge was computed as the lease liability multiplied by the assumed incremental borrowing rate, and this charge was added to finance costs. Operating profit on the IFRS 16 basis was increased by the finance element of the former rental charge, reflecting the lower aggregate depreciation of the right-of-use asset relative to the former straight-line rental. These procedures are consistent with the mechanics set out in the standard and in practitioner guidance (International Accounting Standards Board, 2016a; Deloitte, 2016).
The discount rate warrants specific comment because it is the single assumption to which the recognised lease liability is most sensitive. IFRS 16 requires the lessee to discount the future lease payments at the interest rate implicit in the lease where that rate is readily determinable, and otherwise at the lessee’s incremental borrowing rate, which is the rate the lessee would pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value (International Accounting Standards Board, 2016a). For property leases the implicit rate is rarely determinable, so retailers almost invariably apply an incremental borrowing rate, exercising judgement over its term structure and credit component. For this study a uniform incremental borrowing rate of 5% is applied across the sample, a figure chosen to be broadly representative of the medium-term secured borrowing cost of a listed retailer in the period of adoption. Because the sensitivity of the liability to this assumption is itself a finding of interest, the effect of varying the rate is examined explicitly in Chapter 4, and the use of a single rate across firms is acknowledged as a simplification that aids comparability at the cost of abstracting from the firm-specific rates that real preparers would apply.
Three leverage and coverage ratios form the dependent variables of the study, chosen for their prominence in covenant and analytical practice. Their definitions, applied identically on both the IAS 17 and the IFRS 16 bases, are set out below.
| Ratio | Definition | Interpretation |
|---|---|---|
| Gearing (net debt to equity) | Net debt ÷ total equity, expressed as a percentage | Balance between borrowed and owners’ funds; rises as lease liabilities enter net debt |
| Net debt to EBITDA | Net debt ÷ EBITDA, expressed as a multiple (times) | Indebtedness relative to cash-generative capacity; both terms move under IFRS 16 |
| Interest cover | Operating profit (EBIT) ÷ finance costs, expressed as a multiple (times) | Capacity of operating profit to service finance costs; falls as lease finance charges enter the denominator |
Net debt is defined to include lease liabilities on the IFRS 16 basis, consistent with the requirements of the standard. The independent variable is the accounting basis itself, a within-firm factor with two levels, IAS 17 and IFRS 16. Firm characteristics used in the cross-sectional analysis, principally lease intensity measured as the ratio of the lease liability to pre-transition net debt or to equity, serve as explanatory variables for the magnitude of the effect.
To make the measurement mechanism transparent, consider a single illustrative store lease with a term of ten years, annual rent of £1,000,000 payable in arrears, and an incremental borrowing rate of 5%. The present value of the ten annual payments, using an annuity factor of 7.7217, is approximately £7,722,000, which becomes both the opening lease liability and, in this simplified case, the opening right-of-use asset. Under IAS 17 the retailer would simply recognise a £1,000,000 rental expense each year. Under IFRS 16 the liability unwinds at 5% while the right-of-use asset is depreciated on a straight-line basis at £772,000 per year. The table below sets out the first three years and the ten-year totals.
| Year | Opening liability (£000) | Finance charge at 5% (£000) | Payment (£000) | Closing liability (£000) | Depreciation (£000) |
|---|---|---|---|---|---|
| 1 | 7,722 | 386 | 1,000 | 7,108 | 772 |
| 2 | 7,108 | 355 | 1,000 | 6,463 | 772 |
| 3 | 6,463 | 323 | 1,000 | 5,787 | 772 |
| 10-year total | — | 2,278 | 10,000 | — | 7,722 |
The example shows that the total expense over the life of the lease is unchanged at £10,000,000, equal to the sum of the rentals, but its composition and timing differ. Under IFRS 16 the expense comprises £7,722,000 of depreciation and £2,278,000 of finance charge, and it is front-loaded, since the finance charge is highest in the early years when the liability is largest. In the first year the combined charge of £1,158,000 exceeds the former rental of £1,000,000, so profit before tax is lower; in the later years the position reverses. Critically for this study, the entire £1,000,000 rental leaves the operating expenses that sit above the EBITDA line, so EBITDA rises by the full rental amount, while £7,722,000 of asset and liability appear on the balance sheet where previously there was nothing. Scaled up across hundreds of store leases, this mechanism drives the leverage effects examined in Chapter 4.
The analysis proceeds in four stages. First, descriptive statistics, comprising the mean, median, minimum and maximum of each ratio on both bases, summarise the magnitude of the effect across the sample. Second, the change in each ratio is computed firm by firm, both in absolute terms and as a proportion, to reveal the distribution of the effect. Third, the cross-sectional relationship between the magnitude of the effect and firm characteristics, principally lease intensity, is examined to address the heterogeneity question. Fourth, the statistical significance of the change is assessed. Because the design is paired and the sample is small, a paired-samples t-test is applied to the change in gearing, with the non-parametric Wilcoxon signed-rank test used as a robustness check given the modest sample size and the non-normal distribution of ratio changes. The null hypothesis in each case is that the accounting transition produced no change in the ratio; the alternative is that it produced an increase in leverage and a decrease in coverage.
Reliability concerns the replicability of the study. Because every ratio follows a stated formula and every post-transition figure is derived mechanically from disclosed inputs by the application of the IFRS 16 rules, the computations are fully reproducible: a second researcher applying the same inputs and formulae would obtain identical results. Internal validity is high by virtue of the paired, within-firm design, which attributes the change in each ratio to the accounting transition rather than to confounding firm differences. Construct validity rests on the use of standard, widely accepted ratio definitions aligned with covenant and analytical practice. External validity is the principal constraint: because the sample is illustrative and representative rather than a census of actual firms, the precise magnitudes should not be generalised to any specific company, although the direction of the effect and its broad scale are consistent with the wider literature and may reasonably be taken as indicative of the sector.
The study raises limited ethical issues because it does not involve human participants and uses illustrative rather than confidential data. Nonetheless, two considerations were observed. First, the study avoids attributing constructed figures to any identifiable company, so that no firm is misrepresented; the firms are anonymised and the data are explicitly described as illustrative. Second, the study is presented as a model academic exercise for learning purposes and makes no claim to provide investment advice or to report the audited results of any entity. These safeguards align the study with the standards of academic integrity expected of postgraduate research.
Three limitations follow from the design. First, the use of illustrative data limits external validity, as discussed above. Second, the study measures the immediate transition effect and does not track the evolution of the ratios in subsequent years, during which portfolio maturity, new leases and lease modifications will cause the figures to drift. Third, the study computes leverage on a single, IFRS 16-consistent basis and does not model the many adjusted definitions that individual lenders and analysts apply, although the discussion addresses the consequences of those alternative conventions. These limitations are revisited in Chapter 6.
This chapter presents the results of applying the before-and-after method to the illustrative sample of ten UK listed retailers. It begins with the composition of the sample, then quantifies the balance-sheet impact of transition in terms of the lease liabilities and right-of-use assets recognised. It proceeds to the leverage effects, examining gearing, net debt to EBITDA and interest cover in turn, supported by firm-level tables. It then analyses the cross-sectional variation in the effect and reports the significance testing. All monetary figures are stated in millions of pounds and are illustrative.
The ten sample firms span the principal retail sub-sectors and vary considerably in scale and pre-existing leverage. Table 4.1 summarises the sample on the pre-transition (IAS 17) basis.
| Firm | Sub-sector | Equity | Net debt (IAS 17) | EBITDA (IAS 17) | Annual lease rental |
|---|---|---|---|---|---|
| R1 | Food and grocery | 3,200 | 1,100 | 1,900 | 520 |
| R2 | General merchandise | 1,800 | 600 | 950 | 430 |
| R3 | Food (discount) | 950 | 250 | 560 | 300 |
| R4 | Clothing and fashion | 720 | 180 | 410 | 240 |
| R5 | Specialist / DIY | 1,350 | 480 | 760 | 300 |
| R6 | Health and beauty | 540 | 160 | 300 | 180 |
| R7 | Department store | 430 | 300 | 220 | 160 |
| R8 | Electricals | 880 | 120 | 470 | 210 |
| R9 | Convenience / food | 2,100 | 700 | 1,150 | 360 |
| R10 | Fashion (small-cap) | 260 | 90 | 150 | 95 |
On the pre-transition basis the sample appears conservatively financed. Mean gearing is approximately 34% and the median is 33%, ranging from a lightly geared electricals retailer at 14% to a thinly capitalised department store at 70%. Mean net debt to EBITDA is about 0.6 times, and interest cover averages roughly 24 times. These figures are typical of a sector that, under IAS 17, carried the bulk of its financial obligations off balance sheet. The pre-transition picture is, in this sense, incomplete, and the purpose of the analysis is to reveal how much that picture changes once leases are recognised.
Table 4.2 reports the lease liability and right-of-use asset recognised by each firm on transition, together with the lease liability expressed as a multiple of pre-transition net debt, a measure of lease intensity.
| Firm | Lease liability recognised | Right-of-use asset | Net debt (IAS 17) | Lease liability ÷ net debt |
|---|---|---|---|---|
| R1 | 3,400 | 3,100 | 1,100 | 3.1× |
| R2 | 2,900 | 2,650 | 600 | 4.8× |
| R3 | 1,950 | 1,800 | 250 | 7.8× |
| R4 | 1,560 | 1,420 | 180 | 8.7× |
| R5 | 1,980 | 1,820 | 480 | 4.1× |
| R6 | 1,150 | 1,050 | 160 | 7.2× |
| R7 | 1,040 | 900 | 300 | 3.5× |
| R8 | 1,320 | 1,210 | 120 | 11.0× |
| R9 | 2,350 | 2,150 | 700 | 3.4× |
| R10 | 610 | 560 | 90 | 6.8× |
| Total | 18,260 | 16,660 | 3,980 | 4.6× |
The scale of the balance-sheet impact is the single most striking result. Across the sample, firms recognised aggregate lease liabilities of £18,260m against pre-existing reported net debt of only £3,980m. In other words, the lease liabilities brought onto the balance sheet were, in aggregate, some 4.6 times the retailers’ previously reported borrowings. Expressed differently, after transition approximately 82% of the sample’s total net debt consisted of lease liabilities that had previously been invisible on the face of the statements. This finding directly answers RQ1 and confirms the sector’s status, identified in the literature (International Accounting Standards Board, 2016b; Goodacre, 2003), as among the most lease-intensive. The lease-intensity multiple ranges from 3.1 times for the large grocer R1, which carries meaningful conventional borrowings, to 11.0 times for the lightly borrowed but store-heavy electricals retailer R8, foreshadowing the wide cross-sectional variation in the leverage effect.
The right-of-use asset recognised is in each case slightly smaller than the lease liability, reflecting the modified retrospective transition approach in which previously accrued lease payments and the absence of certain prepayments cause the asset to be measured below the liability. The aggregate difference of £1,600m, net of deferred tax at 19%, reduces opening retained earnings by approximately £1,296m across the sample. This equity reduction, though small relative to the liability recognised, compounds the gearing effect because it lowers the denominator of the gearing ratio at the same time as the numerator rises.
Table 4.3 presents gearing, measured as net debt to equity, on both bases, together with the change. Post-transition net debt includes the lease liability, and post-transition equity reflects the transition adjustment described above.
| Firm | Gearing (IAS 17) | Gearing (IFRS 16) | Change (percentage points) |
|---|---|---|---|
| R1 | 34.4% | 152.2% | +117.8 |
| R2 | 33.3% | 219.2% | +185.9 |
| R3 | 26.3% | 265.7% | +239.4 |
| R4 | 25.0% | 286.7% | +261.7 |
| R5 | 35.6% | 201.6% | +166.0 |
| R6 | 29.6% | 285.4% | +255.8 |
| R7 | 69.8% | 422.7% | +352.9 |
| R8 | 13.6% | 182.0% | +168.4 |
| R9 | 33.3% | 157.4% | +124.1 |
| R10 | 34.6% | 319.6% | +285.0 |
| Mean | 33.6% | 249.3% | +215.7 |
Gearing rose for every firm in the sample, confirming the direction predicted by the literature and answering the first part of RQ2. The mean gearing ratio increased from 33.6% to 249.3%, an average rise of 216 percentage points, so that the typical sample firm moved from a position that would be regarded as conservatively financed to one that, read without context, would appear highly leveraged. The median rose comparably, from 33.3% to 242.5%, indicating that the mean is not merely the product of outliers. The magnitude of the increase is closely related to lease intensity: the largest rise, 353 percentage points for the department store R7, combines a high pre-existing gearing with a substantial lease portfolio, while the smallest rises occur for the large grocers R1 and R9, whose sizeable equity bases absorb the lease liability more readily. It is worth emphasising that this transformation in reported gearing occurred with no change whatsoever in the firms’ contractual obligations, cash flows or commercial position; it is entirely a consequence of the change in measurement.
The second and third ratios behave differently from gearing because their denominators also respond to the standard. Table 4.4 reports net debt to EBITDA and interest cover on both bases. Post-transition EBITDA includes the add-back of the former rental charge, and post-transition finance costs include the lease finance charge.
| Firm | Net debt / EBITDA (IAS 17) | Net debt / EBITDA (IFRS 16) | Interest cover (IAS 17) | Interest cover (IFRS 16) |
|---|---|---|---|---|
| R1 | 0.58× | 1.86× | 26.7× | 6.4× |
| R2 | 0.63× | 2.54× | 20.0× | 4.1× |
| R3 | 0.45× | 2.56× | 28.3× | 4.0× |
| R4 | 0.44× | 2.68× | 27.8× | 3.8× |
| R5 | 0.63× | 2.32× | 21.4× | 4.7× |
| R6 | 0.53× | 2.73× | 22.5× | 3.6× |
| R7 | 1.36× | 3.53× | 7.3× | 2.4× |
| R8 | 0.26× | 2.12× | 50.0× | 5.1× |
| R9 | 0.61× | 2.02× | 22.5× | 5.6× |
| R10 | 0.60× | 2.86× | 17.0× | 3.3× |
| Mean | 0.61× | 2.52× | 24.4× | 4.3× |
Net debt to EBITDA rose for every firm, with the mean increasing from 0.61 times to 2.52 times and the median from 0.59 times to 2.55 times. This result is particularly instructive because it demonstrates that the numerator effect dominates the denominator effect. Although EBITDA itself increased substantially on transition, by an average of around 50% as rental charges moved below the EBITDA line, the addition of the lease liability to net debt outweighed that increase, so the ratio more than quadrupled on average. For a covenant written in terms of net debt to EBITDA without a lease carve-out, this is a material deterioration driven entirely by the accounting change. The department store R7, already the most indebted firm on the pre-transition basis, reaches 3.53 times, approaching levels at which conventional covenant thresholds of, say, three times would be breached.
Interest cover deteriorated most dramatically of the three ratios, answering the remainder of RQ2. The mean fell from 24.4 times to 4.3 times, and the median from 22.5 times to 4.05 times, as the lease finance charge enlarged the denominator. For the most lease-intensive firms the fall is stark: R8, which enjoyed interest cover of 50 times under IAS 17 on the strength of minimal conventional borrowings, sees that cover collapse to 5.1 times once lease finance charges are recognised, and R7 falls to just 2.4 times. The improvement in operating profit arising from the lower depreciation of the right-of-use asset relative to the former rental is far too small to offset the growth in finance costs. These results illustrate why coverage ratios are the most sensitive of the conventional leverage metrics to IFRS 16 and why they demand the most careful handling in covenant and credit analysis.
Although leverage is the focus of the study, the income-statement effect of the standard is important both in its own right and because it shapes the net debt to EBITDA ratio. Table 4.5 reports EBITDA on both bases, isolating the add-back of the former rental charge that no longer appears as an operating expense.
| Firm | EBITDA (IAS 17) | Rental add-back | EBITDA (IFRS 16) | Uplift |
|---|---|---|---|---|
| R1 | 1,900 | 520 | 2,420 | +27.4% |
| R2 | 950 | 430 | 1,380 | +45.3% |
| R3 | 560 | 300 | 860 | +53.6% |
| R4 | 410 | 240 | 650 | +58.5% |
| R5 | 760 | 300 | 1,060 | +39.5% |
| R6 | 300 | 180 | 480 | +60.0% |
| R7 | 220 | 160 | 380 | +72.7% |
| R8 | 470 | 210 | 680 | +44.7% |
| R9 | 1,150 | 360 | 1,510 | +31.3% |
| R10 | 150 | 95 | 245 | +63.3% |
| Total / mean | 6,870 | 2,795 | 9,665 | +49.6% |
EBITDA rose for every firm, by a mean of 49.6% and in aggregate by 40.7%, with the largest proportional uplifts recorded by the most lease-intensive firms R6, R7 and R10. This uplift is purely presentational: it arises because the rental charge, previously an operating expense above the EBITDA line, is now represented below that line as depreciation and finance cost. No additional cash is generated. The effect is nonetheless consequential, because EBITDA is a headline performance measure and the basis of many valuation multiples; an unwary comparison of a retailer’s pre-2019 and post-2019 EBITDA would overstate the apparent improvement in trading. Operating profit also rose, though far more modestly, by about 22% in aggregate, because the straight-line depreciation of the right-of-use asset is lower than the former rental by approximately the finance element. Return on capital employed, by contrast, deteriorated, because the grossing-up of the asset base by the right-of-use asset far outweighs the modest increase in operating profit; the mechanical inflation of the denominator dominates. The income-statement effects therefore reinforce the central theme that IFRS 16 reshapes reported performance and position without altering the underlying economics, and they explain why the net debt to EBITDA ratio, examined above, rose by less in proportional terms than gearing despite the identical lease liability.
Because the recognised lease liability is the present value of the future payments, its magnitude, and hence the leverage effect, depends on the discount rate applied. To gauge the sensitivity, the single illustrative store lease introduced in Chapter 3, with annual payments of £1,000,000 over ten years, is revalued at incremental borrowing rates of 3%, 5% and 7%. Table 4.6 reports the result.
| Discount rate | Ten-year annuity factor | Lease liability (£000) | Relative to 5% case |
|---|---|---|---|
| 3% | 8.5302 | 8,530 | +10.5% |
| 5% (base) | 7.7217 | 7,722 | — |
| 7% | 7.0236 | 7,024 | −9.0% |
Lowering the discount rate from 5% to 3% increases the recognised liability by around a tenth, while raising it to 7% reduces the liability by around a tenth. The sensitivity is greater for longer-dated leases, since the present value of distant payments responds more strongly to the discount rate; retail property leases, which can run for a decade or more, sit firmly in this sensitive region. Two implications follow. First, the leverage effect estimated for the sample is itself conditional on the assumed 5% rate, and a sample of retailers applying materially different incremental borrowing rates would show a correspondingly different distribution of lease liabilities and gearing. Second, and more importantly for users, the reliance on a judgemental incremental borrowing rate introduces a source of cross-firm incomparability into the very figures that IFRS 16 was intended to make more comparable: two retailers with identical lease commitments but different assumed borrowing rates will report different lease liabilities and different gearing. This is a subtle but genuine limitation of the recognition model and reinforces the need, discussed in Chapter 5, for users to read the leverage figures with an understanding of the assumptions beneath them.
The firm-level results reveal substantial heterogeneity in the magnitude of the leverage effect, addressing RQ3. The common thread is lease intensity. Firms whose lease liabilities are large relative to their pre-existing net debt and equity experience the greatest proportional increases in gearing and net debt to EBITDA and the sharpest falls in interest cover. The clearest illustration is the contrast between the large grocers and the smaller, store-heavy specialists. R1 and R9, the two largest firms, hold substantial equity and conventional borrowings, so that although their lease liabilities are large in absolute terms they are only three to three-and-a-half times pre-existing net debt; their gearing rises by around 120 percentage points, the smallest increases in the sample. By contrast, R8, whose lease liability is eleven times its modest conventional borrowings, and R7, whose thin equity amplifies every effect, exhibit the most extreme transformations.
Summary descriptive statistics across the sample are collected in Table 4.7, which provides a concise answer to the overall measurement question posed by RQ1 and RQ2.
| Ratio and basis | Mean | Median | Minimum | Maximum |
|---|---|---|---|---|
| Gearing — IAS 17 | 33.6% | 33.3% | 13.6% | 69.8% |
| Gearing — IFRS 16 | 249.3% | 242.5% | 152.2% | 422.7% |
| Net debt / EBITDA — IAS 17 | 0.61× | 0.59× | 0.26× | 1.36× |
| Net debt / EBITDA — IFRS 16 | 2.52× | 2.55× | 1.86× | 3.53× |
| Interest cover — IAS 17 | 24.4× | 22.5× | 7.3× | 50.0× |
| Interest cover — IFRS 16 | 4.3× | 4.1× | 2.4× | 6.4× |
The table makes plain that the effect is both large and pervasive. On every metric, on both the mean and the median, and across the full range from minimum to maximum, the IFRS 16 basis shows materially higher leverage and lower coverage than the IAS 17 basis. There is no firm in the sample for which the standard left reported leverage broadly unchanged.
Although the direction of the effect is unambiguous from inspection, its statistical significance was formally assessed to satisfy the requirements of the deductive design. A paired-samples t-test was applied to the firm-level change in gearing. The mean change was 215.7 percentage points with a sample standard deviation of 75.6 percentage points across the ten firms, giving a standard error of 23.9 percentage points and a test statistic of t(9) = 9.02. This exceeds the critical value at the 0.1% level, so the null hypothesis of no change is rejected with p < 0.001. The non-parametric Wilcoxon signed-rank test, used as a robustness check appropriate to the small sample, likewise returned a significant result, since all ten firms moved in the same direction and the signed-rank statistic attains its maximum. Equivalent tests on the change in net debt to EBITDA and in interest cover were also significant at conventional levels, reflecting the fact that every firm moved in the predicted direction on every metric. The statistical evidence therefore corroborates the descriptive finding: the adoption of IFRS 16 produced a significant increase in the reported leverage, and a significant decrease in the reported coverage, of the sample firms.
The findings can be summarised in four propositions. First, the balance-sheet impact was very large, with lease liabilities averaging several times pre-existing net debt and accounting for the great majority of post-transition net debt. Second, gearing, net debt to EBITDA and interest cover all moved markedly and in the directions predicted by theory, with gearing and net debt to EBITDA rising and interest cover falling. Third, the magnitude of the effect varied widely across firms and was governed principally by lease intensity, amplified where equity was thin. Fourth, the changes were statistically significant. These results provide the empirical basis for the interpretive discussion that follows.
This chapter interprets the findings of Chapter 4 in the light of the literature and the theoretical framework developed in Chapter 2. It considers what the measured leverage shift means, relates it to prior evidence, draws out its theoretical significance, and examines its economic consequences for the users of retailer financial statements. Throughout, the central tension identified in the introduction recurs: IFRS 16 changed the reported numbers substantially while leaving the underlying economics of the firms unchanged.
The most important interpretive point is that the scale of the leverage shift reflects the scale of what was previously hidden rather than any new obligation. The sample firms did not become more indebted on transition; they had always been committed to the lease payments that the lease liability now capitalises. What changed is the visibility of those commitments on the face of the balance sheet. The finding that lease liabilities amounted, in aggregate, to more than four times pre-existing reported net debt is therefore best read as a measure of the inadequacy of the former off-balance-sheet treatment for this sector. Under IAS 17, a user relying on the face of the balance sheet would have seen only a small fraction of the retailers’ true financial obligations. This vindicates the long-standing criticism in the literature (Imhoff, Lipe and Wright, 1991; Beattie, Edwards and Goodacre, 1998; Goodacre, 2003) that operating-lease accounting materially understated the indebtedness of lease-intensive firms.
At the same time, the magnitude of the reported change creates a risk of misinterpretation in the opposite direction. A user who compares a retailer’s pre-2019 gearing of around 34% with its post-2019 gearing of around 249% without understanding the cause might wrongly conclude that the firm had undergone a dramatic deterioration in its financial position. The finding therefore carries a clear analytical warning: time-series comparisons that straddle the transition date, and peer comparisons between firms that adopted at different times or that lease to different extents, are liable to be seriously misleading unless the analyst adjusts for the accounting change. This echoes the caution in the methodological literature that the IFRS 16 effect must be understood metric by metric and in the context of each firm’s lease intensity (Morales-Díaz and Zamora-Ramírez, 2018).
The contrasting behaviour of the three ratios is itself informative. Gearing rose the most in proportional terms because both its numerator rose, through the lease liability, and its denominator fell slightly, through the transition adjustment to equity. Net debt to EBITDA rose substantially but less dramatically than gearing, because although the numerator rose with the lease liability, the denominator also rose as rentals left operating expenses; the finding that the ratio nonetheless more than quadrupled confirms that, for lease-intensive retailers, the numerator effect overwhelms the EBITDA uplift. Interest cover fell the most sharply, because its denominator, finance costs, is the item most directly enlarged by the lease finance charge, while its numerator, operating profit, improves only marginally.
This differential behaviour matters because the three ratios are used for different purposes and are embedded in different covenants. A lender whose covenant is framed in terms of interest cover will perceive a far more alarming change than one whose covenant is framed in terms of net debt to EBITDA, even though both changes arise from the same transition. The finding reinforces the point made by Morales-Díaz and Zamora-Ramírez (2018) that no single summary of the IFRS 16 effect is adequate and that the choice of metric materially shapes the apparent severity of the change. It also highlights a subtlety that the EBITDA uplift can partially mask the leverage effect in the one widely used metric, net debt to EBITDA, where EBITDA appears in the denominator, potentially lulling users who focus on that ratio alone into underestimating the change in the firm’s reported indebtedness.
The findings speak directly to the theoretical perspectives set out in Chapter 2. From the standpoint of agency theory, IFRS 16 is an information-improving reform: by recognising lease obligations, it narrows the information asymmetry between managers and the external users who rely on the financial statements, reducing the scope for a misleadingly conservative presentation of indebtedness and, in principle, lowering monitoring costs (Lim, Mann and Mihov, 2017). The sheer scale of the previously off-balance-sheet obligations revealed by the analysis suggests that the information gain was substantial for this sector.
From the standpoint of the debt-covenant hypothesis within positive accounting theory (Watts and Zimmerman, 1990), the findings identify a clear channel through which a measurement-only change can have real consequences. Where covenants are written on reported figures without a lease carve-out, the mechanical increase in reported leverage erodes covenant headroom and could, in principle, trigger technical breach without any deterioration in the borrower’s cash-generative capacity or economic position. The prediction of the hypothesis, that firms and lenders will respond to this by renegotiating or redefining covenants, is consistent with the practical observation that many loan agreements entered into around the transition adopted frozen-GAAP or pre-IFRS 16 definitions of leverage precisely to neutralise the effect. The recognition-versus-disclosure debate is also engaged: if, as signalling theory in its strong form would suggest, all users had already fully adjusted for note-disclosed lease commitments, the recognition of those commitments would be of no consequence. The evidence from the value-relevance literature that operating-lease liabilities were only partially priced (Giner and Pardo, 2018), together with the practical steps taken to insulate covenants from the change, suggests that adjustment was in fact incomplete and that recognition was not merely cosmetic.
The economic consequences of the leverage shift fall on several groups of users. For lenders and those who design covenants, the principal consequence is the need to decide whether to measure leverage on an IFRS 16 basis or on a frozen pre-IFRS 16 basis, and to set thresholds accordingly. The finding that net debt to EBITDA for the most indebted sample firm reaches 3.5 times, a level at which a conventional three-times covenant would be breached, shows that the choice is not academic: a failure to recalibrate could convert a performing loan into a technical default. For credit-rating agencies, many of which had long capitalised operating leases in their own adjusted metrics, the standard brings reported figures closer to the agencies’ adjusted view and may reduce the size of the analytical adjustment required, although the agencies’ treatment and the accounting treatment are not identical.
For equity analysts and investors, the consequence is the need to recalibrate sector benchmarks and to exercise care in historical comparison. A gearing ratio that would have signalled distress under the old regime may be unremarkable under the new one, and benchmarks must shift accordingly. For the firms themselves and their boards, the standard affects the presentation of the capital structure, the framing of financial policy and communication with the market, and potentially the design of management incentives where these are linked to leverage or coverage targets. In each case the underlying theme is the same: a change in measurement, if not understood, can distort decisions that depend on the measured numbers, even though the economic position those numbers are meant to represent has not changed.
A concrete illustration drawn from the sample makes the covenant point vivid. Suppose that the department-store operator R7 had in place a term loan with two maintenance covenants typical of the sector before the standard took effect: a net debt to EBITDA ceiling of 3.0 times and a minimum interest-cover ratio of 4.0 times. On the IAS 17 basis R7 complied comfortably, with net debt to EBITDA of 1.36 times and interest cover of 7.3 times. On the IFRS 16 basis, and with no change whatsoever in its trading, its cash flows or its lease contracts, R7 reports net debt to EBITDA of 3.53 times and interest cover of 2.4 times, breaching both covenants. Absent a lease carve-out or a renegotiated definition, the borrower would be in technical default purely as a consequence of an accounting change. This hypothetical is not far-fetched; it is the natural consequence of covenants written on reported figures and is precisely the outcome that the debt-covenant hypothesis predicts and that the widespread adoption of frozen-GAAP covenant definitions around the transition was designed to avoid. It demonstrates in the sharpest possible terms why the findings of this study matter beyond the reporting function and reach into the financing arrangements on which retailers depend.
The findings are broadly consistent with the prior literature in direction and, allowing for the sector focus, in magnitude. The increase in gearing, the rise in net debt to EBITDA, the fall in interest cover and the uplift in EBITDA all match the pattern established by the constructive capitalisation studies (Beattie, Edwards and Goodacre, 1998; Fülbier, Silva and Pferdehirt, 2008; Fitó, Moya and Orgaz, 2013) and by the post-adoption and simulation studies (Öztürk and Serçemeli, 2016; Magli, Nobolo and Ogliari, 2018; Morales-Díaz and Zamora-Ramírez, 2018). The magnitudes observed here sit at the upper end of the range reported in cross-sectoral studies, which is to be expected given that those studies dilute the retail effect with asset-light sectors, whereas the present study isolates retail. The finding is also consistent with the sector-specific work of Goodacre (2003) and Sari, Altintas and Tas (2016), which identified retail as among the most affected industries. The contribution of the present study is not to overturn this consensus but to demonstrate, through a transparent before-and-after design on a focused UK retail sample, just how large and how uneven the effect is within the single most affected sector, and to draw out the interpretive and practical consequences in a structured way.
A further consequence of the findings concerns the international comparability of retailer financial statements. As noted in Chapter 2, the Board and the United States standard-setter did not fully converge, so that IFRS 16 applies a single on-balance-sheet model while ASC 842 retains a dual model with different income-statement presentation for operating leases. The implication for the metrics examined here is significant. A UK listed retailer reporting under IFRS and an otherwise identical retailer reporting under US GAAP would recognise broadly similar lease liabilities and therefore comparable gearing, but their net debt to EBITDA and interest cover would differ, because under the US operating-lease model the lease expense remains a single operating charge rather than being split into depreciation and interest. The EBITDA uplift and the interest-cover deterioration documented in this study are, in part, artefacts of the specific presentation chosen by IFRS 16, and they would not appear in the same form for a US operating lease. Analysts comparing retailers across the two regimes must therefore adjust not only for differences in lease intensity but for the differing geography of the lease expense within the income statement. The residual divergence between the two frameworks thus qualifies the comparability gains that recognition was intended to deliver, and it is a reminder that the apparent severity of the leverage and coverage effects is conditioned by accounting presentation as well as by economic substance.
Finally, the findings invite reflection on the limits of ratio-based analysis itself. The study has shown that three widely used ratios move sharply on transition, yet the cash flows available to service obligations are unchanged. This exposes a weakness in any analysis that relies on balance-sheet and income-statement ratios without reference to cash. A cash-based measure, such as the ratio of operating cash flow to total contractual commitments, would have been largely unaffected by the transition, because the lease payments themselves did not change; indeed, one effect of IFRS 16 is to reclassify the principal element of lease payments from operating to financing activities in the cash flow statement, improving reported operating cash flow without any change in total cash generated. The lesson for users is that the leverage and coverage ratios examined here are useful but incomplete signals, and that a rounded assessment of a retailer’s financial resilience should triangulate them against cash-based measures and against the maturity profile of the lease and debt obligations. This does not diminish the importance of the ratio effects, which remain central to covenant compliance and to market perception, but it places them in a broader analytical context and underscores that the standard changed the map rather than the territory.
This final chapter draws the dissertation to a close. It revisits the research objectives and shows how each has been met, states the study’s contributions, sets out its practical implications and recommendations, acknowledges its limitations, and proposes directions for future research.
The dissertation set out to evaluate the effect of IFRS 16 adoption on the reported leverage of UK listed retailers and to interpret its significance for users. The first objective, to review the literature and identify the mechanisms through which lease capitalisation affects reported position, was met in Chapter 2, which traced the transition from IAS 17 to IFRS 16, synthesised the constructive capitalisation and post-adoption literature, and developed a theoretical framework. The second objective, to quantify the recognised lease liabilities and right-of-use assets and the resulting ratio changes, was met in Chapter 4, which found that lease liabilities averaged several times pre-existing net debt and that gearing, net debt to EBITDA and interest cover all moved substantially and significantly. The third objective, to analyse cross-sectional variation and test significance, was met through the firm-level analysis and the paired-samples testing, which showed that the effect was governed by lease intensity and was statistically significant. The fourth objective, to interpret the findings and draw out implications, was met in Chapter 5 and is developed into recommendations below.
Three conclusions stand out. First, the adoption of IFRS 16 transformed the reported leverage of UK listed retailers, increasing mean gearing from around 34% to around 249%, raising mean net debt to EBITDA from about 0.6 to about 2.5 times, and reducing mean interest cover from around 24 to around 4 times, with lease liabilities accounting for the large majority of post-transition net debt. Second, this transformation was a change in measurement, not in substance: the firms’ contractual commitments, cash flows and economic position were unchanged, and the standard simply brought onto the balance sheet obligations that had always existed. Third, the effect was large but highly uneven, driven by lease intensity and amplified where equity was thin, so that no single summary statistic adequately captures its impact across firms. Together these conclusions confirm that, for the retail sector, IFRS 16 was among the most consequential reporting changes of recent years, not because it altered reality but because it altered how faithfully the financial statements represent that reality.
The study yields several practical recommendations. For lenders and covenant designers, it is recommended that leverage and coverage covenants be reviewed and, where appropriate, defined on a consistent basis, whether frozen pre-IFRS 16 or fully IFRS 16, with thresholds recalibrated so that the accounting change does not of itself create covenant pressure unrelated to borrower performance. For analysts and investors, it is recommended that sector benchmarks for gearing, net debt to EBITDA and interest cover be reset to reflect the post-IFRS 16 basis, and that comparisons spanning the transition be made only after adjustment, with particular attention to the fact that the EBITDA uplift can mask the leverage effect in the net debt to EBITDA ratio. For preparers, it is recommended that transition be accompanied by clear disclosure of the quantitative effect on key ratios and by transparent explanation that the change is one of measurement, so that users are not misled. For standard-setters and regulators, the findings support the continued monitoring of the comparability and usefulness of post-transition reporting, and reinforce the case, made in the Board’s own effects analysis, that recognition conveys information that disclosure alone did not fully deliver (International Accounting Standards Board, 2016b).
The study contributes in three ways. Methodologically, it offers a transparent, fully reproducible before-and-after demonstration of the IFRS 16 leverage effect, in which every post-transition figure follows deterministically from stated inputs. Empirically, it provides a focused, sector-specific picture of the effect for UK listed retailers, complementing the cross-sectoral and pre-adoption emphasis of much prior work and showing that the retail effect sits at the upper end of the reported range. Interpretively, it connects the measured change to accounting theory and to practical decision-making, articulating clearly why a measurement-only change can nonetheless have real consequences through covenants, benchmarks and the behaviour of users who do not fully adjust.
The limitations of the study should be restated so that its conclusions are read appropriately. The use of an illustrative, representative sample rather than audited data for named firms limits the external validity of the precise magnitudes, although the direction and broad scale of the effect are consistent with the wider literature. The analysis captures the immediate transition effect and does not follow the subsequent evolution of the ratios as portfolios mature and new leases are signed. It examines three leverage and coverage ratios rather than the full range of metrics a user might consider, and it computes leverage on a single IFRS 16-consistent basis rather than modelling the many adjusted definitions used in practice, though the discussion addresses the latter. Finally, the study is confined to lessee accounting in a single sector and jurisdiction and does not consider lessor accounting or sectors other than retail.
These limitations point to several avenues for future work. A natural extension would apply the same before-and-after framework to the actual audited transition disclosures of a full census of named UK listed retailers, subject to the variability of those disclosures, to replace the illustrative magnitudes with observed ones. A longitudinal study could track the evolution of the ratios in the years following transition to separate the accounting-driven change from subsequent genuine changes in indebtedness. Comparative work could extend the analysis to other lease-intensive sectors, such as travel, leisure and transport, or to other jurisdictions, to test the generality of the retail findings. Market-based research could examine whether, and how quickly, equity and credit markets repriced retailers around the transition, directly testing the recognition-versus-disclosure question that this study addresses only through interpretation. Finally, research into covenant design could investigate how lenders and borrowers actually responded to the standard and whether the frozen-GAAP approach has become the norm. Each of these would build on the foundation that this dissertation has laid.
IFRS 16 offers a rare natural experiment in which the way an obligation is measured changed while the obligation itself did not. For UK listed retailers, the result was a dramatic increase in reported leverage that revealed, rather than created, the true weight of their lease commitments. The central lesson of this dissertation is that the users of financial statements must distinguish carefully between changes in reported numbers and changes in economic reality, and must recalibrate their benchmarks, covenants and comparisons accordingly. Properly understood, the standard improves the faithfulness with which the financial statements represent the financial position of lease-intensive firms; misunderstood, it is a trap for the unwary analyst. This study has sought to illuminate the difference.
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