IFRS 16 has drastically altered the way companies must calculate and report their lease liabilities. Financial Director explores the new reporting standard and what finance directors must do in order to meet the new compliance obligations.
Leasing is absolutely critical to the success of businesses across a variety of sectors. Retailers, telecoms companies, property firms, logistics and professional services providers are all heavily reliant upon leasing as a means to utilise business critical assets without incurring enormous cash outflows. On the flip side, the process enables lessees to mitigate inherent threats of residual value risk and obsolescence – which is why it’s little wonder the global leasing industry has charted phenomenal growth over the course of the last decade.
According to the White Clarke Group’s Global Leasing Report 2,019, the world’s top 50 leasing markets have seen business volumes increase by 16.6% year-over-year. Surges in demand have grown leasing transaction vol the International Accounting Standards Board (IASB) announced its intention to implement a new financial reporting standard in 2010 that will force businesses to be more open about their leasing obligations and how those obligations are subsequently reported. That new standard, IFRS 16, came into effect on 1 January 2019 – and so financial directors are now in a position in which they must vastly accelerate the compliance process in order to meet the new accounting requirements.
Fortunately, IFRS 16 provides a relatively straightforward blueprint for organisations on how to record and report both leasing transactions and obligations where payments and incentives are concerned.
What is IFRS 16 and how does it impact leases?
Before delving into how IFRS 16 actually impacts accounting and reporting, it’s worth pointing out that the scope of the standard is actually quite similar to IAS 17. IFRS 16 generally covers all contracts that incorporate the right to utilise an asset for a defined period of time in exchange for consideration – although there are several notable exemptions like the licensing of most intellectual property, leases on biological assets, service concession agreements and an optional scope exemption for lessees of intangible assets.
But for those leases that IFRS 16 does cover, the standard has essentially just introduced the requirement for lessees to include leases on their balance sheets that may have previously been treated as operating leases and consequently tallied as an in-year expense in the company’s profit and loss statement.
Prior to the introduction of IFRS 16 in January 2019, leases were treated in one of two ways under IFRS and UK GAAP: depending upon the balance of risk and reward of the underlying asset under contract, a lease would either be classed as a financial lease or an operating lease.
Under previous practice, a huge chunk of lease transactions were being chalked up as operating leases so that no liability would appear on the occupier’s balance sheet. Instead, only in-year lease costs would be recognised on an income statement – potentially enabling firms to misrepresent their actual liabilities to would-be investors, international regulators or existing stakeholders.
From here on out, IFRS 16 seeks to mitigate this transparency risk by broadening out its official definition of what constitutes a lease as previously outlined in IFRIC 4 by effectively removing any and all distinction between financial leases and operating leases.
“IFRS 16 was introduced to enable a level playing field between companies that would mostly acquire assets (on balance) and companies that would mostly lease assets (off balance),” explains Casper van Leeuwen, of the European consultancy Satriun Group.
“The gearing of those companies was not sufficiently comparable in their respective IFRS financial statements. Also, the previous lease standard would open the door to financial engineering and the cosmetical presentation of gearing.”
In order to mitigate this potential threat, the new leasing standard requires all leases to be recorded on the balance sheet as liabilities at the current value of future lease payments. Lessees must also record each asset and include any rights to use that asset over a specified leasing term. In turn, lessees will appear to have bigger debt levels and will seem to be far more asset-rich.
That being said, there are two notable exemptions companies are permitted to utilise – namely short-term leasing agreements and leases for low value assets. For reference, a short-term lease has been defined within the context of IFRS 16 as any leasing agreement with a maximum terms of twelve months. Meanwhile, the IASB defines a low value asset as anything with a value of $5,000 or less when it’s new.
For reference, under IFRS 16 assets are initially measured at the amount of the lease liability with any incentives (which are payments received, reimbursements or assumptions by a lessor) subtracted. These incentives most typically take the form of an up-front cash payment to the lessee.
Notably, it doesn’t matter how many low-value leases a company has. Under the new rules, every single one of these liabilities can continue to be reported as expensed.
“These are potentially important exemptions as they will save entities from having to spend time analysing and accounting for such leases,” says Matthew Stallabrass, Corporate Audit Partner at national audit, tax, advisory and risk firm Crowe UK.
So, how must the leases that are not exempt be reported under IFRS 16?
First and foremost, the liability of each lease will need to match the initial indexation or rate linked payments, and each lease liability will need to include renewal options or break clauses. Contingent rents will not need to be reflected. IFRS 16 then dictates the liability and its corresponding asset will need to be remeasured when payments and indices change. That means most leases must now be calculated on a case-for-case basis unless the company in question has a portfolio dominated by very similar leases.
IFRS 16 poses a particularly large impact on how rent is reported – as under previous regimens rent was typically chalked up as an operating expense, and interest and depreciation were not considered when measuring EBITDA. Now, rent expenses will effectively be replaced with interest and depreciation expenses. Bearing that in mind, organisations should prepare for a material increase in reported levels of EBITDA – and FDs must prepare to capitalise all operating leases for real estate and movable assets in particular.
Finally, it’s worth pointing out that IFRS 16 will force up income statement expenses for the initial years of most lease liabilities, as the IASB has replaced a straight line rent charge with the previously mentioned interest charge on liabilities and depreciation charge on assets. This will effectively create front-loaded pattern of expense on most leases, regardless of when constant annual rentals are paid.
“This tends to result in a higher income statement charge in the early years of a lease and a lower charge in the later years of the lease than under the previous accounting,” Stallabrass says.
How should companies prepare for IFRS 16?
The January implementation of IFRS 16 shouldn’t have come as a surprise to any affected organisation or its leadership team. After all, the standard was in the pipeline for almost a decade, and all publicly traded companies reporting under IFRS are required to comply with the new standard. Likewise, all companies reporting under US GAAP have been required to comply with a pretty similar accounting policy (ASC 842) since December 2018.
Yet research indicates that a worrying proportion of firms definitely weren’t prioritising IFRS 16 compliance in the run up to the first quarter of 2019. Last March, EY conducted a survey with European banks and insurers in order to gauge progress with IFRS 16 implementation – and the results weren’t pretty. Half of all those surveyed had yet to set up a project team, only a third had conducted an impact assessment and less than a fifth had started to identify their full population of contracts.
Fast forward to December 2018, and Deloitte’s Global IFRS 16 and ASC 842 readiness survey found that almost 23% of companies had not yet started their implementation projects – while just 6% of those surveyed said they were actually fully prepared for the new standard hitting them in January.
What does adequate preparation for IFRS 16 leasing changes actually entail? Above all else, all affected companies must start prepping by assessing the impacts the standards could pose to business, placing particular focus on analysing effects on financial results, cost of implementation and any required changes to processes.
“Organisations need to start engaging with this standard if they have not already done so,” says Crowe UK’s Matthew Stallabrass.
“Firstly, they will need to identify all the leases they have entered into. They will then need to consider what exemptions they will take and their approach to transition, to ensure they have an understanding of the lease terms and have a consistent approach to making any judgements that they need to under the standard, for example over the lease term or the appropriate discount rate to use.”
One process change many FDs will need to be aware of is a fresh requirement to actually decipher and collect all of the data that’s relevant to IFRS 16 compliance. Under previous accounting requirements, lessees in many jurisdictions were not technically required to have the data to split lease and non-lease components and price various elements separately for customers. Similarly, companies will need to exercise judgement when identifying and separating components to determine observable prices.
“This change will force changes and tight coordination for lease administration, lease accounting and fixed assets,” says Sham Karim, an associate partner and co-SAP service lead at Clarkston Consulting.
“Lease administrators can no longer act independently and rely on spreadsheets to track critical dates and terms on lease contracts. Terms such as sales-based rent, common area rent, multiple renewal options, and early termination options can affect the value for real estate leases. Failure to properly account for these leases is a compliance risk that can affect the company valuation.”
In order to mitigate that risk, FDs would do well to explore software solutions capable of streamlining transition to simplify the compliance process.
Fortunately, there are plenty of reliable cloud-based solutions on the market that have been designed with IFRS 16 requirements in mind that can accommodate the consolidation of lease data and simultaneously deliver the core accounting functionality financial teams need to deliver all-encompassing and fully compliant financial statements.
Yet according to Clarkston Consulting’s Sham Karim, adequate IFRS 16 preparation at the institutional level extends beyond even the critical implement of lease accounting software.
“It’s not just about getting to a level of compliance,” he says. “But also to enabling informed decision-making in the future.”