Regulation & Standards

Preparing for IFRS 16

Published: Jul 2018
Financial data monitor

IFRS 16 is coming – and with the new accounting standards expected to bring trillions of dollars of assets onto balance sheets around the world, treasurers need to be prepared. What steps should treasurers be taking, and which challenges should they be aware of?

The new IFRS 16 lease accounting standards are due to come into force on 1st January 2019. Expected to bring over US$2.8trn of assets onto balance sheets around the world, the new rules will have a significant impact on IFRS and US GAAP reporting firms, affecting everything from financial metrics to debt covenants. So what are the implications for corporate treasurers – and what should you be doing to prepare?

Why change the rules?

In a nutshell, IFRS 16 Leases is being introduced to address criticisms of the current lease accounting requirements in IAS 17 Leases, as Victor Chan, International Director, Ernst & Young GS LLP, Professional Practice – IFRS Services group, explains. He notes that the current requirements have been criticised for failing to meet the needs of users of the financial statements – “particularly because IAS 17 does not require lessees to recognise assets and liabilities arising from operating leases”. In contrast, IFRS 16 “addresses those criticisms by requiring lessees to recognise most leases on their balance sheets and providing enhanced disclosures”.

While the new rules were published in 2016, the history of IFRS 16 dates back a number of years. “The standard was introduced as a response to the financial scandals of the early 2000s,” explains Michael Keeler, CEO of LeaseAccelerator. He says that the IASB began investigating loopholes in the accounting standards that could potentially allow for accounting fraud – and that one of the biggest loopholes discovered by the IASB was that of off-balance sheet operating leases.

“Under the old lease accounting standard, IAS 17, leases classified as operating leases (rather than finance leases) could be reported in the footnotes of financial statements,” Keeler says. “As a result, operating lease liabilities were omitted from a corporation’s total liabilities. While professional financial analysts have always had their own methods of calculating a corporation’s true liabilities, the average retail investor was typically left in the dark.”

IFRS 16 closes this loophole by eliminating the difference between operating leases and finance leases. “Now, all leases, with limited exceptions for short-term and low-value leases, will be treated as finance leases and reported on the balance sheet as a right-of-use asset and corresponding lease liability,” says Keeler.

Finance lease vs operating lease

Under IAS 17, lessees treated finance leases and operating leases differently:

  • A finance lease is one which transfers substantially the risks and rewards relating to ownership to the lessee. For example, this would include a lease in which ownership of the asset is transferred to the lessee at the end of the lease term. Under the previous rules, finance leases were recognised as a liability on the balance sheet.
  • In an operating lease, the risks and rewards remain with the lessor. Under the previous rules, operating leases had no balance sheet impact.

Under IFRS 16, both types of lease will be accounted for using a single, on-balance sheet accounting model. Lessors, however, will continue to differentiate between finance and operating leases.

The new rules do not require lessees to recognise assets and liabilities for short-term leases of 12 months or less, or for leases of low-value assets.

What’s changing?

Keeler describes IFRS 16 as “one of the biggest accounting standards changes in history”. Indeed, the IASB estimates that over US$2trn of leases will move onto the balance sheet following the changes – and that half of all listed companies currently using IAS 17 or FAS 13 will be affected by the changes.

Chan points out that when the new leases standard becomes effective, an entity’s financial statements “may look quite different”, depending on the significance of its leasing activities. Where the balance sheet is concerned, Chan explains that IFRS 16 requires lessees to recognise assets and liabilities for most leases.

“Specifically, leases are accounted for based on a ‘right-of-use model’,” he says. “The model reflects that, at the commencement date, a lessee has a financial obligation to make lease payments to the lessor for its right to use the underlying asset during the lease term.” As Chan points out, this is a significant difference from the current lease accounting requirements in IAS 17 for operating leases that are off balance sheet.

Also significant is the impact on the income statement. An Effects Analysis published by IFRS in 2016 explains that for companies with material off balance sheet leases, IFRS 16 “changes the nature of expenses related to those leases”, replacing the previous straight-line operating lease expense with a depreciation charge for the lease asset and an interest expense on the lease liability. The document explains that “Although the depreciation charge is typically even, the interest expense reduces over the life of the lease as lease payments are made,” which results in a reducing total expense as an individual lease matures.

The Effects Analysis does note that the difference in the expense profile between IFRS 16 and IAS 17 is expected to be insignificant for companies holding a portfolio of leases that start and end in different reporting periods.

Implications for treasurers

For corporate treasurers, the new standards bring a number of possible implications including the following:

  • Increased auditor scrutiny.The new rules will result in greater auditor scrutiny over companies’ leasing processes and controls, so companies will need to track their leases more closely than in the past.
  • Financial ratios.IFRS 16 is expected to impact financial ratios including the leverage ratio, return on assets, and current ratio which could impact agency ratings, existing debt covenants, and future debt arrangements. Keeler says that the effect on each company will vary – “so treasury should research and confirm how these metrics will change when the standard is implemented.”
  • Data management.Leases will need to be tracked more closely under the new rules, so robust data management will be essential.
  • Lessor relationships.Keeler also points out that treasury often takes on the role of managing lessor relationships, which will be important under the new standards as a source of lease data “that companies need to track, but may not currently have access to.” He points out that maintaining these relationships may allow companies easier access to this data in the future – “and potentially advantages in negotiation.”

Keeler adds that achieving greater visibility into companies’ leasing programmes can bring opportunities for treasurers to identify unnecessary costs. He notes that many companies have uncovered inefficiencies in their sourcing – “either from not conducting a lease versus buy analysis, or not competitively sourcing assets.” He also says that end-of-term management can be associated with inefficiencies if companies do not stop payments on leases in a timely manner.

Getting ready for the new rules

George Dessing, Senior Vice President, Treasury & Risk

As a treasurer you are responsible for daily liquidity and compliance to debt covenants, which is where IFRS 16 will have an implication. So we’re currently working on getting that secured.

IFRS 16 will also lead to certain efforts at work that will probably be demanded from your department in relation to the discount rate, for example – this is a number that probably comes from the treasury teams in order to assist the group accounting and reporting departments.

In fact, the group accounting and reporting departments are the ones who are leading this project here at Wolters Kluwer, although we do of course have a role to play. They are preparing various discussion papers and organising webinars to inform the whole group internally about the changes.

We are also seeing a new data collection effort for the different kinds of contracts, including real estate contracts as well as car leases – every car is a new contract in itself, so there are a high number of leases that will need to be evaluated. Another thing for us is looking at IT data centres and assessing whether such contracts include leases or not.

You can imagine that this is quite an undertaking – first of all getting the information from your business, but also the interactions with auditors, rating agencies and banks. Luckily we have acquired our own software provider, Tagetik, a leading global provider of corporate performance management software and services, which can help organisations get their lease requirements into their systems more effectively. So it’s a great opportunity to use our own products.

As it relates to liquidity, I would say it’s better to arrange this over the summer – don’t wait until the moment when you’re actually in need of your credit facility, but do it right now while it’s still relatively early days.

What should treasurers be doing?

Naturally, the first step for treasurers is to understand the requirements under the new leases standards. “Compared with the existing accounting standard on leases, there is detailed guidance under IFRS 16 on the definition of a lease, identifying and separating lease and non-lease components, recognition and measurement of lease liability, and the right-of-use asset on initial and subsequent accounting, as well as presentation and disclosure requirements,” says Chan.

“Achieving greater visibility into companies’ leasing programmes can bring opportunities for treasurers to identify unnecessary costs.”

He adds that the second step should be to evaluate how the new leases standard would impact the financial statements both of the entity and of its peers, including the impact on financial ratios and credit profile. “Corporate treasurers also need to ensure that banks and other lenders understand the impact of IFRS 16,” he adds, pointing out that it may be necessary to negotiate revised covenants with lenders if the impact from the implementation of IFRS 16 will be significant.

The final step, Chan says, should be to evaluate how the new leases standard would impact the financial statements of the entity’s customers, and to update the entity’s model and process for evaluating the creditworthiness of its customers.

Overcoming the challenges

Treasurers should be aware of the challenges that may arise while adopting the new standard. Chan says that implementing IFRS 16 may require a closer look at the new standard’s transition provisions. “For example, the standard allows for transition fully retrospectively or using a modified retrospective approach (with various practical expedients) that does not recast prior years,” he explains. “Therefore, comparing financial statements may require carefully considering the transition-related disclosures to understand the impact of the new leases standard across a sector.”

Data capture

Keeler observes that data capture is considered to be the largest challenge, noting that corporations will need to capture up to 100 data fields per lease, including information on payments, expenses and end-of-term options.

This may be not be a straightforward exercise, as Keeler explains: “At many large organisations, this data is scattered around systems, spreadsheets, and file cabinets in different business units and cost centres around the world,” he says. “Some of the information may not even exist in the corporation’s records.”

“Corporate treasurers also need to ensure that banks and other lenders understand the impact of IFRS 16.”

As a result, Keeler says that the project team is unlikely to focus on establishing long-term processes or controls, such as a lease versus buy analysis, or on optimising the use of capital and maintaining lessor relationships. “It will be up to treasury to explain the importance of these policies to the leasing programme and the company as a whole,” he notes.

According to Keeler, this could include pointing out that a lease versus buy analysis control “not only helps optimise the use of capital, but also serves as a data capture point which can be used to prove completeness of lease data in an audit”.

Positive lessor relationships

Finally, maintaining positive relationships with lessors can provide another way of tracking down lease data. Whereas many companies do not have access to all the data fields they need to properly complete the accounting under the new standard, Keeler points out that lessors “have built their business off tracking this information”. He adds, “having a strong relationship with the lessors will allow the treasury group to reach out, should there be a question about a lease or a missing data field.”

Taking action

Where specific actions are concerned, Keeler suggests a number of steps that corporate treasurers should take in the time leading up to the implementation deadline:

  1. Help accounting develop a methodology for determining the Incremental borrowing rate or discount rate to use for calculating the present value of the lease payments.
  2. Assist accounting with capturing key financial variables, including Weighted Average Cost of Capital (WACC).
  3. Share the information that treasury has on file about the lease portfolio, including which assets are leases, the lessors, and the asset owners.
  4. Leverage relationships with leasing companies to get the latest copies of leases or other critical data.
  5. Advise on long-term processes, policies, and controls for the future state design of the leasing programme:
    1. Establish sourcing policies to optimise capital use in the leasing programme. One control could be requiring a lease versus buy analysis for every asset request to ensure that the best acquisition decision is made.
    2. Develop long-term lessor relationships. As the leasing process becomes more visible, relationships with a company’s vendors and landlords will become more important. Strong relationships with lessors will give the company advantages in the sourcing and negotiation processes for equipment and real estate assets.
    3. Keep financial metrics up-to-date. Treasury can establish an internal process for their organisation to ensure that they keep financial metrics relevant to the leasing programme up-to-date in the organisation’s lease administration software. These data points include the company’s incremental borrowing rate and current market rates.

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