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07/04/2018

CALL TO ACTION: IFRS 16 – LEASE ACCOUNTING, SIA PARTNERS’ INTERPRETATION & RECOMMENDATIONS

The IFRS 16 Standard has been published by the IASB (International Accounting Standards Board) in January 2016 and will replace IAS 17 – and related norms – as soon as January 2019. It will allow more transparency in companies’ financial statements. According to the IASB, more than US$3 Trillion of Off Balance Sheet lease commitments were identified in 2014 (listed companies in IFRS/US GAAP only). As illustrated by recent bankruptcy examples in the retail industry – Borders in the USA in 2011 or Clinton Cards, HMV & Woolworth in the UK – all these companies had an off-balance-sheet-lease-to-debt ratio between 7 & 11.

Hence, this new standard proposes a complete model to identify the leasing contracts, and their accounting treatments, for lessors and lessees. IFRS 16 applies a control model to the identification of leases, distinguishing between leases and service contracts, depending on whether or not there is an identified asset controlled by the customer (lessee).

In this article, Sia Partners will introduce you the new norm and the changes induced before explaining the main impacts expected on key financial ratios, and challenges for your organization. Then we will walk you through the best practices as well as our recommendations – full or modified retroactive application, depending on your firm’s lease accounting maturity and readiness for change.

Decoding IFRS 16

IFRS 16 provides a new definition of a leasing contract (including operational leases) and redefines the lines between a leasing contract and a service contract. It defines a new accounting model in which all leasing contracts shall be included in the balance sheet, and almost all of them shall be treated as current finance leases.

The lessees have the option, but not the obligation, to apply this new standard to the leasing contracts on intangible assets (other than licenses). Still, there are some exemptions: for contracts that are part of a specific standard (mining, intellectual property license, ...), short-term contracts (<12months), small contracts (<5 000€).

IFRS 16 defines a lease as a contract or part of a contract that gives the right to use an asset during a given period of time in exchange of a compensation. The identification and collection of exhaustive lease data is a key element in the accurate implementation of IFRS 16 in the organization. It follows the herein below logic:

Logic tree: Determining whether a contract contains a lease

Lessees Lease Accounting

As of today, there is a difference between a finance lease and an operating lease. The former has to be acknowledged in the company’s balance sheet whereas the latter does not. The recognition of such leases expenses is done in operating expenses.

Lessees accounting model, in a nutshell

IFRS 16 will require the recognition of assets and liabilities for all leases with the following exemption:

  • Contracts that are part of a specific standard (mining, intellectual property license, ...)
  • Short-term leases (<12 months)
  • Leased asset of low value (<5000€).

The initial measurement of the lease liability will be the value of payments for the right to use of the underlying asset that are not paid at the commencement date.

Subsequent measurement rules:

  • P&L: recognize interest expense on the lease liability and depreciation on the right of use asset
  • Balance Sheet: re-measure the carrying amount at year end to reflect the interest and repayment of principal

Impact of IFRS 16 on Key Financial Ratios  

The implementation of IFRS 16 is expected to have a major impact on several of the key financial ratios companies use in their reporting:

  • Since previously off balance-sheet assets will be recognized in debt with tangible/intangible asset counterparties, the net debt will increase.
  • Since operating lease expenses will be reclassified in financial leases:
    • all the operating lease expenses will be excluded from EBITDA.
    • a part of the operating expenses will be reallocated in interest expenses.
  • Profit before tax will decrease in the short term, due to the higher interest component of the payments upfront. Over the lease lifetime, the impact will be neutral.

Impact of IFRS 16 on Key Financial Ratios

Key challenges of IFRS 16

Complying with IFRS 16 will require significant enterprise effort, from preparation through to the implementation process. Indeed, implementing IFRS 16 should be a continuous process, requiring the review and update of lease information and its processing every year. Following are the main challenges companies will face and the key elements for consideration.

Changes in Key Ratios:

As mentioned above, Key Finance Performance metrics will be redefined, and the impacts will need to be studied and explained, first and foremost, to investors and creditors, notably due to their impacts on covenants: EBITDA, EBIT, and Net Debt Gearing. To ensure continuity in financial statements and communication, during the transitionary implementation phase, financial reports should be prepared in compliance with both IAS 17 and IFRS 16, and a gap analysis performed.

Cross-department Deployment:

Various departments will need to participate in this initiative. Thus, setting up this new standard and tool will require companies to accompany the change and train people in the new standard early in the process, to ensure operational readiness from day one in January 2019.

  • IT department, as the regular review of leases’ contracts will need the set-up of an appropriate tool, either an IFRS 16 pure-player system or an integrated reporting system,
  • Procurement department to accompany the change and train people in the new standard and processes,
  • Accounting, Finance & Treasury, to revise their policies, their chart of accounts and processes to integrate the new lease recognition process,
  • Real Estate strategy to optimize cash flows and reduce exit costs. Now that operating leases need to be added back to the balance sheet, reducing the interest of leasing, buying real estate can again be an option.

Contracts and Data Gathering:

To comply with the new standard, all leases contracts will then need to be collected and reviewed. This can be done through three steps:

  • Gather and define the treatment for all lease contracts,
  • Estimate and document for all contracts the payments, the duration of the contract, the discount rate,
  • Study the impacts on the key financial ratios.

In order to successfully achieve this step, companies can use the help of external contractors and vendors providing IFRS16 accounting solutions software.

Processes (re)design, Policies and Change Management:

In parallel, actions have to be taken to be in a position of frequently updating the leases’ values. A review and redesign of existing process and tools, will be necessary as well as the onboarding of key employees on the new best practices and tool implemented, to drive the initiative in the company via a change management program. The following steps will be required:

  • Implement the appropriate data management system,
  • Update the Accounting policy,
  • Build or review the processes and control,
  • Train the staff to the new tools and processes.

Focus on retailers

Retailers are heavy users of Real Estate. It is estimated that the implementation of the new standard will induce a 98% median increase in debt (and a corresponding 41% median increase in EBITDA). Hence, their metrics will be highly impacted, and implementing the new standard will require to:

  • Assess if the retailer is going to renew a location (renewal options),
  • Estimate and reforecast variable payments linked to index or rate, for each reporting period,
  • Separate lease and non-lease elements in contracts.

Key challenges of IFRS 16 – Application

Companies have two different ways to cope with the transition phase and implement the new standard – full or modified retroactive application – depending on the timeline, resources available, readiness of the finance (and operations) teams and quality of the existing data.

Full retroactive application

Full retroactive application - Timeline

How does it work? For this approach, Sia Partners recommends a three-step implementation:

  • Comparative exercise in 2018: apply IAS 8 as if IFRS 16 had always been applied,
  • Retreatments of comparative exercises,
  • Indicate the impacts for each line of the financial statements.

Modified retroactive application

How does it work? For this approach, Sia Partners recommends a three-step implementation:

  • Recognize the cumulative impact at the date of first application in equity,
  • No retreatment of comparative exercises,
  • Indicate the impacts in appendices

The modified approach requires more preparation time but allows significant reduction in transition costs. However, the full approach, based on extensive historical data gives better quality of financial information for the transition year.

 

Pros

Cons

Full retroactive application

  • Better quality of financial information for the transition year
  • Clear & consistent financial communication
  • One year to prepare
  • Processes and teams ready on day 1

 

  • Need to gather all historical rates
  • Production of two financial statements
  • Transition cost (dual run IFRS16 / IAS17)

 

Modified retroactive application

  • Significant reduction in transition costs
  • Lesser volume of data to be collected
  • Impacts only appear in appendices

 

  • More preparation time
  • Consistency of financial communication towards investors & shareholders
  • Possible initial discrepancy in year-on-year financials.

 

 

Conclusion

IFRS 16 will induce major shifts across the enterprise. Sia Partners has designed a five-step implementation plan in order to help you understand the new regulation, communicate about it and get the stakeholders involved, in order to obtain the right data and build comprehensive and resilient models as well as monitor the changes and prepare consistent financial statements. Sia Partners has reviewed different IFRS 16 solution vendor, in order to suggest you the most handy and compatible ones with your business.

As 2019 approaches, regulators and other key stakeholders’ will place greater scrutiny and importance on this. Companies should be aware of it and implement solutions as soon as possible to ensure a clean transition and clear comprehension from shareholders, regulators and investors.

To learn more or to get our service offering to ensure your enterprise is not caught out, please contact us here.

Sia Partners’ implementation approach

 

Your Contacts

Ewan Chow, Senior Manager, Hong Kong Office

Vladimir Le Chatelier, Senior Consultant, Hong Kong Office

Geoffroy Borensztejn, Consultant, Hong Kong Office

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