Lease accounting - IFRS 16: A new age

Financial Reporting Brief June 2019

This article, 'Lease Accounting – IFRS 16: A new age' comments on IFRS 16: Leases and the challenges it presents on first time implementation for adopters in 2019.

Lease Accounting – A New Age

With the season of interim reporting on the horizon for many companies, there will be sharpened focus on where change will be necessary to the accounting policies adopted in previous reports, annual and otherwise. This most often arises where a new accounting standard is being implemented. While there are a number of amendments to standards to be implemented in the current year and some interpretations, including ‘uncertainty over income tax treatments’ the most significant feature for many entities will be the new standard, IFRS 16: Leases.

IFRS 16 is mandatory for accounting periods commencing on or after 1 January 2019.

The requirements for interim reports provide that an entity should use the same accounting policy throughout a single financial year and, accordingly, both lessors and lessees must make the appropriate changes, taking account of the transition provisions. It is expected that the changes will have a much greater impact for lessees.

From an investor perspective, the short answer to what is changing is that previously invisible leverage from leasing activities will now become visible, as all lease obligations will be presented on balance sheet with the corresponding ‘right of use’ asset. IFRS 16 will result in changes for many companies to their reported profits and their assets and liabilities. These changes are likely to be material for corporates with large leased asset portfolios, such as certain distributors, manufacturers, retailers and hotel and leisure operators.

Our illustrative financial statements include additional guidance on lease accounting.

While changes to financial reporting may be material, many may be consistent with adjustments currently performed by rating agencies and financial analysts. Complex areas of implementation could include, for example (a) determining the lease term and the discount rate, (b) assessing which contracts are scoped in, (c) the implication of lease modifications.

'Leases – A Guide to IFRS 16' assists preparers and users of financial statements to understand the impact of IFRS 16.

The changes could impact covenant calculations, and current covenant definitions may be inadequate to encompass the changes, resulting in ambiguity and the potential for disagreement between lenders and corporates on treatment. Corporate borrowers need to evaluate the potential impact of this now, to avoid surprises when the standard is implemented. It may have a bearing on current negotiations regarding future covenants, cash sweep mechanisms, management incentive structures and the like.

The Control Model
IFRS 16 applies a control model to the identification of leases, distinguishing between leases and service contracts on the basis of whether there is an identified asset controlled by the customer.

Control is considered to exist if the customer has:

The right to obtain substantially all of the economic benefits from the use of an identified asset, and
The right to direct the use of that asset.

A contract is, or contains, a lease if the contract provides a customer with the right to control the use of an identified asset for a period of time in exchange for consideration.
Identification of whether a contract contains a lease should take place at inception and should only be reassessed if there is a modification to the terms and conditions of the contract.

How Conditions are Met - Guidance
IFRS 16 includes detailed guidance on how to determine whether the conditions are met to identify whether control exists. The most significant features are:

Use of an identified asset – an asset is typically identified if it is explicitly specified in a contract or implicitly specified at the time the asset is made available for use by the customer. However, if the supplier has substantive rights to substitute the asset throughout the period of use then the asset is not considered to be ‘identified’.
Substantive substitution rights – a supplier’s right to substitute an asset is substantive only if both of the following conditions exist – (a) the supplier has the practical ability to substitute alternative assets throughout the period of use; and (b) the supplier would benefit economically from the exercise of its right to substitute the asset;
Right to obtain economic benefits from use of the identified asset – to control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use;
Right to direct the use of the identified asset – a customer has the right to direct the use of an identified asset throughout the period of use only if either – (a) the customer has the right to direct how and for what purpose the asset is used throughout the period of use, or (b) the relevant decisions about how and for what purpose the asset is used are predetermined, to the benefit of the customer.

IFRS in focus includes comments and observations on the Control Model, and how the criteria are met.

Modifications to a Lease
Seemingly innocuous changes to an agreement could be a lease modification. They could affect a company’s Right to Use asset and lease liability at unexpected times with major consequences for balance sheet ratios.

IFRS 16 contains detailed guidance on how to account for lease modifications, which are defined as changes in the scope of a lease, or the consideration for a lease that was not part of the original terms and conditions of the lease. A lease modification includes adding or terminating the right to use one or more underlying assets, or extending or shortening the contractual lease term.

If the modification is treated as a separate lease, a lessee applies the requirements of IFRS 16 to the newly added leased asset independently of the original lease. If it is not treated as a separate lease, complex allocation requirements apply.

Our publication, ‘Lease Modifications – extending the lease term’, provides guidance including illustrative examples.

Transition to New Requirements
The transition provisions of IFRS 16 allow entities to adopt a retrospective approach, with prior periods restated, or a modified retrospective approach where prior periods are not restated. It is anticipated that the most likely approach to transition by lessees will be the modified retrospective approach. It is important that the implications of this are understood, including that all lease cash flows are discounted at borrowing rates as of the date of transition rather than representing a blend of discount rates based upon the inception date of the leases.

Investors must understand the nature of the leases being recognised on the balance sheet and the assumptions and judgements used in the measurement of the lease obligations. These factors will have a major impact on future income statements. The disclosures required by different transition methods must also be understood, with perhaps the most useful being that which explains how the previous lease commitment disclosure equates to the amount on transition.

Challenges of Implementation
Our publication ‘Navigating the impact of the new Leases Standards’ is based on a survey of over 200 respondents globally. It highlights the challenges and complexities facing organisations when implementing IFRS 16 and ASC 842 (the US GAAP equivalent) across the world. The survey found that, with a few regional exceptions, many of the challenges and issues identified are similar across all organisation sizes and industries.

The key challenges that lessees have had to deal with include (a) the collection of lease data and gathering complete populations of lease contracts, (b) resourcing and coordination between departments, and (c) suitable IT systems.

There remains a question of whether the standard will lead to changes in the way in which entities do business, including lease versus buy decisions, debt renegotiations, management and employee compensation structure etc, with some mixed views including those that consider it will impact contract renewal negotiations.

CFA Institute – Top Ten Considerations
The mission of the CFA (Chartered Financial Analyst) Institute is to be a leader of the investment profession globally by promoting the highest standards of ethics, education and professional excellence for the ultimate benefit of society. It has recently published its Guide entitled ‘Leases: What investors need to know about the new standard – top ten considerations’.

The Guide is designed to help an understanding of the changes that IFRS 16 (and ASC 842) will lead to, with a focus on the following areas:

Basics of new US GAAP and IFRS standards and their differences
Methods and implications of transitioning to the new standard under US GAAP and IFRS
Transition disclosures investors should expect and how investors should evaluate the impact
The implications on financial statement captions
The implication on non-GAAP measures – alerting that while net income is likely to be lower, measures such as EBIT and EBITDA will be higher
Impact on cash – no change to cash balance, but statement of cash flows will change
Impacts on ratios – analysis of the implications for solvency, liquidity, profitability, earnings per share, return on equity, performance and coverage
New disclosures to be provided will have more significance given that lease finance liabilities are on balance sheet
Industries with biggest impacts including property, retail, transport
Market expectations – how the market may react to the newly visible leverage

Conclusion
For entities with substantial leasing portfolios, IFRS 16 is a major standard and for lessees with substantial finance leases will change the shape of the balance sheet substantially. Time and resources need to be invested to ensure appropriate accounting treatment and disclosure and to achieve transparency of reporting in communicating with stakeholders and investors.