A discussion around the IFRS 16 new leases standard and how organisations can better prepare for the transition into lease accounting.
In just over a year, companies will face one of the biggest accounting changes in more than a decade: the adoption of IFRS 16, the new leases standard.
UK PLC is starting to prepare for the new world of “on-balance sheet” lease accounting and all that entails. For the first time, analysts and other stakeholders will have insight into a company’s assessment of its leased assets and liabilities. Businesses’ key financial metrics will change, such as EBITDA, EPS and net debt. The recognition of new assets and liabilities is likely to have an impact across the entire organisation, including areas such as debt covenants, tax balances, remuneration schemes, M&A evaluations and ability to pay dividends.
Initially you should establish a governance and project plan. Having a clear timetable, resource strategy and steering committee with representatives from across the business (i.e. IT, Tax, Finance, Human Resources, Treasury, etc.) will prevent individuals from working in silos and will ensure that you can identify and deal with both the compliance and business change aspects of the implementation effectively.
The standard provides a host of different transition options and practical expedients that involve a trade-off between the cost of implementation and the comparability of your financial statements / key metrics. For example, the fully retrospective approach requires companies to apply IFRS 16 as if the standard had always been applied, which provides year-on-year comparability. It is also likely to result in the lowest P&L charge post implementation. However, it requires companies to gather and assess extensive historic information about their leases, which is particularly challenging for large portfolios of leases that were entered into many years ago.
The modified retrospective approach, where you calculate the liability based on the remaining lease cash flows at your transition date (e.g. 1 January 2019) and set the asset and liability equal to that amount, is the simplest approach and will require the least amount of effort. It is also likely to result in the highest P&L charge post implementation. However, many organisations are modelling the different transition options to work out the relative P&L and Balance Sheet impacts of the options so as to make a more informed decision. Indeed, the Board / CFO may want to understand the P&L benefit being missed by following the least cost approach!
It is tempting to get a ‘jump start’ on collecting data. Yet it is important that you have decided on your transition approach before sending your requests for data. The transition approach will determine the data fields you need and so if you haven’t decided, you run the risk of collecting incomplete data sets and may have to go back to the source information, resulting in duplication of effort. Gathering lease data is a big practical challenge being faced by many companies that can take thousands (and thousands) of hours, particularly for multi-national organisations with large portfolios of leases spread out across the globe written in multiple different languages.
A key part of your planning should be to establish a data collection plan within your overall IFRS 16 project, reflecting your transition choice. You may want to perform this data collection exercise by starting with a pilot location, so you can determine the scale of the challenge and the best approach (e.g. manual vs automated data collection).
Sometimes the practical challenges of implementing IFRS 16 can overshadow the theoretical complexities. A big change for some sectors - in particular for Energy, Transport and Telecoms - will be the new definition of a lease. Under IFRS 16, an arrangement would only be a lease if the customer controls the asset – ”controls” in the sense that the customer can make the important decisions about the use of the asset in a similar way it makes decisions about the assets it owns. Assessing ‘control’ can be particularly difficult in those common transactions where assets are used to fulfil outsourcing contracts, such as IT agreements, transportation agreements, power purchase agreements and many others.
Do not underestimate the accounting challenges. Determining whether an arrangement is a lease is an important gating question for the entire project; you can’t collect the data until you know what leases you have!
Senior Manager, Accounting Advisory Services, KPMG