IFRS 16, and the five questions every lessee needs to consider now
With the new leasing standard IFRS 16 coming into effect on 1 January 2019, it is key to get a head start with the preparations now, as the new standard brings along a lot more than only considerable implementation efforts.
IFRS 16 will also have a significant impact on many organisations’ financial statements as well as their key analysis’ and management metrics. It is therefore crucial for boards, CFOs and finance leaders of companies with significant operating leases to consider the following five questions and be ready to answer them:
1. What impact will the implementation of IFRS 16 have?
Apart from a small number of exceptions, IFRS 16 requires all leases to be recognised on the balance sheet. Whereas operating leases were previously entirely off-balance sheet - in other words neither an asset nor a liability needed to be recognised - a right-of-use asset and a respective lease liability will have to be recognised for each lease contract in future. The operating lease expense is replaced by a depreciation expense and financing costs. This will have far-reaching implications for key figures such as the equity ratio, gearing ratio, return on assets, EBIT and EBITDA of companies that make extensive use of operating leases. The change in key figures can also give rise to further knock-on effects such as a failure to meet loan conditions, impact on bonus schemes, analysts’ estimates and much more.
2. Who is affected?
The new lease accounting rules affect all sectors and industries. The impact is likely to be particularly severe for companies and sectors who are lessees of numerous or high value operating leases such as large-scale building rentals. This includes retail companies, hotels, banks and telecommunications companies. However, companies in the logistics and transport sectors are also heavily affected.
3. What are the options available to mitigate the potential impact?
While lease contracts can no longer be structured as ‘off-balance sheet’ leases, the standard does offer numerous alternatives. It grants considerable discretion and a number of options to mitigate the impact on key figures, thus addressing the knock-on effects. Some of the impact of IFRS 16 can be mitigated by restructuring business relationships (e.g. a mobility contract rather than a vehicle lease). And, there are also options available should some lease contracts be maintained. Lease terms can be shortened, for example, with the option to extend. Converting fixed lease payments into variable payments can also reduce the impact. However, it is important to note that in this scenario the lessor will actually have to take on a higher risk in order to achieve an effect for the lessee. Assuming this increased risk will – in most cases – not be free of charge. Furthermore, there will be some discretion with regard to the valuation of the lease liability and thus, of the right-of-use asset. For example when determining the discount rate or assessing the minimum lease payments, which can then be used for structuring purposes.
4. Is the use of IT-tools beneficial for the implementation efforts?
In the case of large-scale or complex lease contracts, the volume of data required for balance sheet recognition and notes disclosures grows rapidly. Centrally or locally managed Excel models quickly reach their limits. As vital figures sometimes have to be determined from lease contracts for financial reporting purposes, care must be taken to guarantee the reliability of the supporting data and calculation methods. The corresponding processes have to be integrated into the internal control system. The implementation of an IT tool, such as Innosys for leasing, should therefore be considered to ensure a high-quality and efficient process through largely automated controls.
5. What are the next steps?
In case of not already having done so, all companies that are lessees with operating lease contracts should launch an implementation project as soon as possible. The first stage is a general assessment of the potential impact the implementation of IFRS 16 can have, including knock-on effects. This assessment will then serve as basis to develop the implementation strategy tailored to the company in question.
For further a more in-depth analysis on IFRS 16 and its potential impacts, please refer to our Expert Focus article below (in German):
- IFRS 16 – New leasing standard
- IFRS 16, the financial reporting revolution
- IFRS 16 - Time to take action, three steps to success
- 10 question checklist: Preparing your plan for IFRS 16 - Leases
- IFRS industry insights: Property occupiers – implications of the new leasing standard
- Get it on balance – Deloitte solution for the new leasing standard