Financial reporting Brief July 2017

Insights

Financial Reporting Brief

July 2017

Our featured article for July is 'Balance Sheet Size To Grow? – New Leases Standard' with Brendan Sheridan commenting on the move to IFRS 16 in 2019 together with some implementation challenges and some proposals for meeting those challenges.

Balance Sheet Size To Grow? – New Leases Standard

The third of the major standards currently to the fore, IFRS 16 Leases, is due for implementation with effect for periods beginning on or after 1 January 2019. The time is nigh!

Significant concern existed amongst the investment community and broader business community that significant assets and liabilities were not being included on the balance sheets of entities.

Companies in more than 100 countries will be forced when implementing IFRS 16 in 2019 to bring around $5b of lease commitments onto their balance sheet in a major overhaul of international accounting rules governing how companies should report their leasing obligations.

The former Chairman of the International Accounting Standards Board, Sir David Tweedie, was once drawn by this situation to commenting ‘one of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet’.

Size Matters!!
The new rules are intended to provide investors with more transparent and reliable information about a company’s leasing commitments, without having to make difficult estimates about a company’s true level of debt.

The new standard will provide much needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet leasing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.

Entities that have significant operating leases, such as leases of real estate, large equipment and machinery and large transportation vehicles will be most affected by the standard.

The standard will have a significant effect on financial metrics because of the newly recognised assets and liabilities on the balance sheet.

Companies will also be keen to understand the size of the lease liabilities arising from transactions they enter into between now and 2019.

Commentators have expressed some concern that the accounting should not govern business decisions, that 'the tail should not wag the dog’. However, the new recognition of leases will have that potential impact and will therefore lead entities to perhaps consider differently their asset financing decisions.

Scope and Application
The standard will apply to all leases with the permitted but not mandatory exception of those leases which are shorter, i.e. leases of 12 months or less, and leases of low value assets, for example, a personal computer. It should also be noted that IFRS16 does not change accounting for services, which continue to be not recognised on the balance sheet.

A company assesses whether a contract contains a lease on the basis of whether the customer has the right to control the use of an identified asset for a period of time.

Leases are treated in a similar way to finance leases currently applying IAS 17. Leases are ‘capitalised’ by recognising the present value of lease payments and a company also recognises a financial liability representing its obligation to make future lease payments.

IFRS16 replaces the typical straight line operating lease expense with a depreciation charge for leased assets, included within operating costs, and an interest expense on lease obligations, included within finance costs. This change aligns the lease expense treatment for all leases.

Consideration needs to be given to ‘special’ cases where, for example, there are variable lease payments, sub-leasing or other non-routine elements of the lease arrangement.

Considerations for Implementation
If not already done, a preliminary assessment should be carried out to identify the scale of the challenge and the critical path to implementation of IFRS 16 requirements. Businesses should consider the wider impact on KPIs, remuneration schemes and lease strategy to determine areas where they need to adopt mitigating measures now rather than later. Other areas which may be expected to require attention are:

  • The new standard will require a change in accounting policy with potentially complex transition provisions to be considered; and
  • Given that substantial lease portfolios are likely to find adoption of IFRS 16 a heavy-load data task, they will need to consider whether their lease data bases are robust enough to facilitate analysis.

Good project governance will be essential in preparing for the implementation of IFRS 16 and, when appropriate, representatives from the following departments should be involved in discussions and planning:

  • Accounting/Finance
  • Real Estate/Property
  • Operations
  • Procurement
  • Information Technology
  • Tax
  • Treasury
  • Investor Relations

Support from external providers may also be desirable at some stages during the transition project.

Change Management
Of importance also are the overall structural and relationship aspects of the transition with some key questions being:

  • Have the board and executive management identified the financial and commercial impacts of the forthcoming changes, and the options available, so that all decisions are fully informed?
  • Has the impact on the interests of key stakeholders, such as banks, investors, landlords and contractual partners, been fully considered and have they been consulted?
  • How will stakeholders deal with the lack of comparability with historical financial reports that will result from IFRS 16 and any implications for company valuations where lease obligations are significantly different to those currently assumed?

Readiness Check
An overall check of the state of readiness of companies to implement IFRS 16 may incorporate addressing the following key questions:

  1. Do you know which of the entity’s contracts are, or contain, leases?
  2. Are your systems and processes capturing all the required information?
  3. Are systems and processes capable of monitoring leases and keeping track of the required ongoing assessments?
  4. Have you considered the potential use of IFRS 16’s recognition exemptions and practical expedients?
  5. Do you know which transition reliefs are available, and whether you will apply any of them?
  6. Do you know what discount rates you will be using for different leases?
  7. Have you considered the impacts of the changes on the financial results and position?
  8. How will you communicate the impact to affected stakeholders?
  9. Have you planned when you will consider the tax impacts?
  10. Have you considered whether your leasing strategy requires revision?

Entities may well be advised to consider the potential knock on effects in the following areas:

  • Key performance indicators
  • Bonus targets and executive remuneration schemes
  • Contingent considerations in business combinations
  • Tax
  • Debt covenants (if not based on ‘frozen GAAP’)
  • Ability to pay dividends
  • Regulatory capital requirements

Conclusion
Investors will not welcome surprises when amounts and adjustments reported on transition are considerably different to those that had been anticipated, and the sooner the potential impacts are communicated the better.

Entities would do well to examine the existing disclosures regarding operating lease commitments to ensure that they are doubly confident in the information presented therein, given that it is likely to bear some resemblance to amounts arising on transition.

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