Leases have long been favoured as a form of off-balance sheet financing. But that's set to change from 1 January 2019 when IFRS 16 comes into effect. The implications for businesses are significant and now is the time to act.
IFRS 16, the new lease standard, will impact virtually every business around the globe. It calls for lessees to incorporate leased assets into balance sheets, recording both the right to use the asset and the liability for lease payments.
Although IFRS 16 was a long time in the making, and was formally published in January 2016, the standard doesn't come into force until 1 January 2019. This gives lessee companies less than three years to become IFRS 16-ready, and the time to take action is now.
Four key changes
In a nutshell, IFRS 16 will bring about four key changes:
- Eliminating the classification of leasesas operating leases and finance leases.
- Introducing a single lessee accounting model.
- Requiring lessees to recognise leased assets and any related financial obligations to make future lease payments for all leases with a term of more than 12 months, and
- Distinguishing between leases and service contractsbased on whether a customer controls the use of the asset.
Breaking this down, leasing entities will be required to bring operating leases onto the balance sheet as lease assets - with a corresponding increase in liabilities. In short, lessees will become more asset-rich but also more indebted.
Income statements will be impacted by a reduction in operating costs and an increase in interest costs, thereby impacting a company's EBITDA (earnings before interest, tax, depreciation and amortization). In terms of cash flow statements, IFRS 16 is likely to see a reduction in operating cash outflows among lessee companies and an increase in finance-related cash outflows.
Considerable work ahead for accounting and finance departments
In practical terms, IFRS 16 may all but eliminate leasing as an off-balance sheet financing mechanism for long term assets. The end result will ultimately be a win for stakeholders, who will be able to make more accurate comparisons between businesses. Behind the scenes however, IFRS 16 and the changes it brings to lease reporting will undoubtedly put corporate accounting and finance teams under tremendous pressure as the new standard is bedded down.
If we can, for a moment, overlook the IT issues around meeting the new recording and reporting requirements for lease data, the process of complying with IFRS 16 inevitably begins by compiling an inventory of an entity's lease obligations including the relevant details of each lease. Given the ubiquitous nature of leasing this alone is an enormous task.
The challenge is greater for companies with global interests
For companies with global interests, IFRS 16 brings additional challenges. Conducting a roll call of worldwide lease contracts will likely involve verifying lease details and standardising them. Yet among foreign subsidiaries, leases may be presented in a foreign language that requires translation. Determining an underlying asset's fair value and residual value, as required by IFRS 16, can call for local knowledge. And companies will need to identify existing leases, gaps in lease data and ensure full and complete information to provide sufficient disclosure to comply with IFRS 16.
Completing the full range of tasks can call for a multi-disciplinary approach involving departments beyond accounting and finance. It is likely IT skills will be heavily called as all lease data must be captured and disclosed in a uniform way.
In short, the initial stages of complying with IFRS 16 can place substantial demands on in-house resources. This can bring new costs to enterprises that do not currently have a complete catalogue of lease details – let alone a standardised catalogue.
Relieving the burden on in-house teams
Using an external services provider for part or all of the data collection process can relieve some of the strain on in-house teams. But where disparate providers are used, the task of standardising information may fall back onto head office teams.
Overarching these practical implications is the possibility that companies may want to review their current leasing commitments to avoid potentially undesirable outcomes. This could mean for instance, renegotiating existing lease terms to shorter periods which can escape the ambit of IFRS 16.
The bottom line is that planning, preparation and good advice are essential. Companies have less than three years to prepare for IFRS 16, and for businesses with a global network, partnering with a single global service provider can streamline several key stages of compliance including collating and standardising lease details.
From here, informed decisions can be made about how to continue with existing lease commitments, and steps taken to onboard lease data into financial statements ahead of 1 January 2019.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.