From 1st January 2019, most leases will need to be treated for accountancy purposes as if they were finance type leases – all leased assets (with just a couple of exceptions) will appear on the balance sheet along with all associated committed liabilities.
Published in 2016 by the International Accounting Standards Board (IASB) IFRS 16 the new lease accounting standard sets out to accomplish this by requiring the reclassification of all leases extant at that date or contracted to after that date. The aim of the standard is transparency, but its effects may be far reaching with particular regard to the financial metrics and financial reporting of many entities.
The impact will be felt company wide, but the adoption, implementation and compliance will likewise necessarily involve many departments and areas across the company – particularly PROCUREMENT and Accounting. There will be many approaches to resolving the compliance issue but with less than 10 weeks to go and time at a premium they will all undoubtedly involve some degree of external intervention. Cue PROCUREMENT! This blog is intended to steer the procurement department of any entity through the issues, concerns and solutions around IFRS 16 by understanding the work involved, the impact of compliance (positive and negative) and the availability of assistance.
This blog recognises that Procurement will be involved in assessing the value of leasing to the company going forward but today with the clock ticking Procurement needs to involve itself in recognising the work to be done, assisting in identifying a cost-effective option and procuring an easily implemented technology solution.
IFRS 16 adoption - Reclassification of leases
This is in its self a hefty piece of work.
- How many leases does the organisation have running?
- Where are the assets?
- What were the purchase costs of such an asset?
- What are the outstanding financial commitments?
- Where is the paperwork?
- When did they leases start and when did or do, they finish?
- Who is responsible for collating all of this?
With limited exceptions all leases, whether finance or operating, will need to be reported on the balance sheet of the lessee who has, substantially, all of the economic benefits of the “use of the asset or assets” associated with the lease or leases. The main feature of the new standard is that rather than concentrating on the lease itself, which it does redefine, it recognises a lease only where it can identify an asset together with a “right to use” that asset. As stated above - who benefits from the right to direct the use of the asset must place the asset on their balance sheet together with any contingent liabilities whether rentals, dismantling costs or indeed installation costs. Reporting of such an asset will need to include where appropriate purchase options, residual guarantees, termination option penalties and any variable lease payments. The treatment of the lease of any asset as an expense will cease with just a couple of exceptions around low value and short period hire. This applies retrospectively to any leases still extant and of course to all leased assets going forward.
Procurement will play a key role in ensuring an accurate and timely transition to IFRS 16 compliancy particularly in the area of reclassification. Here Procurement can assist in the locating, identification and collating of the data and contract information – being initially involved in the acquisition of the assets under scrutiny will mean that Procurement have knowledge and possibly a “purchase trail” of some critical components relating to the leases. This pivotal role will also see Procurement leveraging its relationship with the lessors to attain the required asset and rental information and to plug gaps in the organisation’s own records. In short, the early and full involvement of Procurement will lead to a faster implementation.
IFRS 16 adoption - What are the advantages and disadvantages of adoption?
- Improved comparability of companies for potential investors, stakeholders and lenders
- Assists in investment decisions
- Improved disclosure through transparency
- Improved and more reflective of the actual in financial reporting
- Improved lease and asset management
- High cost of implementation in time and personnel
- Need to separate out services from assets in contracts
- Information gathering and storing workload
IFRS 16 impact - Financial and Performance Metrics
Whilst the treatment of leases, assets and liabilities for Lessors remains generally the same as prior to IFRS 16, for the lessee there will be an impact on both the balance sheet and the income statement –
- Assets will increase as any leases previously treated as operating leases are reclassified
- Financial liabilities will increase as all committed lease rentals are reported
- Equity will fall to reflect the above
- Profit or loss before tax will be largely unaffected but here may be a moderate impact
- Financial Costs will rise
- Operating Profit will be affected as rentals are no longer expensed
- EBITDA will likewise be negatively affected
IFRS 16 - Where do you go?
Time dictates that an in-house solution will not meet the deadline and so there are essentially three areas to consider for help or that complete solution.
- Accountancy Firms – you know these and perhaps your auditors have an opinion
- Consultancy or Advisory Companies – just like us here at Innervision
- Technology Solution Providers – surprise here too as unlike so many consultancies we have our own in-house purpose-built technology solution LLA but enough plugging for the moment!
With the above in mind under IFRS 16:BC128, the lessee must take into account any periods that are likely to be non-cancellable under either termination options or extension options. Under IFRS 16:18 the lessee will include any such non-cancellable periods as part of the lease term calculation.
Procurement's role in technology selection
With just weeks to go until IFRS 16 acquisition of a software solution is necessary for most organisations if they are going to meet that deadline. Above has shown where to go but Procurement will need to be involved at each key stage of finding the right software solution from raising of an RfP through negotiation of an agreement to ensure a cost effective and timely transition to the new standard. Procurement, as they work with the interested parties within the organisation (Tax, Finance, Audit and IT) will be the driving force behind identifying and then selecting capable, proven and suitable solutions as they will have full knowledge of the size and scope of the organisation’s lease portfolio and its outstanding rental commitments. With this information potential vendors will be able to realistically calculate the work required and accurately cost and quote for their products and services – this is what Procurement does best and as they assemble the RfP areas for consideration will typically include –
- IT Security – a cloud or web-based solution won’t require a software install and subsequent upgrades
- Data Storage – where will it be held and how can it be accessed and by whom?
- System requirements being kept to a minimum
- Checks on the vendor - its track record in this arena and its reference-able client base
- Competence of people involved in supply, implementation and support of the software solution
- A solution that can forecast the impact of implementation and generate the reports that can be communicated to interested parties – internal and external stakeholders such as lenders and investors as well as those whose remuneration may be affected.
- Ability of the software to import data as well as having inputs
- Recording and reporting options with the data
- Classification of existing leases and generation of general ledger entries for assets and liabilities
- Simple and manageable solution going forward that allows the data to be downloaded at any time by an authorised internal officer
- Auditable tracking of changes, updates and upgrades
- Alert creation for leases requiring termination notices
- Transparent Pricing!
IFRS 16 - What do you need done?
- Collation of all lease documentation, asset location, lease status, asset costs
- Creation of and loading to lease portfolio database of the data
- Analysis of the collated data and then recognition of leased assets and classification of each lease and recording of each asset
- Impact testing of the accounting treatment on financial metrics and statement going forward
- Communication of the forecasted impact of compliance to all interested parties – lenders, stakeholders, investors and anyone measured on metrics that will be affected.
- Generation of general ledger entries that reflect the accounting treatment of the asset and its contingent liabilities
- Audit Trail to record all upgrades, updates and amendments concerning each asset
- Reporting on leased asset status to ensure improved lease management in the future
- Compliance on 1st January 2019 and continued compliance into the future
In Conclusion - Procurement's pivotal role going forward
Whilst Procurement will undoubtedly execute this role in lease accountancy compliance under IFRS 16, any successful transition and implementation will require a multiple functional/departmental approach. Procurement will be key in these areas during this phase –
- Knowledge of existing leases
- Relationships with lessors
- Forecasting the impact of compliance
- Lease versus purchase decisions going forward
- Acquisition of a software solution for the successful management of leased assets and the transition of existing leases to an IFRS 16 compliant “right of use asset” and “liability” model.
- Identification of today’s challenges with transition and planning future compliance with interested parties such as accounting, financial reporting, tax, investor relations, treasury, operations, IT, legal and real estate – anyone forgotten?
Finally this blog wishes to remind all lessees that in this time of change where existing leases may be reclassified and future leases will need to have a record of any updates, extensions or adjustments then a portfolio system with full audit trail will be essential and LOIS Lease Accounting (LLA) from Innervision is just such a process and system. LLA is a cloud based solution that while easy to implement is well proven and purpose built to assist companies in transitioning to IFRS 16 compliance. Time is running out but adoption today and use of just such a system will allow you to accurately and easily accomplish the implementation of IFRS 16 on time.
To find out more about the challenges presented by the new lease accounting standards and for guidance on how to successfully comply with either IFRS 16 or FASB ASC 842, download our free guide - '7 Steps to Lease Accounting Compliance' by following the link below.
Disclaimer: this article contains general information about the new lease accounting standards only and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.