Lease finance accounting – A new standard

International Financial Reporting Standard (IFRS) 16 came into effect on January 1. The impact of the new standard can be felt across all industries, particularly those that rely heavily on rentals and leasing as part of their core business. A global leader in accounting and corporate secretarial services, TMF Group explains how this regulation is likely to affect global businesses

In 2019, asset ownership is not what it used to be. The world’s largest taxi service company, Uber, does not legally own any vehicles directly and Airbnb, the world’s largest accommodation provider, owns no real estate. Against a backdrop of evolving business realities, a sea change in how leases are accounted for has been introduced by the International Accounting Standards Board in its latest lease accounting regulation: IFRS 16. These changes have a far-reaching impact on lessees’ business processes, systems and controls, and redefine many commonly used financial and evaluation metrics such as gearing ratio and earnings before interest, tax, depreciation and amortisation (EBITDA).

IFRS 16 guidance considers any type of contract a lease if it gives the lessee the right to control the use of an identifiable leased asset for a period of time in exchange for monetary consideration, and – with the exception of a few optional exemptions – the lease must be brought onto the balance sheet regardless of its legacy classification as finance and operating leases. This shift in how leases are accounted for is intended to enhance comparability among firms, but also has a significant impact on lessees’ covenants, credit ratings, borrowing costs and valuations.

Fundamentally, the definition of a lease contract has changed – in implementation, the need to involve legal and business teams becomes apparent when assessing whether the contract or arrangement contains a lease from an accounting perspective.

 

Operational adjustments

In speaking to firms about how their operations are affected by preparations for the changes, most businesses historically have simply considered a lease to be a contract that involves renting an asset. Some expressed concern that contracts that do not initially appear to meet the definition of a lease arrangement may now be considered as such for accounting purposes. For example, where an asset is used – both implicitly and explicitly – as part of a service that another party is delivering, there is an opportunity that, from an accounting perspective, the arrangement would no longer be accounted for as a service contract, but rather as a lease contract. As the new standard redefines what a lease is, businesses must be careful to understand the requirements. Whether you control the use of that asset is typically where the judgement comes in, and will require a careful assessment of facts and circumstances.

Companies must also carefully consider how data on leases is collected and maintained – and these records may need software and data management systems in place, along with personnel to be responsible for them.

Another question firms must ask themselves is whether they intend to renegotiate lease arrangements – with shorter or longer terms where applicable – and whether leasing assets still offers advantages over acquiring assets outright. Early adopters of the new standard say that, in practice, this means involving the business development team to help define the commercial terms, and the legal team to draft the contracts. There are also country-specific tax or business practice issues to consider, as there is no universal leasing concept across countries. 

As for the impact on revenue recognition for lessors, one of the interesting things about the new rules from a lessor perspective is the need to carve out two elements of any contract that includes both a service and a lease component – for example, the lease of an aircraft that includes a maintenance fee component. For lessees, however, the standard provides a policy election for these entities to not separate the two components but rather account for the whole contract as a lease.

For leases with terms of less than 12 months, the short-term lease exemption will apply – but not in all cases. When looking at leases that include an automatic renewal option, special attention should be paid to penalty clauses, as IFRS 16 may still apply. There may be a stated term of the lease in the contract, but this may not necessarily match the duration of depreciation for the asset – you would also need to take into consideration whether each party can exercise relevant renewal rights without a significant penalty.

Resourcing constraints and organisational performance evaluation are also affected by the new standard. While some companies intend to engage external accounting and tax service providers, others are reallocating internal resources to accommodate the incremental workload. Some early adopters of the standard have reported they have been hiring consultants to help analyse their lease contracts, reducing the burden on existing staff. Also, as the measurements of organisations’ performance are altered, targets and incentives within various divisions of the company – or even key management personnel – may also require realignment. As multiple stakeholders will need to be engaged, the first step is to turn IFRS 16 accounting language into business language so personnel from IT, procurement and operations can understand how to help the finance team. For listed entities, this means sharing expected impacts with shareholders.

 

Managing the transition

In an increasingly globalised world, multinational companies have leases spanning national borders, making the effect of the changes even more complex. Such companies now face the challenge of standardising their leasing contracts and data collection across multiple jurisdictions, each with their own language, common business practices and legal regimes. They will also have to carefully consider the impact of foreign exchange rates on the group’s lease liability as an integral part of their analysis. 

The standard may also affect a company’s ability to secure funding, given the changes may result in additional debt on their balance sheets. A company’s treasury function may need to take the lead in revising funding strategies, renegotiating covenants with lenders, and providing discount rates as required by the new standard to calculate lease assets and liabilities. Processes will need to be established, codified and communicated to investors, analysts and auditors – with the treasury’s involvement in modelling and calculations playing a significant role in shaping future leasing strategy and decisions. Other critical considerations include effectively redefining key covenant ratios (for example, gearing ratio) and other key performance indicators (such as EBITDA) that have a direct effect on how a company’s performance is evaluated under its covenants – along with the need to effectively communicate these changes to the relevant lenders.

As a representative from a regional airline noted, resulting major changes in key financial ratios need to be clearly communicated to stakeholders as early as possible, with an emphasis on transparency.

Finally, as part of the transition to the new standard, companies will need to choose between two approaches – the full retrospective and the modified retrospective. The former involves retrospectively applying the new standard to each prior reporting period as per International Accounting Standard 8, and adjusting equity at the start of the earliest presented comparative period. This offers better comparability, but could be more challenging, depending on the availability of historical data. For companies that choose to apply the latter method, the new standard is applied from the beginning of the current period, and there is no need to restate comparative financial information, although this would distort the comparability of the current year and comparative period financial data.

Once a transition approach has been selected – full retrospective or modified retrospective – the requirements must be consistently applied. Deciding on a method means evaluating several key factors, including the complexity and accessibility of lease data, the results of financial modelling based on either choice during the relevant financial periods, and resource availability.

 

Conclusion

Having an external partner that has helped other companies adjust to the new rules – particularly one with cross-jurisdictional knowledge – can go a long way to achieving a smooth transition.

Given the significant cross-functional impact, there is a significant risk of teams working in silos. To minimise the impact, different teams across functions will need to come together to make changes. 

Organisations from all industries that deal with leases will need to think carefully about whether they are going to hire more people, or if they are going to outsource the work to consultants. From creating the right pro formas to managing risk arising from organisational challenges, they will need to ensure clear responsibilities cascaded to various departments; for this, effective planning and co-ordination will be required. 

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