While travelling in an airline, I wondered if that aircraft was ever on the airline’s balance sheet? The reason behind such indiscreet thinking was that majority of airlines lease their aircrafts instead of buying them. A clever structuring of lease arrangements thereafter makes the aircraft as well as its related lease liability an off-balance sheet item.
This concern has now been addressed with the introduction of new international financial reporting standard (IFRS16) lease accounting. Companies will now be required to report all leases on their balance sheets as assets and liabilities. The impact of this standard will be seen on several finance areas including operating profits, interest coverage ratios, asset turnover ratios, cash flows, and net income.
IFRS 16 removes the age-old distinction between finance leases and operating leases. It introduces a single lessee accounting model, referred to as ‘right-of-use’ model (with some exceptions related to short term and low value leases).
Since I am associated with an airline customer where we are working to achieve IFRS 16 compliance, thought of sharing some basic understandings of this standard and the ongoing challenges.
What does IFRS 16 say?
IFRS 16 is effective for companies whose reporting periods start on or after 01 January 2019.
According to this standard, lease liability is equal to the present value of remaining lease payments (using a discount factor). Also, right-of-use asset is the sum of lease liability and initial direct costs incurred to put the asset in use.
Why is it difficult for organizations to adopt IFRS 16?
Three key challenges that the organizations will need to overcome are discussed below.
Devils of Discount Factor
Unlike bank loans and other debt instruments, lease agreements do not have specific interest rate stated therein. Hence, it’s challenging for the lessees to make a prudent judgement on the discount rate (which can either be Interest Rate Implicit or Incremental Borrowing Rate) due to:
- Nature and Quality of the security
- Economic environment (jurisdiction, currency, timeframe) under which the transactions happen
- Credit risk of the Lessee
Half-baked IFRS16 Tools and Applications
Since this is a brand-new standard with only a handful of companies going for an early implementation, there are hardly any ready tools and applications available in the market that comply with all the requirements required under the IFRS-16 framework.
Foreign currency leases involving forex gain/losses, hedging the exposures, automating the recalculation of debt based on fluctuating parameters, and simulation analysis are some of the critical areas to be addressed.
Apart from these, lease identifications, inter-company leases, sale and lease back transactions, lease term assessments, and subsequent re-measurements are key challenges, which organizations will come across.
How will IFRS 16 impact financial metrics?
Current Lease Liabilities will increase whereas Current Assets will not
Debt to Equity Ratio
Total Liabilities will increase due to inclusion of Lease Liabilities.
Asset Turnover Ratio
Lease Assets (Right-of-use) will increase entity’s Asset base without increasing the sales.
Earnings before Interest and Tax (EBIT)
Earnings before Interest, Tax, Depreciation and Amortization (EBITDA)
Rent expense which is part of EBIT/EBITDA is replaced by Depreciation and Interest.
What’s the best way to be IFRS-compliant?
- Understand your contracts – Take a stock of all your contracts, have a litmus test of IFRS16 applicability on them. Segregate contracts involving multiple components to identify stand-alone selling prices and whether to apply practical expedients to them as laid down by the standard.
- Adopt agile implementation methodology – Considering the brand-new standard and its initial unknown challenges, organizations need to be careful in selecting an agile software, which creates all the required amortization schedules, accounting journals, and reporting requirements.
- Ensure automation and intelligence while you align with existing IT systems – Changes to contract terms lead to change in Right-of-Use calculations and related lease liabilities. Such frequent changes should be captured, calculated, and accounted in an automated manner. Intelligent tools that report profitability and financial position as per Local GAAP and IFRS16 need to be in place.
Train the Finance team – All change management areas should be digested by Finance team. They should be well-aware of changes in key finance metrics. Budgets and forecasts process should be well-aligned with the new standard.
Despite the above mentioned challenges, I personally believe IFRS 16 will bring more faithful representation of company’s financial position, increased transparency, and better investor confidence.
Since this standard has impacts beyond finance and accounting, in my opinion, organizations should take this opportunity and align with procurement, treasury, regulatory, legal, and compliance departments as well while strategizing the implementation.