IFRS 16: how to ensure your house is in order ahead of January 2019 deadline

Trillions of pounds of lease obligations are set to hit corporate balance sheets in January 2019 for UK companies. That’s trillions with a T. The new lease accounting standards (ASC 842 and IFRS 16) which, together, trigger the balance sheet impact, are the latest in a wave of recent, sweeping regulatory change. They may also be among the most complex, at least from a compliance perspective, as they will require organisations to review their entire contract portfolio.

The two standards will not only meaningfully change how companies identify and measure and report the value of leases, they also redefine the very definition of what constitutes a lease. The regulation expands the definition of a lease to include a broader set of commercial arrangements than under previous accounting standards, which now includes embedded leases.

In addition, while companies must already disclose their lease obligations, it is currently done in the footnotes to their financial statements. Most leases aren’t included in the balance sheet numbers, to which investors pay the most attention. With these new standards, and expansion in the definition of a lease, nearly all off-balance sheet accounting for lessees will be eliminated.  Organisations will also need to report the present value of all lease liabilities on their balance sheet as debt, while also being able to account for a right-of-use asset. In the profit-and-loss statement, rather than lease charges being accounted for as operating income, interest and depreciation will be accounted for separately.

Virtually all large organisations, both in the UK and globally, use leasing agreements to obtain access to assets, and the enormity of the accounting task at hand cannot be understated. However, many companies are ill prepared for the new lease accounting standards – and they’re not alone. According to a recent PwC survey, 39 percent of US companies have not yet started adopting the new lease accounting standards.

To help organisations get started (or continue on their journey) there are three steps companies can take to make meaningful compliance progress:

• Collect:

Collecting all potentially in-scope contracts. In preparing for these new standards, the first step is to gather all contracts that may now include a lease – anything that provides use of a physical asset and is valued at more than £3,000 per year. To many this may seem like a small task. However, companies have not been required to record lease data and contracts in a structured way. Similar to the new GDPR regulations, this will involve sifting through millions of contracts to find the ones that are potentially in-scope for further review.  In most cases, contracts are stored on a number of different systems depending on team and geography, requiring a programmatic effort to collect, sort, and de-dupe thousands of contracts.

• Identify

Finding embedded leases. Not only are companies required to identify lease contracts, firm’s should also identify all the leases hidden inside larger contracts – otherwise known as embedded leases.

An ‘embedded lease’ exists if there is an explicit or implicit asset in the contract and the customer controls use of the asset. Historically, embedded leases have not been considered leases for balance sheet and accounting purposes. But, these embedded leases could form a substantial part of third-party outsourcing agreements that essentially are a lease of equipment, technology, or facilities.

One of the most efficient ways to uncover embedded leases is through the use of artificial intelligence and technology-enabled processes to sift through the high volume of contracts that need to be reviewed. AI technology can rapidly and effectively identify key phrases or concepts such as references to assets and accompanying exclusivity language to help accelerate the review process.

• Amend & Remediate

Few accounting departments have the needed visibility of their contract portfolio to locate and review thousands of embedded leases. Contracts are frequently stored in disparate locations making it difficult for teams to find them and therefore meaning there is much less review time. With less than six months to go before the new deadline, companies may be quickly running out of time.

Technology, can, however, speed up this process, enabling clients to understand, at scale, their embedded lease exposure, and give organisations time to meet the new account standards.

It also creates an opportunity for Accounting and Legal collaboration to minimize the impact of these changes on a company’s financial statements. As the new standards force leases onto company balance sheets, companies have the opportunity to calculate the downstream impact on debt ratios, financial covenants, loan agreements and potential investor expectations. The better the insight the better the opportunity to minimize the balance sheet impact or better prepare for it. By combining legal and accounting expertise, the two organisations have a real opportunity to provide strategic value to the business above and beyond simple compliance.

Mathew Keshav Lewis is SVP of Regulatory Response Solutions at Axiom