This article was first published in July 2018’s edition of ‘By All Accounts’, the ICAEW’s Financial Reporting Faculty’s highly-acclaimed biannual magazine which is exclusively available to Faculty members.
Jake Green, technical partner at Grant Thornton, details the practical challenges companies face in applying IFRS 16 Leases
Applying IFRS 16 leases requires identifying all your leases, completeness of lease information, getting all the documentation, doing estimates, using the portfolio exemption, modifications, and modelling and transition.
Everyone knows the headline: leases are on the balance sheet. In most cases, the calculations to achieve this will be straightforward. However, the key challenges in applying IFRS 16 leases relate to obtaining all of the necessary information to determine lease assets and liabilities, both at transition and thereafter.
The requirements in brief
For lessees, IFRS 16 requires all leases to be recognised on the balance sheet, subject to some exemptions for short term and small ticket leases. The process for this is broadly to identify all lease contracts. Then for each you must:
- Estimate the lease term;
- Calculate the lease liability by discounting the lease payments at the interest rate implicit in the lease; and
- Recognise a right-of-use asset.
Although there are some circumstances in which revisiting the carrying value of either the lease liability or the right-of-use asset is required, generally the lease liability is carried at amortised cost and the right-of-use asset is amortised over its useful economic life.
There are plenty of detailed provisions in the standard and this article does not set out to detail them all but instead considers some of the practical challenges in applying the standard.
The practicalities – identifying all of your leases
IFRS 16 contains a slightly revised definition of a lease but in practice this is likely to only cause differences at the margins. Where previously there were difficult judgements as to whether a contract contained a lease, those past conclusions may need to be revisited.
However, while the definition might lead to very similar conclusions, it could still cause problems in practice. For example, whether a contract was an operating lease or a contract for services did not make a big difference under IAS 17; the expense was generally recognised straight line over the term of the contract. Under IFRS 16 however, if it is a lease, it will affect the balance sheet.
One area this could have a practical effect on would be some IT contracts. For example, software service contracts might contain leases of equipment, such as a dedicated fibre optic connection. Finding and reviewing all these contracts and then applying the standard’s definition of a lease could be time consuming.
Completeness of lease information
Even where identifying leases is easy, gaining comfort over the completeness of lease information could be resource intensive and complex.
Groups with numerous subsidiaries – especially multinational groups – often apply different accounting systems and processes across the group.
There are technology solutions that can help, for example using data analytics programs to find regular payments or payments to particular named counterparties. Such solutions can help provide comfort that all possible lease transactions have been identified.
Getting all the documentation
The next step will be gathering all the actual contracts to analyse. This requirement should not be underestimated; even in simple groups, the actual contracts themselves might be held by numerous different teams within the business.
Property, IT, finance or even legal teams, for example, might hold all or some of the relevant contracts; assuming they are not in archive storage somewhere!
Some of these documents can be very long, and occasionally poorly drafted. This can add considerable time to the analysis process.
Estimates, estimates, estimates
The standard requires a large number of estimates to be made, including the stand-alone selling prices of lease and non-lease components; the length of the lease term where the lessee has either an extension or termination option; the interest rate implicit in the lease; and amounts payable under residual value guarantees.
Some of these estimates will require new information, such as the stand-alone selling prices used to allocate the payments under the contract to the lease and non-lease components pro-rata. For example, a lease contract might contain both the right to use a floor in a property, the lease component, and a payment for services such as cleaning and reception services, the non-lease component.
A practical expedient provides, by class of underlying asset, an election not to separate lease and non-lease components. Although if selected, this election requires all payments to be capitalised as though the entire contract was a lease.
Estimating the interest rate implicit in the lease could also be problematic. If the interest rate implicit in the lease cannot be determined readily, the standard does allow the incremental borrowing rate to be used but estimating this could also be challenging.
When the entity’s incremental borrowing rate is used, it is not simply the entity’s WACC or overall incremental borrowing rate. The incremental borrowing rate is supposed to be asset specific (i.e, what rate would be obtained to borrow the same amount as the right-of-use asset over a similar term and with the same security).
Practically this could mean estimating different incremental borrowing rates for:
- Different types of underlying asset, for example property and plant;
- Different locations, for example property in London versus property in York;
- Different lengths of lease, for example three-year, five-year, 10-year etc;
- Different group entities: some entities in the group may have very different credit ratings and this may need to be reflected in the incremental borrowing rate.
Using the portfolio exemption
While IFRS 16 is applied to leases individually, it does allow application at a portfolio level if the impact is not materially different.
Selecting a discount rate for groups of similar assets – for example, all property in London with a lease term of 10 years – is likely to be a situation where the portfolio approach is acceptable. However, it is a matter of judgement and such judgements should be tested with auditors sooner rather than later.
Modifications, another new area, are accounted for as either separate leases or as increases or decreases to existing lease liabilities and right-of-use assets with a gain or loss recognised in profit or loss.
Determining the treatment requires obtaining information about whether the modification increases the scope of the lease by adding the right to use one or more underlying assets and whether the consideration for the lease modification represents the stand-alone sales price for the modification.
When the standard is applied fully retrospectively, obtaining this information for all previous modifications might be challenging.
Modelling and transition
The standard contains a number of different choices, for example capitalising both the lease and non-lease components of a contract. In addition, there are a number of choices on how to apply the transitional provisions which can have a significant impact on the transition balance sheet and on the income statement in subsequent years.
As a result, it is important to think hard about which choices to take. This will involve modelling all of the possible options and assessing the impact of the choices on broader issues such as bank covenants, employee bonus arrangements and distributable profits, etc.
While the basic premise of the standard is simple to understand – all leases are on the balance sheet – the real challenge in the application is data completeness. Obtaining all of the information needed to apply the standard will take time and effort. If you’ve not started your implementation programme yet what are you waiting for?
The ICAEW Academy offers refresher CPD courses for IFRS 16 Leases – managing the risks and IFRS 16 Leases – embedded leases led by expert industry leading trainers.
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