Embarking on a journey to comply with IFRS 16 for the first time? Lease accounting compliance, especially when navigating through IFRS 16, can often feel like threading a financial needle – it’s meticulous, detailed, and requires a strategic approach. Here’s a step-by-step guide to compliance.
Navigating the complex waters of the IFRS 16 leases can be a challenging journey for businesses of all sectors. Ensuring a smooth sail requires a deep understanding, rigorous planning, and a strategic approach toward lease accounting. This guide aims to light the way by breaking down the essential steps – not only to achieve compliance but also to leverage the transition as an opportunity to optimize your financial reporting and management.
Step 1: Form an implementation team
Lease accounting can involve several departments in your organization: Obviously, it is about accounting, but it can also involve the legal team, contract managers, and IT. To get it right, establish a cross-functional team involving all relevant stakeholders.
Step 2: Understand the IFRS 16 standard
Get the knowledge needed to comply with the standard. Getting to grips with the standard itself, exploring reports, and fostering a collective understanding through team meetings to decipher what IFRS 16 demands. Given that companies across various sectors will have different types of lease contracts, understanding how IFRS 16 applies to your specific company and industry is crucial. Early engagement with auditors is key, seeking to gauge if your understanding aligns with theirs, and uncovering how they can guide you through the stormy seas of IFRS 16 compliance.
Step 3: Identify the leases
Now for the detective work. Identify and compile all of your company's lease contracts. This is one of the most time consuming parts of the work. Throughout your operations – what office rents do you have? What equipment and cars have been leased? Next step is to review the agreements and assess whether they contain a lease as per the IFRS 16 definition.
Step 4: The leases you have, are they leases according to IFRS 16?
According to IFRS 16, a lease is a contract that gives you the right to use an asset (like a building, machine, or vehicle) for a certain amount of time and in return, you pay for using it. You need to have control over the asset. Thus, you get most of the economic benefits from using it (like profits or advantages). You also have the right to decide how the asset is used.
If it’s not clear whether you have control, consider: Can you operate the asset without the owner being able to change how you do that? Did you have a say in designing the asset to decide how it will be used? In plain words, if a contract allows you to control and get most of the benefits from using an asset, and you’re paying for that use, it’s a lease under IFRS 16.
However, there are some key IFRS 16 exemptions. If the leasing term is 12 months or less, it does not qualify as an IFRS 16 lease. The same goes for leases where the value of the underlying asset is of low value (USD 5,000 or less) when it is new.
Step 5: Collect data for each contract
For each contract, you need to find the lease term, the payments, and renewal/termination options.
The lease term definition is the non-cancellable period of the lease. It affects the size of the lease liability. You start by determining the length of the period of a lease and the period for which the contract is enforceable. The lease term cannot be shorter than the non-cancellable period. Optional renewable periods (if you would normally extend the lease) as well as periods after an optional termination date (if you normally do not terminate early) can be added to the lease term.
You will also need to determine the discount rate, which is the rate used to calculate the present value of lease payments. Risk, currency, and the duration of a lease contract impacts the discount rate used for IFRS 16. The discount rate is the rate implicit in the lease, if it can be determined. The discount rate should represent the alternative borrowing rate if the company had purchased the asset rather than leasing it and financed the purchase with debt.
Step 6: Determine the transition method
When recognizing existing lease contracts on the balance sheet, choosing between the retrospective and modified retrospective approach requires strategic thinking about their implications.
With the retrospective approach, you act like IFRS 16 has always been applicable. You go back to all your leases and calculate what the numbers would have been if IFRS 16 was in play from the start of the lease. You will need to change your past financial statements. This method can take a lot of work because you have to look back at all the financial years that the lease was active and change the numbers.
With the modified retrospective approach, you kind of say “let's start now” – and don’t bother much with the past. You don't need to alter your previous financial statements. Instead, you apply IFRS 16 from the beginning of the year you adopt it, not worrying about previous years. This might be less accurate, but it’s also less work and can be handy if you want to make the switch without delving too much into past transactions.
Using the modified retrospective approach, you either recognize the right-of-use (ROU) asset at the same amount as the lease liability at the inception date, or recognize the right-of-use asset at the present value at inception (contract start) and amortize from that point. More on ROU below.
Step 7: Evaluate your software
As described below, it demands precision to calculate the right-of-use asset and the corresponding liability. Determine whether your current accounting system can handle the lease accounting requirements. Some use Excel for IFRS 16, but most experience that spreadsheets are not fit for purpose when the number of leases surpass 15. Thus, consider implementing a lease accounting software solution that can manage and account for leases under IFRS 16. Lease accounting software can also bring substantial business value to contract management – by professionalizing document management, avoiding unwanted renewals, speeding up budgeting, and reducing dependency on key personnel.
Step 8: Initial measurement
In step 6 and 7 we paused to consider transition methods and software. Now is time to move on from step 5. Calculate the present value of future lease payments using the appropriate discount rate. Determine the right-of-use asset, the lease liability, as well as interest expense and amortization/depreciation.
A right-of-use is the right to use an underlying asset. A lease liability is the obligation to make payments. A lessee measures the lease liability at the commencement date of the lease. The commencement date is the point in time when a lessor makes an underlying asset available for use by a lessee.
At the commencement date, the right-of-use asset and the lease liability are the same. From that point, the RoU asset is depreciated over its expected economic lifetime, and the lease liability is subject to interest calculation and repayment.
The lease liability (and RoU): When you first start a lease, you need to figure out how much it will cost you over the whole lease period. To do this, you look at all the payments you'll be making that you haven't paid yet. You'll then adjust this amount to its present value. This means you're considering how much those future payments are worth in today's money (when discounted).
To get the present value, you'll use an interest rate. First, try to use the interest rate that's built into the lease (if you can figure it out). If you can't, use the rate it would cost you to borrow a similar amount of money.
Now, what payments should you consider when working out this amount?
- Regular payments you're committed to make, minus any discounts or incentives the leaser gave you.
- Payments that might change based on things like inflation rates or interest rates. You'll use the rates from the start of the lease for this.
- Any money you expect to pay if the item you're leasing loses value.
- If you have the option to buy the item you're leasing and you're pretty sure you'll do so, include that cost.
- If you can end the lease early but have to pay a fee to do so, and you think you'll end it early, include that fee.
Step 9: Subsequent measurement
After the lease starts, you need to update the lease liability you owe by doing the following:
- Add any interest that's accumulated on what you owe.
- Subtract any payments you've made for the lease.
- Adjust the amount if there are any changes to the lease terms or if there are fixed payments that change in nature (as outlined in some specific guidelines).
Right-of-use asset: After the lease starts, you need to keep track of the value of the item you're leasing. You'll usually use the cost model for this, unless there are other specific methods mentioned. Using the cost model means:
- Start with the original cost of the item.
- Subtract any wear and tear or damages.
- Subtract any value loss.
- Adjust the value if there are changes to the lease liability, like if the terms of the lease change.
Simply put, after your lease starts, regularly update the amount you owe and the value of the item you're leasing. For the item's value (RoU), usually, you'll subtract any decrease in its worth and adjust for changes in the lease terms.
Step 10: Adjust your financial statements
After performing step 8 for all lease contracts, it’s time to aggregate all RoU, liability, interest expense, and amortization numbers. The meaning of IFRS 16 is to make sure that all your lease obligations are clear and transparent in its financial reporting, giving a fuller picture of your financial position. It also divides up how lease costs appear in different financial documents:
Balance sheet: Record lease agreements as “lease liabilities” and “right-of-use assets” on the balance sheet. This basically allows anyone reading the balance sheet to see what your company owes due to leases (liabilities) and the value it gets from them (assets).
Profit & loss statement: Instead of just showing lease payments as an expense, they now get split into two parts: interest expense and the reduction of the asset value (amortization).
Cash flow statement: Lease payments now get divided between operating activities and financing activities in the cash flow statement. This change highlights that leases are kind of like financing – you’re using something now and agreeing to pay for it over time.
Notes to financial statements: You will have to give extra information about your leases, such as how long they last, and details about payments and values.
Thus, IFRS 16 will likely affect EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) in a number of ways:
- As the costs according to IFRS 16 mostly relates to interest and depreciation, the standard will have a positive effect on the EBITDA compared to non-IFRS accounting.
- IFRS 16 results in an increase in assets, liabilities, and net debt. That is because leases are brought on to the balance sheet.
- Other operating expenses will be reduced as lease expenses are reversed from the profit and loss statement.
- Depreciation expenses will be increased due to capitalized right-of-use assets.
- Interest expenses will be increased due to higher liabilities in the balance sheet.
Step 11: Engage with your auditor (again)
Perform testing on the new accounting to ensure it's in compliance with IFRS 16. Ensure that adequate internal controls are in place to guarantee the accuracy of lease data and calculations. Maintain a comprehensive audit trail regarding lease modifications and reassessments. Document all processes, judgments, and estimations made during the implementation.
Did you get it all correct? The final bow is taken when the auditor reviews and provides assurance on the compliance, ensuring that all t’s are crossed and i’s are dotted. The smoothest and least demanding process is to give the auditor access to the software used for calculating the ROU and liabilities.
Step 12: The aftermath
Following the implementation, the RoU asset and lease liability require regular attention, measuring, and possible reassessment or modifications. It’s paramount to have a strategy to efficiently monitor existing and new leases, whilst ensuring optimal internal control through guidelines and procedures. We advise you to conduct a post-implementation review to evaluate the effectiveness of the process. Identify areas for improvement and refine processes accordingly.
In the realm of IFRS 16, strategic planning, thorough understanding, and accurate implementation of each step are the trifecta for a successful transition to compliance. Implementing a practical, meticulous, and strategic approach, infused with the nitty-gritty wisdom of auditors and an understanding of the specific demands of your industry, will pave the way to a seamless IFRS 16 journey. So, roll up those sleeves and dive deep into the numbers, strategies, and details that will guide you through the IFRS 16 seascape!
If you want to dive even deeper into the practicalities of IFRS implementation, great sources to take a look at are big accounting firms such as EY, Deloitte, PwC, and KPMG. For instance, we recommend reading this in-depth guide by KPMG.