GovernanceAccountingIFRS 16: Mitigating and strategising impacts on treasury

IFRS 16: Mitigating and strategising impacts on treasury

What is IFRS 16 and how can treasurers ensure they meet all the requirements of the new standard?

The stream of new regulations treasurers have to deal with is seemingly endless. If it’s not the end of LIBOR it’s PSD2, and just when you think you’ve got those cracked, along comes IFRS 16.

In a nutshell, IFRS 16 is a new way of managing and accounting for leases, which can uninvitingly bring headaches to a lot of companies. The details behind IFRS 16 are complex and must be carefully implemented – but can lead to benefits for treasurers if worked correctly.

IFRS 16 removes the olden differentiation between finance leases and operating leases, bringing an end to off-balance-sheet leasing, though the economic benefits and risks of leasing do not change

IFRS 16 has altered how organizations distinguish, compute, exhibit and account for leases. The new single lessee accounting model required compliance from 1 January 2019 and impacted every piece of disclosure – from financial metrics and ratios, to balance sheets and the way businesses consumes assets.

As a result of IFRS 16, treasurers have a lengthy to-do list to work though over the coming months in order to be ready for its implementation. This article focuses on the background of IFRS 16 and its predecessor (IAS 17), impact and the challenges of the implementation on corporate treasuries and moderation efforts that might cover the risk.

IAS 17 and IFRS 16

The IASB published the definitive IFRS 16 standard on 13 January 2016 (although it has been around since 2010) with the idea to drive a better representation of the assets and liabilities position of a company. It has enhanced the comparability of companies and industries. Virtually every company uses rentals or leasing to obtain access to assets and was therefore affected by the new standard.

The new standard replaced IAS 17.

Under IAS 17 there was a distinction between financial leases and operational leases. Financial leases were liabilities that were shown on the balance sheet of a company. Operational leases were off-balance sheet liabilities.

Operational leases were able to cause a relatively small liabilities position on the balance sheet, while financial leases led to a larger liabilities position on the balance sheet. The two kinds of leases not only impacted the balance sheet differently, the P&L of a company was also impacted in a different manner. Financial leases had an impact on the P&L through both the depreciation line (of the leased assets) and the finance costs line. On the other hand, operational leases were expensed in the P&L, this was mostly done on the operating costs lines.

With IFRS 16, there is not a distinction between financial leases and operational leases anymore.

Readiness for the new standards

According to Deloitte’s Global IFRS 16 and ASC 842 readiness survey, which ran from November 2017 to March 2018, many of the challenges and issues identified are similar across all corporates, regardless of size or industry.

The survey highlighted the following findings:

  • A material change to the financial reporting is anticipated, however, there is less clarity on whether the impacts will be considered with adjustments currently performed by ratings agencies and financial analysts
  • Collection of lease data and gathering complete populations of lease contracts and resourcing and coordination with other departments have been noted as major challenges
  • There is a need for an externally developed leasing system that can be managed internally as well as externally for variety of tasks
  • The most complex areas with the new standards are determining the lease term and discount rate, assessing which contracts are scoped in, and the implication of lease modifications

Impact on treasurers

For corporate treasurers, the new standards brought several possible implications, starting from increased auditor scrutiny to financial ratios, data management and lessor relationships. Treasurers are responsible for daily liquidity and compliance to debt covenants, which is where IFRS 16 has had an implication.

FX exposure and hedging strategy also changed with the new regulation. From an accounting perspective, monetary liabilities such as lease liabilities are retranslated at current FX rates at the balance sheet date however non-monetary assets (i.e. the right of use asset) are recorded at historical FX rates. Therefore, there is an accounting mismatch for FX in profit and loss accounts. Lease liabilities need to be recorded at present value, so determining the discount rate to apply to a lease is an important consideration. The discount rate applied will drive the future financing costs that need to be recognised for the lease, as well as the aggregate amount recorded for the liability.

The lease liabilities will generally be discounted by the lessee’s implicit borrowing rate. This rate remains fixed throughout the lease term, unless there are modifications to the lease. Because the entity will be exposed to fixed-rate interest rate risk, the hedge would normally be designated as a fair value hedge. Some forecast future leases will not be firmly committed. The question arises, ‘Could an uncommitted but highly probable forecast lease be designated in a hedge of interest rate risk in a cash flow hedge’? It might be possible to designate such forecast leases if it can be demonstrated that the expected payments under a forecast lease will vary based on market interest rates.

For corporates with operating leases, this is not a new FX risk, however under IFRS 16 as operating leases are brought on balance sheet, the extent of the accounting exposure is now highlighted.

Financial ratios and covenants have been impacted. The new standard has affected virtually all commonly used financial ratios and performance measures required within financial covenants; balance sheet debt has grown, gearing ratios have increased and capital ratios have decreased.

Lease versus buy decisions have changed. IFRS 16 has increased transparency and improved comparability between companies that lease and those that borrow to buy. Internally, this added transparency has enabled lease portfolio optimisation and cost savings.

Challenges with the new standard

While adopting IFRS 16, the primary challenge for treasurers is the transition provision of the new standard. The standard allows for transition fully retrospectively or using a modified retrospective approach (with various practical expedients) that does not recast prior years. Hence, comparing financial statements may require carefully considering the transition-related disclosures to understand the impact of the new leases standard across a sector.

Also, data capture is another major challenge. Treasurers need to capture up to 100 data fields per lease, including information on payments, expenses and end-of-term options. As a result, the treasury teams are unlikely to focus on establishing long-term processes or controls, such as a lease versus buy analysis, or on optimising the use of capital and maintaining lessor relationships.

Another challenge are the lenders and ratings agencies. The effect on financial statements and ratios may trigger breaches of loan or other pre-existing debt or interest covenants, unless an entity has included ‘frozen’ GAAP clauses in its financing arrangements.

Road to mitigation

The first step for treasurers is to understand the requirements under the new lease standards. Post this, treasurers need to evaluate how the new leases standard would impact the financial statements both entity and of its peers, including the impact on financial ratios and credit profile.

Lastly, there needs to an evaluation on how the new leases standard would impact the financial statements of the entity’s customers, and to update the entity’s model and process for evaluating the credit worthiness of its customers.

Key action points to take away are:

  1. Corporates may consider hedging the accounting volatility but need to be sure this makes sense from an economic perspective. Alternatively, if running FX gain/losses through the profit and loss account, the key will be to manage stakeholder communications.
  2. There is an option to adopt the standard on a retrospective basis, which would require consideration of the rates that would have applied historically, using the implicit rate if it was readily determinable.
  3. Corporates should consider commencing conversations with lenders and ratings agencies as soon as a formal impact assessment has been completed.
  4. One control could be requiring a lease versus buy analysis for every asset request to ensure that the best acquisition decision is made. Corporates should ensure that decision making frameworks and financial modelling/due diligence approaches are reviewed to take consideration of this new standard.
  5. As the leasing process becomes more public, relationships with the suppliers will become critical. Formidable rapports with the lessors will give advantages in the sourcing and negotiation processes for equipment and real estate assets.
  6. Treasury can create an internal process to ensure they keep financial metrics pertinent to the leasing programme up to date in the lease administration software. These data points consist of the incremental borrowing rate and current market rates.

Corporate treasurers need to be compliant with the new standards and understand why operationalizing compliance with the new lease standards is imperative. IFRS 16 has given much food for thought.

Have you heard back from your Treasury Management System (TMS) provider of the system upgrade required for the implementation? What have been you biggest challenges with regards to the changes? We would love to hear from you. Email us or head to our LinkedIn page.

Whitepapers & Resources

2021 Transaction Banking Services Survey

Banking 2021 Transaction Banking Services Survey

CGI Transaction Banking Survey 2020

CGI Transaction Banking Survey 2020

TIS Sanction Screening Survey Report

Payments TIS Sanction Screening Survey Report

Enhancing your strategic position: Digitalization in Treasury

Payments Enhancing your strategic position: Digitalization in Treasury

Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation