From the IFRS Institute - Aug 31, 2018
With just four months to go, companies are in various stages of adopting IFRS 16.1 The challenges posed by the new leases standard go beyond the accounting and financial reporting functions, and are pushing companies to consider broader organizational effects. Here we discuss some of the issues we are seeing around IT systems and controls, lease versus buy decisions, and contract negotiations.
2018 has been a very busy year for many IFRS preparers. Hot on the heels of adopting the new revenue recognition standard (IFRS 15) comes IFRS 16. The new leases standard has a pervasive organizational effect on a company beyond the confines of the accounting and financial reporting functions. KPMG has been working with companies large and small in support of their IFRS 16 adoption efforts, and has seen the effects of this new standard first-hand.
Companies may be relying on some form of lease accounting solution to track their global lease population. Introducing a new system in an established financial reporting process is always a challenge. However, some of the system design decisions have a wider implication on how a company handles its leases.
Many of these supplementary challenges have come as a surprise, but there are some common themes that we discuss here. Sorting through these issues now may save money and frustration later.
The pros and cons of a centralized approach
From an operational standpoint, day-to-day management of leases is often decentralized. This could be the case where a company operates in multiple jurisdictions and leases are drafted in the local language, based on local laws or customs, or when different departments enter into leases separately (e.g. procurement, IT and real estate groups).
However, a company may decide to handle the IFRS 16 accounting centrally as a financial reporting overlay. This means that access to, and training about, any lease accounting solution deployed by the company as part of its IFRS 16 implementation effort may be limited to the central accounting team.
While this centralized approach allows the majority of the company’s subsidiaries to operate in a ‘business as usual’ mode, it introduces additional responsibilities for the central accounting and financial reporting teams. Additionally, to comply with internal control requirements, accounting decisions made centrally (e.g. the discount rate applied or determination of the accounting lease term) need to be sent back to local teams for review and confirmation before being incorporated into the lease accounting solution. Local statutory reporting may also present its own set of issues and challenges under a centralized approach if the leases are no longer tracked locally.
The alternative of implementing the new standard using a decentralized approach requires involvement of a significantly larger group, which carries a higher initial cost to implement (e.g. additional training, disruption of existing processes). However, it may reduce ongoing costs because of the knowledge gained and future autonomy at the local level.
Can a lease accounting solution do it all?
Another challenge posed by IFRS 16 relates to the requirement to abstract pertinent terms from a lease contract. Because the disclosure requirements under IFRS 16 are more extensive than those under IAS 172, a typical lease accounting solution will require a large number of data points related to each individual lease or asset. Despite the promises of smart contracts with blockchain or AI-enabled optical character recognition technologies, for most complex leases, there still needs to be an experienced pair of eyes to accurately identify and capture this information.
There are also situations in which a company relies on a lease accounting solution to perform the IFRS 16 calculations, but the solution does not offer a comprehensive audit trail that complies with the company’s internal control requirements. As a result, additional resources are required to establish and monitor new processes established and controls around the new lease accounting solution. These types of costs surprise many companies, and are the reason why design decisions and vendor selection are very important aspects of adopting IFRS 16.
Additionally, the transition to IFRS 16 usually requires companies to implement or modify processes related to applying the portfolio approach, assessing impairment of right-of-use assets, capturing reassessment events (e.g. interest rate changes for interest rate-indexed lease payments) and complying with additional financial reporting and disclosure requirements. All of these accounting determinations will affect the form and type of data that needs to be gathered as inputs to the lease accounting solution. Certain accounting decisions, including the practical expedients discussed in our article, Lessees: Transition differences between IFRS and US GAAP, could significantly reduce the number of leases that need to be captured via the lease accounting solution, and reduce the implementation workload. However, we often see companies making these decisions after implementation of the lease accounting solution is well under way.
Is leasing still the better option?
Under IAS 17, leasing transactions offer three potential key advantages over purchasing:
IFRS 16 eliminates the third potential advantage for entering into a lease arrangement by requiring that all leases (other than short-term and ’small ticket’ leases) be recognized on-balance sheet. Many companies are therefore revisiting their process of making lease versus buy decisions for assets they are certain to use for a significant period.
Leasing often comes at a premium because of the risks taken on by the lessor. For companies with strong credit ratings, this means that the cost of financing an asset acquisition using existing or even new credit facilities may be less than the cost of leasing the same asset.
Furthermore, the introduction of 100 percent ‘bonus’ tax depreciation, as part of the recent US tax reform, allows US taxpayers to immediately deduct 100 percent of the cost of certain assets that would otherwise have a tax depreciable life of up to 20 years. This ‘bonus’ tax depreciation can therefore significantly increase the tax benefit of purchasing, rather than leasing, certain assets and may make outright purchases of some assets a more attractive alternative to leasing those assets. For more information, read KPMG’s US tax reform impacts M&A for IFRS acquirers.
Between the adoption of IFRS 16 and the new tax rules introduced by the US tax reform, many lessees are comparing the true cost of leasing assets to their incremental borrowing rates, and have come to the conclusion that it is sometimes preferable to purchase the assets. This process is often assisted by a lease accounting solution that allows for transparent reporting of the incremental borrowing rates not just across a portfolio of leases, but at the individual asset level.
To the negotiation table
IFRS 16 is also changing how companies enter into contractual arrangements. Minor variations in the contract terms may preserve most of the economics while avoiding lease accounting altogether.
A lease exists under IFRS 16 if there is an identified asset (explicit or implicit) in the contract and the customer has the right to control the use of the asset. For example, a contract such as an Infrastructure-as-a-Service arrangement could potentially contain a lease if the hardware or data centers are identified in the contract, and the supplier does not have substantive substitution rights.
IAS 17 and IFRIC 43 already require companies to identify, and separately account for, embedded leases. However, the accounting treatment for a service contract was largely consistent with that for an operating lease, and disclosures may not have been material. IFRS 16 brings most leases entered into by lessees on balance sheet, increasing the scrutiny around embedded leases. This is prompting some companies to take another look at those arrangements, and sometimes even going back to the negotiating table with their vendors.
We are also starting to see steps being taken toward renegotiation of real estate leases. For example, many lessees are looking to convert their real estate leases into triple-net leases with no minimum fixed payments related to common area maintenance or tax reimbursements. Such leases allow the lessee to reduce the amount of the lease liability, further reducing the effect on the company’s balance sheet. Some real estate lessors are also proactively engaging with their tenants about ways to structure their leases to benefit both parties’ accounting.
Marybeth Shamrock, KPMG’s Advisory lead for Leasing, has helped and discussed the new leasing standards with several clients. While highlighting the need to start early and inventory all leases, companies should assess what their new processes under IFRS 16 will entail including if a potential lease solution addresses the need for:
Designing and implementing a process and associated controls are key to a successful adoption of IFRS 16.
1 IFRS 16, Leases
2 IAS 17, Leases
3 IFRIC 4, Determining whether an Arrangement Contains a Lease
Article, Lessees: Transition differences between IFRS and US GAAP, August 2018
Article, Leases: Top differences between IFRS 16 and ASC 842, updated August 2018
All IFRS resources on lease accounting under IFRS 16, IFRS Institute
All US GAAP resources on lease accounting under ASC 842, including amendments and the latest proposals: Financial Reporting View
Comparison between IFRS 16 and ASC 842 (before FASB amendments): IFRS compared to US GAAP
Technology consulting and selection of a lease accounting system – KPMG Lease Accounting Tool