"Implementation of IFRS 16, leases"

From the IFRS Institute – August 30, 2019

The new leases standard, IFRS 16, is now effective and its US GAAP equivalent, ASC 842, is effective for public business entities in 2019. However, adoption efforts are not yet behind us and many companies still face significant challenges to get to business as usual. Further, private companies that apply US GAAP were due to adopt the new leases standard next year, but the FASB has tentatively decided to defer the effective date. This deferral will create further complexities when bridging IFRS Standards to US GAAP for companies with dual reporting. KPMG discusses key lessons we have learned from implementation of the leases standard.

The new standards on lease accounting are here, but our experience with companies around the world demonstrates that many companies still have accounting questions and implementation issues in significant areas. Adoption of the standards proved more difficult than originally expected and the costs of implementation were often greater than what companies had budgeted. Here are some of the lessons learned along the way.

1.  Embedded leases

Assessing whether an arrangement is, or contains, a lease has been one of the biggest practical issues for lessees when applying IFRS 16. Lease definition is the new test that determines whether an arrangement is on-or off-balance sheet.

In many cases, the assessment is straightforward, and a transaction that met the definition of a lease under previous lease accounting guidance (IAS 17¹ and IFRIC 4²) also meets the lease definition under IFRS 16. However, many companies have identified new leases under IFRS 16, which was unexpected. Under IAS 17, not all leases, particularly embedded leases, may have been identified. This has happened because the accounting treatment for a service contract was largely consistent with that for an embedded operating lease under IAS 17, and disclosures may not have been material.

The term ‘embedded lease’ refers generally to a lease within a larger contract that is not characterized as a lease contract. The contracts may not use terms such as ‘lease’ or ‘rent’, and the lease may be a relatively minor element of the larger, overall arrangement.

Companies should establish a process to ensure that no material population of unidentified leases remains. The following are some procedures that companies have undertaken to identify leases, including embedded leases.

• Identify ‘at risk’ arrangements (i.e. arrangements with potential lease elements) through discussions with representatives from multiple functions within the company – e.g. finance, legal, facilities, procurement, IT, marketing and business. Employees in operational capacities may be more familiar with typical contracting practices and specific terms and deliverables of relevant contracts. Embedded leases can be present in any contract, but they are commonly found in IT service contracts, ‘as-a-service’ contracts, sales contracts, supply contracts and contracts for dedicated manufacturing capacity.
• Analyze expenses and payments to identify recurring payments to vendors, and determine whether such payments are for lease contracts or contracts with embedded leases.
• Walk the floor. Tour manufacturing facilities or office premises to identify potential leased assets that may not appear in an asset register.
• Review contracts. For contracts identified as ‘at risk’, perform detailed contract reviews to analyze the underlying terms and conclude whether the arrangement is, or contains, an embedded lease.

2.  Lease information

Gaining comfort over the completeness of the lease population and accuracy of lease information has been resource intensive, time consuming and complex. The following are some of the key learnings from this data gathering.

• Data collection is more difficult than anticipated. Companies might have a good handle on their larger real estate leases. However, the information for smaller equipment leases, which could be a substantial number in certain industries, is often not readily available and very spread out across businesses and geographies. Additionally, for multinational companies, lease contracts could be in foreign languages and require translation. As a result, the level of effort to gather all of the required lease information has been significant.
• New data is obtained and surprises await. Through the IFRS 16 project, new leases are often identified, or contract terms are better understood. This has led some companies to realize that their population of leases may have been underestimated or not classified properly under previous standards. While these errors are not necessarily material to the financial statements, careful analysis of all facts is required to determine if any restatement is required under the requirements of IAS 8.³
• Huge amounts of data are generated with potential for inconsistency or errors. Collecting, standardizing and proofing data has proven a substantial effort, due to the complexity of lease contracts and the necessity to involve skilled resources in their review.

Companies should develop or adjust their data collection and maintenance processes and controls to sustainable end-states capable of addressing the ongoing requirements of the new standard.

3.  Incremental borrowing rate

IFRS 16 requires lessees to bring most⁴ leases onto the balance sheet. The new assets and liabilities are initially measured generally based on the present value of the lease payments. A lessee discounts the lease payments using its incremental borrowing rate (IBR) unless it can readily determine the rate implicit in the lease, which is rare.

The approach to determining the discount rate for the lease is similar to that under IAS 17, but applying it in the new world of on-balance sheet lease accounting has proven challenging for lessees. Increased precision is now required for accurate balance sheet reporting, and a substantial portion of leases did not need an assigned discount rate under IAS 17 because it was clear they were operating leases. While many lease accounting tools include a discount rate field, the software itself does not calculate the discount rate for each individual lease. Identifying appropriate discount rates and documenting their basis has proven to be a major task both on transition and on an ongoing basis.

According to IFRS 16, the IBR is a lease-specific rate (estimated for each lease) and adopting a company-wide rate is not acceptable. However, many companies have adopted practical approaches, often based on similar leases and starting from a company-wide calculation adjusted to reflect different lease terms, assets, currencies, securities, etc. Inputs and judgments may differ significantly from company to company (even subsidiary to subsidiary of the same parent or group) and will likely change over time.

The following are some of the key lessons learned to date.

• Involve the treasury function early. The company’s treasury function can help to establish a base rate to be used as a starting point, identify adjustment factors that are readily observable, and track changes in those underlying factors in future periods.
• Determine IBR at portfolio level. As a practical expedient, a company can apply lease accounting to a portfolio of leases that have similar characteristics. IFRS 16 allows this practical expedient if the effect is reasonably expected to be materially the same as a lease-by-lease approach. Using a portfolio approach can significantly reduce the number of leases for which the IBR must be individually determined.
• Establish processes and controls over IBR. Processes and controls may differ for the discount rates that will apply on transition and, separately, for new leases that commence after adoption.

4. Systems challenges

Many companies⁵  have chosen to implement a lease accounting tool in order to avoid the operational burden of manual calculations and associated errors. There are multiple software options available. Choosing the best solution (or indeed, deciding if software is required) can be challenging because it requires a thorough understanding of business requirements and impacts before selecting a tool.

Extracting and loading all the necessary lease data, and configuring the tool for the company’s reporting purposes has caused some operational challenges and slowdowns.

The following are key lessons learned on implementing a tool.

• Organize data centrally in a standard template. It is imperative to create a common template for collecting and standardizing lease data.
• Test the leasing tool for lease modifications and renewals. Many companies with larger lease portfolios frequently modify, terminate and renew leases. Each of those events has a different accounting treatment. Not all leasing tools are capable of handling complex scenarios, and companies should test all possible iterations with sample cases.
• Design new processes and controls. Companies need to comply with and report regularly under the new standard; hence, effective internal controls and processes around a lease accounting tool are required to be in place.
• Allow sufficient time to roll out the lease accounting tool. Implementing a tool may take anywhere from four months to more than a year, depending on the size of the lease portfolio and the configuration requirements. Many companies are still implementing new IT systems to extract lease data needed to comply with the accounting and disclosure requirements.

5.  Significant differences between IFRS 16 and ASC 842

While the lease definition and Day 1 lessee accounting are mostly converged under IFRS Standards and US GAAP, there are significant differences between the two with respect to transition and Day 2 lessee accounting. In particular, lessees no longer classify their leases as operating or finance under IFRS 16, but continue to do so under US GAAP. Further, the exemptions from on-balance sheet accounting (i.e. the low-value and short-term lease exemptions) differ. Under US GAAP, there is no low-value lease exemption and the definition of short-term lease differs.

Lessor accounting under IFRS 16 continues to be similar to that under US GAAP. Notable differences include: issues of collectibility, lease modifications and leases that are classified as direct financing leases under US GAAP.

These differences have complicated the adoption process for dual reporters, specifically for companies located in multiple geographies. Their cost of adoption has been relatively higher, because of the additional processes and reporting requirements, complex systems, training and duplication of auditing efforts.

The following are some of the lessons learned.

• Ensure the lease accounting tool implemented can apply both IFRS 16 and ASC 842. Although the general on-balance sheet rule prevails under both leases standards, the accounting is very different, especially for leases classified as operating under US GAAP. The leasing tool should be capable of performing calculations under both standards.
• Maintain different processes and controls for each framework to comply with the different lessee reporting requirements.
• Look for accounting policy alignment opportunities. Though companies have to live with some of the differences, the impact can be minimized by aligning certain policies and practical expedient (transition and ongoing) elections.
• Educate stakeholders on the potential lack of comparability between peers. The dual classification model for on-balance sheet leases under US GAAP governs subsequent measurement of the right-of-use asset; the nature, timing and pattern of lease expense; and the classification of cash flows. The resulting differences give rise to less comparable financial statements between companies applying IFRS Standards and US GAAP preparers. For example, investors’ favorite measures such as operating cash flows or EBITDA can be significantly different. This lack of comparability is further accentuated by the differences in exemptions to on-balance sheet accounting and when lessees must remeasure the lease liability for changes in variable lease payments that depend on an index or a rate.
• Revisit valuation and impairment models to ensure GAAP neutrality in metrics used. Models often involve multiples of EBITDA and EBIT, and include lease liabilities as part of debt for the calculation of items such as the cost of capital, capital structure and debt-equity ratios. Because peer companies may be applying a different GAAP with a consequential effect on these metrics, market data may need to be adjusted to ensure it is still comparable. Further, care is required when relying on the company’s historical multiples and metrics – these may no longer be directly comparable after adoption of the new lease standard.

Future developments

In August 2019, the FASB issued a proposed Accounting Standards Update that would defer the effective date of ASC 842 for private companies, not-for-profit organizations and employee benefit plans that do not file or furnish financial statements with or to the SEC. The proposal would defer the effective date of the new leases standard for these entities by one year, to fiscal years beginning after December 15, 2020 and interim periods within fiscal years beginning after December 15, 2021.

Companies with dual-reporting that would be subject to this one-year deferral will need to consider the implications of having different effective dates for IFRS 16 and ASC 842 and may want to consider early adopting ASC 842 to minimize the differences.

The takeaway

The efforts to adopt IFRS 16 have proven to be very time-intensive and challenging given the scope and breadth of its effects on the organization. We hope that the lessons above and in other KPMG articles will help you further navigate through the process of a successful transition to the new standard.

Contributing authors

¹ IAS 17, Leases

² IFRIC 4, Determining whether an Arrangement Contains a Lease

³ IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors

⁴ IFRS 16 provides lessees with optional recognition exemptions for leases of low-value items and leases with a lease term of 12 months or less.

⁵ KPMG’s 2018 Lease Accounting Change Survey reveals 74% of respondents planned to use lease automation software to implement the new leasing standard.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.