Feature of the Month – March 2017
IFRS 16 LEASES: TAKING A RISK-BASED, PRACTICAL APPROACH
by Chris Biggs, Theta Financial Reporting
Much has been written over the last year on the technicalities of IFRS 16 – which I will not repeat here. Instead I will focus on the practical issues surrounding implementation, providing you with insights as to the common pitfalls to beware of and advice on how to best develop a sensible, efficient and pragmatic approach to implementation.
There are numerous IFRS 16 specific risks that need to be managed and these should shape how your project is set up from the outset, how you mitigate these risks, how you address specific issues and your overall approach. Every business is different and will require individual consideration of the likely risks, project requirements, organisational structures and existing processes; my experience of having advised on a real-life early implementation project was eye-opening to say the least regarding the challenges lessees will face, the first being timescale.
Don’t we have plenty of time? In short ‘no’…
The January 1, 2019 adoption date is not that far away when you consider your year-end, half year, quarterly reporting cycles, IFRS 15 and then there is your ever-busier day job.
In fact, my rough calculation shows that there is not much more than one year’s worth of time left now to implement what is set to be one of the most fundamental, data intensive, system impacting and head scratching new standards.
Although in the EU the Commission has yet to endorse, I understand from ‘those in the know’ that this is just a matter of time and endorsement is fully expected. So even those lessees who had been holding out until the final standard was issued (and have since been holding out for the EU commission to endorse) are now accepting fate and starting to work on implementation.
Faced with a complex standard that is far reaching throughout your businesses, that will require locating possibly thousands of lease documents, interpreting and then applying the myriad of IFRS 16 complexities to them (once you have managed to actually find them!), managing the data and making substantial system changes means that you have no time to lose in getting started if you have not already done so. But before you rush in, be sure to plan to mitigate the following risks:
Inability to identify the complete population of leases: Relatively few people in a business can sign up to a finance lease, however many more are able to hire an asset, rent plant and machinery and enter service agreements; the more decentralised the business, the more difficult it is to find the population of leases.
Working with clients we have developed a range of approaches to address this risk, including interrogating existing financial and non-financial data, automated polling of front-line teams and applying pre-screening processes to identify areas where leases are likely to exist. This has helped ensure completeness and efficient use of resources.
Not being able to locate the underlying lease agreements: Once the population of leases is identified, you may find that locating the underlying agreements is a challenge – a lot of time and effort can be spent in this area often yielding frustrating results.
It is hard to avoid the issue that you will need to review the underlying agreements and some of these may not be readily available. We recommend a variety of approaches including incorporating lessors’ input and leveraging centralised legal departments, minimising the need to find leases for less material lease portfolios.
Collating insufficient data: It is all too easy to underestimate the amount of data points you need to assess leases, apply IFRS 16, perform the required calculations and make the required disclosures.
To avoid having to re-perform work to fill gaps I recommend you determine all the data points required at the outset of your implementation project. This will include deciding the new accounting policies needed, making implementation policy choices and identifying all required disclosures (both transition and go-forward).
We use our IFRS 16 accounting policy ‘bible’ to help clients quickly decide the required new accounting policies which will drive certain data needs and our IFRS 16 disclosure ‘library’ to ensure that clients identify early all the precise data points needed. This way clients can commence data collation in the knowledge they will be collecting all the data needed in one single approach, rather than having to go back and collect data a second or third time.
Failing to identify the embedded leases in other agreements: This in practice has shown to be one of the most challenging aspects of implementing the new rules. Embedded leases are highly likely to exist in agreements that do not look like a lease, never mention the word ‘lease’ and look in every aspect like a service agreement.
We have advised clients to manage this risk through applying screening and polling approaches based on embedded lease characteristics to identify ‘hot-spots’ of where these potential leases are likely to exist. This has been applied throughout centralised functions such as procurement, facilities, logistics and legal departments to front-line manufacturing and customer service teams.
Once these ‘hot-spots’ are identified, we have used the approach of applying the complex IFRS 16 embedded lease criteria by focusing on certain agreement specific aspects and indicators only, which means the embedded lease analysis can be efficiently ‘short-cut’. This has proved hugely efficient in identifying embedded leases, whilst quickly ruling out those not containing leases.
Not keeping data up-to-date: Like the analogy of a bath with the taps on and plughole open, the population of leases will be in a constant state of flux as existing leases expire and new leases are entered into. Additionally, leases may be subject to modifications throughout their lifetimes.
Managing this constantly changing population, from the point it is first identified and from then onwards, is a significant challenge – we have helped clients ‘spec-out’ IT solutions, establish automated vendor-systems triggers and develop ways to capture this ever-changing flow of leases through embedding procurement system ‘flags’.
How you will manage this will depend on your current procurement systems, volume of leases and decentralisation of your business.
Failing to assess the impact on financial covenants: For those lessees with ‘floating-GAAP’ covenants (where they report ratios based on GAAP at the time of reporting, they will be reporting under IFRS 16 going forward) – there is a risk that the impact of the new rules will breach existing covenant limits.
For those lessees with ‘fixed-GAAP’ covenants there will still be potential issues, for example having no stated definitions of ‘cap-ex’ – the risk is that with all leases being treated akin to a finance lease this will result in their inclusion and therefore potential cap-ex limit breaches.
This is ‘just an accounting change’, ‘cash won’t change’ and ‘accounting should not drive commercial issues’ – all statements I fully support; however, I have heard ‘interesting’ comments from lenders who may look at potential breaches as a reason to re-negotiate…
I would therefore encourage all lessees to have the impact of covenants ‘front-centre’ in their mind set and recommend that you model and understand the impacts on your covenants in order to maximise the time you have to manage the issue and open discussions with lenders on these issues sooner rather than later.
Wasting time, cost and resources: One area where we have significantly helped our clients is to develop an overall workable but pragmatic implementation solution. There are many aspects to implementing IFRS 16 that could see clients spend huge amounts of time, effort and costly resources in applying a single approach to everything.
In our approach, we prefer (whilst ensuring compliance with the new rules) that clients adopt a practical and pragmatic approach. We encourage clients not to lose sight of the overall aim of their implementation project.
Where necessary we encourage clients to use assumptions and stress test these where the risk/ materiality of the lease portfolio allows – one example is IBR’s for certain less material portfolios of leases.
If IBRs are not readily available, then using a sensible and supportable estimated IBR which is stress tested say +/-25-50% (relative) and shows no material impact to the results, then this is a workable solution. We advise clients to put in place a framework to monitor the continued appropriateness of such pragmatic assumptions.
Inaccurate interpretation of IFRS 16: It does not need to be repeated that the new rules are technically challenging, however additional complexity is introduced by this being a new standard which preparers and the profession are working their way through and market practice is yet to develop.
This presents a challenge for lessees in that changes in interpretation and developing market practice could result in the need to change their project approach or emphasis. It’s therefore important to monitor ongoing developments and ensure that projects incorporate these as needed.
Incorrect specification of system solutions: Determining a system solution is understandably often a first priority for lessees as it drives their project design and ultimate solution. However, we encourage you to complete certain aspects of your implementation projects prior to jumping into defining the required solution.
Without first completing sufficient work to fully understand the detailed needs, data required, data sources, centralisation vs decentralisation, disclosure needs and policy choices, it is impossible to develop a suitable and complete system specification. Once your solution has been specified in detail, you can then design internal system solutions or approach vendors with confidence as to your requirements.
Failing to make the required IAS 8 disclosures in financial statements prior to adoption: The disclosure of the impact of adopting ‘issued but not yet implemented’ new standards is gaining ever more attention from management, auditors and regulators. There is a move away from the old style ‘boiler-plated’ disclosures that ‘management understand the requirements of the new rules and have a project underway to…etc etc etc’. There is a drive now to provide more detailed, insightful and useful disclosures of the expected impacts; however, this does need to be balanced with the risk of inaccurate disclosures.
Therefore, we are advising clients to focus on this required disclosure now and to build it into their overall implementation plan, to ensure they can make the level of appropriate disclosures appropriate for each year nearing adoption date.
A key part of this is also to determine the preferred transition policy (retrospective/ modified retrospective, etc.). This will potentially require modelling the policy choice and therefore will need to be incorporated into the overall project to ensure sufficient and reliable data is available when needed.
Insufficient stakeholder communication: Given the fundamental shift in accounting, the impact on financial statements, impacts on covenants, changing financial ratios and the inherent project risks, it is key to identify impacted stakeholders and define how best to communicate with them.
We have helped clients work through who would be interested in the impact on the business both internal and external. Sometimes this has identified unexpected parties for example HR where pay/bonuses are based on ratios which will change. Once identified, we have incorporated the required communications and timings into the overall implementation project to ensure these can be met.
Not complying by January 1, 2019: This risk is obvious, but without a well-structured and well thought out implementation project that identifies the key work streams, detailed tasks, owners and their due-dates, the interdependencies of each task, allocates sufficient time and resource, identifies system changes, allows for UAT testing time and manages the cost of the project and the inherent risk (a few mentioned above), then non-compliance is a real risk.
As a lessee, what should I be doing now? To ensure a well-planned, efficient, controlled and successful implementation:
- Ensure you fully understand the requirements of IFRS 16 in detail
- Identify the implementations risks specific to your business
- Develop pragmatic approaches to address issues you will face
- Design your IFRS 16 project plan to address the requirements and risks
As an indicator of how much must be fitted into the limited time available, the below shows an example IFRS 16 implementation plan that we tailor for clients:
I have only managed to touch on a few of the key risks and practical issues discovered from implementing IFRS 16. At TFR we have found that issues can be managed and risks mitigated through tried and tested pragmatic and compliant approaches that we have developed. We would be delighted to speak to anyone facing these challenges and who would like to find out more about our experience and real-life insights and how this could benefit them in making a ‘running start’ to their project.
Theta Financial Reporting
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