In the last few months we have seen a big increase in conversations with companies on subjects such as “lease term”, “discount rates” and “transition options”. UK PLC is starting to prepare for the new world of “on-balance sheet” lease accounting. For the first time, analysts and other stakeholders will be able to see a company’s own assessment of its lease liabilities. However, achieving this end will be a significant task for many organisations.
And what is evident from these early stage conversations is that the implementation of IFRS 16 is not just an accounting change, it has much broader implications. Key financial metrics, such as EBITDA, EPS and net debt, will change due to recognition of new assets and liabilities, and differences in the timing and classification of lease expense.
This may affect debt covenants, pension covenants, tax balances, remuneration schemes, M&A evaluation and ability to pay dividends. Companies do not have the systems and processes in place to comply with the new requirements.
Selection and implementation of appropriate solutions will, for many, be a key work stream in the project plan. So our recommendation is that you don’t think about this purely as an “accounting project” and that your IFRS 16 steering committee has representatives from across the business to ensure you can identify and deal with both the compliance and business change aspects of implementation effectively.
Big practical challenge
The big practical challenge facing many companies is how to gather the lease data. In some cases, companies have the data in different sources – Excel spreadsheets, databases, etc. – and so it will need to be checked and collated. In other cases, companies will need to extract the data from the underlying contracts, which is a big exercise for large portfolios of leases and can take thousands of hours.
So much for practical challenges, what about the theoretical? There are many new estimates and judgements that companies will be wrestling with. A big change for some sectors - in particular Energy, Transport and Telecoms - will be the new definition of a lease. This is an important gating question for the entire project; you can’t collect the data until you know what leases you have!
Lease definition – “control” is key
In many cases, determining whether an arrangement is, or contains, a lease will be straightforward, and a transaction that is a lease today will be a lease under the new standard. In other cases, it will be more complex. For example, an arrangement may be a lease today because the customer obtains all of an asset’s output and the arrangement is priced in a certain way. Under IFRS 16 such an arrangement would only be a lease if the customer controls the asset – ”controls” in the sense that the customer can make important decisions about the use of the asset in a similar way to that in which it makes decisions about assets it owns. This will affect common transactions where assets are used to fulfil outsourcing contracts, such as IT agreements, transportation agreements, power purchase agreements and many others.
Companies will want to evaluate carefully whether to apply the transition relief of grandfathering their previous lease assessment. This will include balancing the cost savings that would arise if they take the transition relief against the potential impact of needing to apply the new lease accounting model to arrangements that would fall outside lease accounting under IFRS 16. Other considerations will include the number, size and duration of such agreements – and the extent of inconsistency in accounting for agreements entered into before and after the date of initial application.
No time to lose
There is a lot to think about in implementing the new standard. We only have space here to provide a few thoughts. You will need to decide – soon – on the approach to data gathering and transition method, given the effective date of 1 January 2019. The clock is ticking and there really is no time to lose!
Nick Chandler is a partner, and Almudena Cossio a senior manager, in KPMG’s accounting advisory services team.