Avni Mashru discusses the impact of bringing leases on balance sheet under IFRS 16. She looks at group situations, the impact of acquisitions, impairment considerations, alternative performance measures and the broader impact of IFRS 16.
The start of 2019 was a significant milestone in the accounting world – former chairman of the International Accounting Standards Board, Sir David Tweedie, is finally able to fly on an aircraft that is almost certain to be on an airline’s balance sheet. For accounting periods beginning on or after 1 January 2019, the long awaited IFRS 16 Leases comes into effect. The standard has become associated with its ground breaking headline of requiring almost all leased assets to be recognised on balance sheet along with their associated lease liabilities.
While a simple concept in theory, the practicalities of applying the standard are not so straightforward. Aside from the significant amount of data collection required and transitioning to the standard (two significant areas in themselves), there are a number of other practical application issues that receive less airtime but certainly merit attention.
Group situations
Leasing activity within groups is one area where complexities start to arise. It is not uncommon for groups to have a central property company (often referred to as a PropCo) as a subsidiary. This PropCo will hold all the property that the operating companies in the group (referred to as OpCos) lease from the PropCo to use within their business. Prior to IFRS 16, this resulted in a number of intragroup operating leases where the operating lease income in the PropCo’s books would neatly cancel out against the operating lease expenses in the various OpCos.
Under IFRS 16, however, the situation becomes less symmetrical. The standard maintains the finance vs operating lease distinction for lessors, meaning the PropCo recognises operating lease income as before but the situation in the OpCo is now very different. In place of the previous operating lease expense, OpCos now recognise a right-of-use asset, lease liability, depreciation and interest expense. These items will all require elimination on consolidation with the entries required being more intricate than was the case prior to IFRS 16.
This lack of symmetry will also arise where the PropCo and OpCo subsidiaries are applying FRS 101 Reduced Disclosure Framework since the recognition and measurement requirements of IFRS 16 apply in the same way under FRS 101 as if the subsidiaries were applying full IFRS.
However, where the PropCo and OpCos are applying FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, intragroup leases will continue to neatly cancel out as FRS 102 classifies leases as finance or operating in the same way as IFRS 16’s predecessor.
Impact of acquisitions
A further consideration under the heading of group situations is the impact of acquisitions following transition to IFRS 16. Previously, a group would assess whether any leases held by an acquired entity as a lessee were favourable or unfavourable when compared to market terms at the acquisition date and recognise an intangible asset or liability as appropriate. IFRS 16 has resulted in amendments to IFRS 3 Business Combinations which clarify that a group should measure lease liabilities as if the lease were a new lease at the acquisition date (ie, for the group, the lease commencement date is the acquisition date rather than the original actual lease commencement date). The corresponding right-of-use asset is then adjusted to reflect any favourable or unfavourable terms in the lease when compared to the market, instead of a separate asset or liability being recognised.
Although acquisitions by their nature result in consolidation adjustments, IFRS 16 adds a further layer of complexity. As noted above, the group measures lease liabilities from the acquisition date. This results in the group and the underlying acquired entity having different lease commencement dates for the same leased asset – for the former it’s the acquisition date but for the latter, the actual lease commencement date. This results in different right-of-use assets and lease liabilities which in turn result in different depreciation and interest expenses. This creates more intricate elimination entries on consolidation than was previously the case. This additional complexity will also be the case where subsidiary entities apply FRS 101.
Despite this article not focusing on transition issues, it is worth pointing out that groups will need to take care when identifying leases held as a result of acquisitions prior to transition. In the group accounts, these leases must also be accounted for from the acquisition date rather than the original lease commencement date. Where the previously acquired subsidiary applies FRS 101 and is equally transitioning to IFRS 16, a separate exercise will be required to determine the right-of-use asset and lease liability balances in the context of the original lease commencement date.
Impairment considerations
Moving away from group considerations, a measurement issue that will be relevant to all right-of-use assets is that these assets will be subject to the requirements of IAS 36 Impairment of Assets. Prior to IFRS 16, operating leases were subject to the onerous contract guidance in IAS 37 Provisions, Contingent Liabilities and Contingent Assets to determine whether a provision for the lease contract was required. Now that lease liabilities are recognised on balance sheet under IFRS 16, the assessment is now whether the related right-of-use asset is impaired.
Under IAS 36, an impairment test compares the carrying value of the cash-generating unit to its recoverable amount, which in turn is the higher of value in use and fair value less costs of disposal. An impairment loss is recognised when the recoverable amount is lower than the carrying amount. While it is very unlikely that adopting IFRS 16 will trigger an impairment loss, when companies determine recoverable amount on the basis of value in use, the models used to make this calculation will need to be updated to take account of the changes introduced by the standard, such as future operating lease payments no longer being included and potential changes in applicable discount rates.
Alternative performance measures
A final consideration is around the impact of IFRS 16 on alternative performance (or non-GAAP) measures in the annual report, an area gaining increased focus. As already noted, IFRS 16 will result in leased assets and their associated liabilities coming on balance sheet with associated depreciation and interest expenses being recognised in profit or loss.
A significant number of companies report a variant of one or more measures such as earnings before interest, tax, depreciation and amortisation (EBITDA), free cash flow or net debt in their annual reports. Each of these calculations will be affected by IFRS 16: EBITDA will increase as the operating lease rental expense will no longer be included, free cash flow will likely increase since some of the lease payments will be classed as financing rather than operating cash flows, and net debt will likely increase as lease liabilities are included in the measure. As well as affecting the calculations, companies should explain the changes in these measures due to IFRS 16 to help users understand the impact.
Where next?
You may have imagined that the practicalities alluded to in the title of this article might have focused on matters such as determining the discount rate, lease term or lease payments in a contract. There’s no doubt that a wealth of practical and time-consuming issues lie in each of these areas too. However, as illustrated here, the impact of IFRS 16 goes beyond the direct accounting changes for leases and companies would be well advised to have that broader impact in mind as they go through their implementation projects.
A recording of the faculty’s webinar IFRS 16 Leases – the impact is available at icaew.com/frfwebinars
About the author
Avni Mashru is a Director at PwC
