FinanceJune 05, 2018

IFRS 16 leases: A fresh challenge with a familiar solution

Requirements for the new standard dovetail with those of other supervisory frameworks, and they can be met with similar approaches to data management, IFRS calculations & accounting.

The current regime of International Financial Reporting Standards leaves few realms of financial activity untouched. IFRS 16 concerns the treatment of leases.

This might seem of no great concern to banks. Sure, they enter into many and varied lease arrangements, but so do companies in lots of other industries. And it’s not as if there aren’t more urgent priorities floating in the alphabet soup of procedures and practices that supervisors insist must be implemented in the near future, not least IFRS 9, covering expected losses from impairment, and the other accounting standards.

But there are aspects virtually unique to banking that amplify the importance of the changes mandated under IFRS 16. The centerpiece of the standard is a requirement for lessees to bring assets and liabilities contained in operational lease contracts onto the balance sheet. A material change to the balance sheet will have an impact on any business, but more so for a highly leveraged entity like a financial institution. Think about the impact on key performance indicators and measures like the debt-to-equity ratio, earnings before interest and taxes (EBIT) and operational cash flows.

That raises the stakes for banks as they seek an effective solution for implementing and managing the standard. Meeting the challenge is not as difficult as it might seem at first because the right tool for the job tends also to be the one that firms should be using already for IFRS 9 and other rubrics: a flexible, modular automated system based on solid data management as a foundation.

Many answers related to compliance and reporting are similar because the questions that supervisors ask of institutions are as well, particularly with respect to how to classify and measure a vast amount of data, account for the results and disclose them.

There is much in common between IFRS 16 and IFRS 9, as well as the plethora of frameworks derived from the risk-management guidelines set forth by the Basel Committee on Banking Supervision. Like them, IFRS 16, which goes into effect in January 2019, assigns a central role to management judgment, rather than rote rule following, and calls for greater transparency, internally and externally, and for potential mistakes and their consequences to be anticipated and not merely recorded after the fact.

IFRS 16 requires lessees to recognize all new and existing lease contracts on their balance sheets and to report lifetime liabilities, discounted by an appropriate interest rate, immediately on their profit-and-loss statements at amortized cost. This move toward the balance sheet will have a big impact on businesses with extensive leases, and it could materially affect capital positions in the case of financial companies. The immediate recognition on the balance sheet and estimation of discounted lifetime liabilities will look familiar to bankers who have been working on IFRS 9. The extensive reliance on management judgment, used in crafting the models for calculating credit losses under that standard, comes into play in several aspects of IFRS 16:

  • Identification of non-lease components within a lease contract (relating to equipment maintenance and service, for example).
  • Deciding on the lease term in the light of the economic life of the asset vs. the non-cancelable lease period and optionality (termination or extension).
  • How to treat lease modifications: remeasurement or separate contract.
  • Deciding which contracts should be considered leases that fall under IFRS 16 at all. Other standards apply for arrangements that involve biological assets, mineral rights, licensing of certain intangible assets and so forth.
  • Setting rules for simulations to gauge the impact of prospective lease contracts on key financial metrics.

As a firm’s IFRS 16 preparations proceed, the people charged with the undertaking may find other connections with IFRS 9, some of them complex or surprising. Beyond similarities in the broad concepts and data intensiveness, the changes in the treatment of leases under IFRS 16 could affect estimated loss models and calculations under the other standard.

If an institution has companies that use leases extensively among its loan customers – and it’s hard to imagine that not being the case for a large commercial lender – then the impact of IFRS 16’s provisions on those customers’ balance sheets and P&L statements, and therefore their creditworthiness, needs to be reflected in loss estimates.

An IFRS solution that meets the demands of IFRS 16 and its supervisory cousins will echo the intricate relationships among them. It will cater to the idiosyncrasies of each while allowing institutions to take full advantage of the common threads that weave their way through all of them.

Such a system will be able to maintain all of a firm’s data from disparate sources, but in a standardized format that ensures consistency and reliability, and automates as many functions as possible to improve operational efficiency. It should be a modular solution that extracts data of any sort, from any source and for any purpose, and applies whatever sets of rules and calculations are appropriate for a given task. The broad architecture and the methods for storing, processing, reconciling, verifying, tracking and reporting data are the same; only the specific pieces of information and the processes applied to them change.

This strategy will save resources – financial and human – when implementing IFRS 16 and similar frameworks, and when adhering to their requirements down the road. Indeed, the best way to view IFRS 16 is not as a separate compliance obligation, but as a variation on a single, larger one that has some unique elements but essentially the same objectives overall that can be achieved through a common, yet flexible, approach to managing data, producing IFRS valuations and accounting for them.

By Philippe Franco, Global Product Manager – Finance, Wolters Kluwer
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