AGEFI Luxembourg, February 2019
IFRS 16 Leases: Why banks should not underestimate its impact?
Leasing transactions have become an integral part of the world’s economy. Depending on the type of asset and the company’s specific operations, it may sometimes be more economical and cost-efficient to lease various kinds of assets rather than buying them. In some jurisdictions, laws and regulation dictate that some assets should not be bought (for example, purchase of real properties by foreign investors), so entities are only allowed to lease them.
The banking industry is not so different. It is common for banks to be a lessee of various kinds of assets such as office buildings, IT infrastructure, company vehicles, copy or printing machines, etc. At times, they are also lessors of assets (e.g., vacant office space for trading companies). Entities are accounting for such lease transactions under IAS 17 Leases since 2005. However, in January 2016, the International Accounting Standards Board (IASB) published a new standard that will replace IAS 17, i.e., IFRS 16 Leases, with an effective date of 1 January 2019. The new standard will significantly change the accounting for leases in the books of lessees and could have significant implications for banks’ balance sheets and, consequently, for regulatory capital requirements. As a result, banks will be affected and will have to change their current practices with regard to leases.
Lessor’s accounting for leases remains substantially unchanged from IAS 17.
Accounting change – Impact
2.1 Lessee accounting
Unlike IAS 17 for which leases should be classified as either financial lease or operating lease, IFRS 16 applies a single model and now requires lessees to recognize all leases on the balance sheet, similar to how finance leases are currently being accounted for (except for short-term leases and leases of low-value assets if they choose to apply those exemptions). Hence, at the commencement date of a lease, a lessee will recognize a liability to make lease payments (i.e., the lease liability) and an asset representing the right to use the underlying asset during the lease term (i.e., the right-of-use (ROU) asset).
Lessees will initially measure the lease liability by discounting the future lease payments using the interest rate implicit in the lease, if that rate is readily determinable. If that rate is not readily determinable, the lessee will use its incremental borrowing rate. It is common that lessees cannot determine the rate which is implicit in the lease as all the information needed to determine such rate is normally available to the lessor only.
Lessees will initially measure the ROU asset at the amount of the lease liability, adjusted for lease prepayments, lease incentives received, the lessee’s initial direct costs (e.g., commissions) and an estimate of restoration, removal and dismantling costs.
Subsequently, lessees will be required to separately recognize the interest expense on the lease liability and the depreciation expense on the ROU asset. When the ROU asset is depreciated on a straight-line basis, this will generally result in a front-loaded expense recognition pattern, which is consistent with the subsequent measurement of finance leases under IAS 17.
2.2 Lessor accounting
IFRS 16 substantially carries forward the lessor accounting model in IAS 17, with some changes in terms of accounting for subleases, treatment of initial direct costs and disclosure requirements. At commencement date, entities are still required to classify their lease into two types: operating lease or finance lease. For operating leases, lessors will continue to recognize the underlying asset and lease payments will be recognized as income over the lease term either on a straight-line basis or another systematic basis that is more representative of the pattern of use. For finance leases, lessors will still derecognize the carrying amount of the underlying asset, recognize a lease receivable and recognize, in profit or loss, any selling profit.
How will IFRS 16 affect banks?
For banks which are lessees of various assets, one of the main concerns is the impact of recognizing the ROU asset and the lease liability in the balance sheet for leases that were previously classified as operating leases. This will be common for banks who lease office buildings or spaces, or IT infrastructure where the risk and rewards from these assets are not normally transferred to the lessee and involves significant amount. The recognition of the ROU asset in the balance sheet that is related to a leased tangible asset will certainly affect the risk-weighted assets for capital adequacy ratio calculation as the Basel Committee will treat the ROU asset as a tangible asset with 100% risk weight, hence, it will increase the risk-weighted assets and decrease the capital adequacy ratio. In contrast, if the ROU asset is related to a leased intangible asset, it will be excluded in the calculation of risk-weighted assets, hence no impact on the capital adequacy ratio. In addition, the implementation of IFRS 16 will result in an increase in the balance sheet at a time when banks are trying to decrease their balance sheet in order to comply with the upcoming application of the leverage ratio. The recognition of ROU asset and lease liability may also affect certain financial metrics such as decrease in current ratio, increase in debt-to-equity ratio, and decrease in asset turnover ratio, among others. These effects in the financial metrics may erroneously affect the valuation of the banks’ equity if not analysed properly. In addition, as the financial metrics of the bank’s customers may also be affected, especially those under industries that are highly reliant on leases (e.g., airline companies, oil and gas companies, communications companies, transportation companies and wholesale companies), these customers may start negotiations with the banks either to allow more headroom in their debt covenants or to allow for the continued use of current lease accounting in the covenant calculations.
The interest recognized on the lease liability will be presented as part of expense and will reduce the net interest margin of the banks. In addition, the sum of the interest expense on the lease liability and the depreciation expense on the ROU asset will be higher during the earlier years of the lease agreement (front-loading of expenses) compared to the straight-line rent expense being recognized for operating leases under IAS 17 due to the interest component being calculated based on a higher lease liability during the early years, which will just be gradually reduced by regular lease payments.
With all this in mind, banks will likely need to educate internal and external stakeholders on the financial statement implication of the new standard. Some companies anticipate the need to better manage the communication of key performance indicators to stakeholders under both current lease accounting and the new standard during the transition period.
The implementation of IFRS 16 is also expected to have business implications affecting various processes and practices, including accounting policies and manuals, lease procurement and negotiation, lease data capture and administration, IT systems, customer relations and contract amendments, and tax considerations. Additional internal controls should also be made around these processes to ensure that all leases are properly identified, and all relevant information were gathered to be used for the assessment of lease and calculation of the financial impact and structuring of the disclosure requirements.
Implementation has begun
IFRS 16 has already been effective for annual periods beginning on or after 1 January 2019. Entities have had the option to apply the new standard using either: Full retrospective approach, i.e., retrospectively to each prior reporting period presented, applying IAS 8; or Modified retrospective approach, i.e., retrospectively with cumulative effect of initially applying IFRS 16 recognized as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of the initial application.
Although the implementation of IFRS 16 is expected to be relatively easier than the recently issued standards on financial instruments (IFRS 9) and revenue recognition (IFRS 15), its complexity should not be underestimated. IFRS 16 presents some key challenge areas which include (but not limited to): determining whether an agreement is a lease or a service agreement (or both) is not always obvious; determining the appropriate lease term considering tacit renewal, extension and cancellation options; determining which payments appropriately form part of the future lease payments; and, determining the appropriate discount rate requires some level of judgment, especially for subsidiaries who rely on parent companies for their financing and finance management. Some entities even lack sufficient documentation of their lease agreements to be able to effectively and efficiently perform the required assessments.
IFRS 16 will also have business implications across various areas, and banks are encouraged to plan the implementation of the new standard early on, and start the communications with key stakeholders to provide them training and awareness on the impact of the new standard. Banks should not underestimate the amount of work and resources that will be involved in the implementation, especially on the IT systems and data gathering.
Key elements of the implementation:
Data collection and ongoing data management - Preliminary work will revolve around assessing the state of banks' current lease contract data management (i.e., its systems, policies, processes and controls), including the data required for financial reporting purposes. Also, work for review of completeness and accuracy of the data will be critical as missing or erroneous information may affect required accounting judgments or calculations.
IT systems, processes and controls - Today’s lease-related IT systems are often designed primarily to assist with lease administration and often lack the capabilities to perform the calculations required for accounting and disclosures. To satisfy the new financial statement presentation and disclosure requirements, entities will need to evaluate whether to update their existing systems or to implement a new system. Selecting or updating a lease IT system will probably require input, not only from accounting, but also from the lease administration and IT functions, depending on the company's enterprise resource planning environment.
Accounting policies and manuals - The new standard requires the application of judgment and estimates. For example, evaluating whether an arrangement meets the definition of a lease could require judgement for certain arrangements such as those with a significant service component. Also, there are a number of accounting policy elections that may be made, both at transition and for the accounting post-transition, including whether to apply the recognition exemptions for short-term leases and leases of low-value assets.
Internal controls – Internal controls should be made surrounding IT systems, data capture, and accounting (including controls over application of accounting judgments and estimates) to ensure that all leases are properly identified, and all relevant information were gathered to be used for the assessment of lease and calculation of the financial impact and structuring of the disclosure requirements.
With the contribution of Ken Mark Agustin and Saksham Rohatgi