Struggling with the compliance impact of your lease portfolio?
ASC 842 & IFRS16: How big a liability is your lease portfolio?
Three years ago, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) created new accounting standards to replace IAS17 and ASC 840. Although IFRS 16 became effective on 1 January 2019, many companies are still seeking a structured and standardized approach to cope with the amended regulation. Private companies conforming to US GAAP still have some time left before ASC 842 takes effect at the start of 2020.
Under the old leasing standards lessees classified 85% of their leases as operational leases, which are not reported on the balance sheet. The new standards will make it mandatory to include most of these leases in the future. Unfortunately, many companies are flummoxed by the new regulation and face various difficulties in complying. So, what makes the new standards so challenging? In this article, we will focus on the calculation of the incremental borrowing rate and the corresponding impact on financial statements.
The incremental borrowing rate
Before an operational lease can be moved on-balance, the lessee must measure the right-of-use asset as well as the lease liability. The latter is determined by discounting the outstanding lease payments on a lease-specific basis. The applicable discount rate for most lessees will be the Incremental Borrowing Rate (IBR), which is defined by the new guidelines as “the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment”.
The identification of lease-specific IBRs is a complex, cumbersome and error-prone process needing a standardized and automated approach. When determining the IBR, the company should consider the following five ‘building blocks’:
- the creditworthiness of the lessee,
- the term of the lease arrangement,
- the amounts,
- the security granted to the lessor and
- the economic environment (the jurisdiction, date and currency).
These five IBR features create the need for both a credit rating analysis based on the financial statements of the lessee and a pricing analysis based on the terms and conditions of the lease contract.
Impact on the financial statements
Depending on the number of existing operational leases and the type of industry, implementing the new standards can have a material impact on the financial statements of the lessee. These financials are used by a variety of stakeholders for different purposes such as financial decision-making. For this reason, the lessee should carefully examine the impact of the new standards on the financial statements. The following items should be included in this review:
These changes can have a material impact on a wide spectrum of financial ratios. On the one hand, balance-sheet ratios such as leverage will deteriorate due to the increased level of liabilities (which will increase the net debt position), together with a small reduction in equity caused by financials assets decreasing at a higher pace than financial liabilities, compared to the old standards.
On the other hand, a higher EBITDA will improve income-statement ratios such profit margin. Among the possible consequences of a deteriorated leverage ratio are an increased credit margin or even a breach of financial covenants stated in loan agreements, resulting in additional costs or a lower flexibility. For this reason, definitions related to borrowings (for example, financial indebtedness) should be reviewed to assess the impact on each covenant and the related carve-outs and permitted baskets.
A short-term solution is to adopt a “frozen IFRS”, whereby the company calculates the financial ratios based on accounting standards at a fixed historic date. This method effectively carves out the application of IFRS16. However, this ‘double-edged sword’ gives rise to new challenges, such as safeguarding consistent and transparent financial reports.
How can we help you?
As time runs out, many companies are still experiencing a bumpy road to compliance. While some companies are already dealing with the implications of the new standards, others are still trying to accurately assess the scope of their operational leases. In order to ensure compliance and prevent reputational damage, many companies have designated this a high-priority project.
Zanders developed a standardized IBR methodology that determines the IBR from its five building blocks. In order to serve a wide range of clients, this methodology is offered as a digital solution on the award-winning Zanders Inside-platform. The solution calculates a lease-specific IBR in four easy steps.
In the first step, the user enters the terms and conditions of the lease contract, together with the financial statements of the lessee. This information is used in the second step to perform a credit rating analysis, resulting in an initial standalone lessee credit rating. The assessment is complemented with qualitative information such as country risk, industry risk, business risk and group support. In a third step, a pricing analysis maps the risk profile of the lease to the applicable credit margin on a lease-to-lease basis.
Finally, the user can generate a standardized IBR report that contains a defendable case for the calculated IBR. This documentation can be used by the external auditor as it includes the methodology as well as each lease-specific calculation.
Using this approach, we help many companies with calculating the IBR for a wide range of maturities, types of underlying assets (such as property leases, vehicles leases, etc.) and currencies. In addition to this digital solution, we also provide tailored advice to clients.
Please find here our IFRS16 solution on Zanders inside.