IFRS 16, which is scheduled to come into force on 1 January 2019, substantially modifies the accounting interpretation of leases. Almost all companies are bound by lease agreements, as either lessee or lessor. Although impacts are not significant for the latter, IFRS 16 imposes major changes for lessees.

The IASB estimates that nearly USD 2,800 billion worth of leases should be reintegrated into the balance sheet of companies in view of this regulatory change. In addition to the accounting impacts, implementation of the standard will have considerable spillover effects in terms of financing strategy, financial reporting, organization, and will therefore impact information systems.

Several approaches exist in terms of management systems for IFRS 16. This article presents the advantages of the approach based on financial contracts and transactions.

A new accounting interpretation

IFRS 16 seeks to provide a better interpretation of the impact of leases in financial statements.

Under the current IAS17 framework, finance leases are booked on the balance sheet whereas both operating leases and service contracts are off-balance sheet. As of 1 January 2019, IFRS 16 will require the recognition of finance and operating leases on the balance sheet, while service contracts will continue to be booked in off-balance sheet items. The standard provides for some exemptions such as leases for a duration of less than one year as well as low value leases.

According to this new lessee-side approach, the debt representative of the contract must be recognized as a liability and the right of use created by the contract must be recognized as an asset. The liability will be valued on the basis of the present value of lease payments. The discount rate is determined using the implicit contract rate, which is rarely known at the outset and is generally impossible to determine. Consequently, the marginal rate of indebtedness, in the currency and upon contract maturity, will be used to value the lessee’s contracts.

The right of use recognized as an asset will be determined based on the value of the debt as a liability, as well as any rental payments made before or on the start date of the lease or any initial direct costs borne by the lessee. The contract expense will correspond to the amortization of the right of use (operating result), and the interest expense on the debt recorded as a liability will appear in the financial result. Note that this charge will be determined on a non-linear basis according to the amortized cost methodology (application of the implicit rate of the contract to the present value of the same contract).

In addition, the contractual terms must be carefully examined in order to determine the duration of the contract (depending on any exit or extension clauses) or the existence of ‘service’ components that must be separately accounted.

Moreover, various events may lead to revaluations of the amounts recognized in the balance sheet (such as contract extensions).

In terms of financial reporting, the new standard requires a significant volume of quantitative and qualitative information to be disclosed in the financial statements in terms of amounts, cash flows and maturities. Information likely to impact the amounts must also be reported, such as the value of any indexes or options that have an impact on the life of contracts.

Organizational Impacts and Information Systems

Implementation of the standard requires taking an inventory of all contracts negotiated throughout the Group in order to classify them according to their nature and to make the necessary accounting adjustments.
It is necessary to take advantage of this harmonization of contract management to have an information system deployed in all relevant group entities, in order to address all the issues:

  • Local entry and local accounting processing,
  • Validation of transactions and consolidation of positions at central level and consolidated accounting,
  • Simulation and decision support at central level (market data stress, forecast accounting impact, transaction simulation, etc.).

In addition, the inclusion of operating leases in the balance sheet will lead to a major change in the net debt structure.

Centralising debt instruments in a unique system

Leases are now considered as debt instruments and it is therefore appropriate to manage them in the same system as all financing instruments. Their inclusion in the Treasury and Risks Management System (TRMS) will consolidate all the Group’s debt, including leases, and provide the necessary indicators related to debt and its cost. This greatly facilitates simulation processing, both in terms of transactions and market data. In addition, sharing a single platform makes it possible to use the same communication channel for lease capture as the one used for standard transactions consolidated at the level of a central treasury (cash, forex or interest rate derivatives, financing of all types, etc.).
The contract and financial transaction-based approach offered by a TRMS natively allows you to benefit from the flexibility of an event-driven platform. All types of events can thus be managed, whether they are financial events (rentals, early settlement, extension, modification of indexes and impact on the level of rents, etc.) or accounting events (calculation of implicit interest, accrued interest and rents, amortized cost, etc.).

The combination of such an event engine and a flexible sub-ledger module ensures effective implementation of the standard with all its components.

Conclusion

IFRS 16 will come into force on 1 January 2019. Given the impact in terms of accounting, organization and information systems, its implementation must be organized as soon as possible.

A convergence between treasury and consolidation makes sense in such a project to bring the Group into compliance with the standard, which has an impact on accounting and regulatory standards as well as in terms of debt management.