How Will IFRS 16 Impact Business KPIs and Financial Performance Metrics?
Whilst the changes to lease accounting as part of IFRS 16 will be firmly on your radar as a potential risk or opportunity and you, no doubt, understand there is a sizeable task ahead in order to become compliant, it’s understandable that time is short enough as it is.
Becoming compliant, minimising exposure and capitalising on opportunities are, of course, of main importance - understanding what the effect on business KPIs and key financial performance metrics could be your first port of call to assigning who will manage the issue. Here are the key impacts that every finance director, CFO and finance professional or shareholder, needs to understand when it comes to IFRS 16.
Reminder: What Is Happening When It Comes To IFRS 16
Reminder: What Is Happening When It Comes To IFRS 16
The current lease accounting standards prescribed by IAS 17 will be redundant as of 1st January 2019 and they will be replaced by IFRS 16.
These changes have been years in the making and are the largest shake-up to the leasing industry in a generation. Whilst there will be many more intricate changes to assess and manage, here are the headline changes, followed by further explanation.
- The definition of what constitutes as a lease is being changed.
- There will be no accounting difference between different assets and liabilities arising from leases and whether they are on or off balance sheet.
- Operating leases will be moved on balance sheet.
- Key financial ratios will be affected.
- Day to day managing of lease portfolios and lease accounting procedures will need to be more closely scrutinised.
- Transitional reporting can be employed and some retrospective reporting will need to be issued.
The Definition Of What Constitues A Lease Is Changing
IFRS 16 states that a lease is “a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration". A lease is said to exist when the customer has exclusive use of the item for a period of time and they can decide how to use it.
This change in definition means some current service agreements will become leases and vice versa.
When considering the other lease accounting and reporting changes which form IFRS 16, it becomes quickly apparent the scale of the work involved with managing the change.
Operating Leases Will Be Moved On Balance Sheet
Leases are currently categorised based on risk and reward, rather than who possesses the right of use to an asset. This is what has been a major sticking point for valuers and investors who want to assess the financial liabilities and commitments of a business which heavily relies on lease agreements to function at all.
It’s culminated in the somewhat farcical situation where airline companies don’t have to show their raison d’etre assets - passenger jets - on balance sheets, for example. Without prior knowledge, granted very obvious prior knowledge in the aforementioned example, it can be tricky for potential investors or buyers to gauge the true operating costs of a business.
Under current standards too much can be tucked away in reports when companies have a heavy lease portfolio.
Key Financial Ratios Affected By IFRS 16
Gearing ratio and current ratio financial assessments will be impacted by the IFRS 16 changes. As will asset turnover figures, interest cover, operating profit, net income and operating cash flows.
The company’s EBIT, EBITA, EPS, ROCE and ROE are all affected by the changes. It’s likely that your investors and shareholders will be concerned to understand what the impact to your company books will be because of this change.
Day To Day Managing Of Lease Portfolios And Lease Accounting Procedures Will Need TO Be Closely Scrutinised
If the asset has a purchase ticket price of around $5,000 or less, an entity may choose to exclude it from their lease accounting and keep it off balance sheet in the same way they currently can.
This is to help ease the administration processes involved with becoming compliant with IFRS 16, but it does mean that some management judgement calls may have to be made in your business. It might be more cost-effective, for example, to not spend the time seeing what can remain exempt.
The entire existing lease portfolio will need to be assessed in order to conduct an impact analysis and begin organising compliance.
Transitional Reporting May Be Employed And Retrospective Reports Will Be Required
Whilst the changeover deadline will be 1st January 2019 for the implementation of IFRS 16, there will, of course, be some lease agreements formed under the current set of regulations which will run on into the new period.
To deal with this, lessees (you) will be required to provide a clear comparison of how balance sheet has changed and be able to visibly show compliance before and after the implementation deadline.
This can be done with a modified retrospective approach. This method will allow entities to apply IFRS 16 going forward from a date prior to official implementation of IFRS 16 - but it doesn’t give full financial accuracy so it will, therefore, require additional audit explanation.
The alternative is to conduct a fully retrospective approach where entities will account for leases as though IFRA 16 has always been in existence from the beginning of the lease agreement. This means sourcing more historic lease portfolio information which will provide more accurate figures and mean less explanatory paperwork and auditing than the other method.
These are the key headline impacts of IFRS 16 and they will impact your own KPIs in different ways. Be it diverting management time away from other areas meaning you might need additional resources or even just the timely task of gathering up all of your lease portfolio data so that you can assess where you stand in light of new regulations.
The next step is to read in more depth - or delegate to the relevant team - about what IFRS 16 entails and which of your own KPIs will be affected.
Get Familiar With The Lease Accounting Changes
For further guidance on the new lease accounting standards we have created this inclusive guide to implementing – IFRS 16 or FASB ASC 842. Just follow the link view the ePublication: