The three questions to ask about IFRS 16 compliance
Unless you’ve been living in a bubble for the last couple of years, you’ll know that IFRS 16 is coming – and that it could mean significant changes in how you report leases and other contracts and arrangements that involve the use of an asset. In short, you may be required to show not only the periodic costs in your accounts, but also the total assets and liabilities.
The changes are due to start on April 1st 2020.
While some Public Bodies are well advanced in their preparations for compliance with IFRS 16, we are increasingly approached by those concerned about their readiness. In our work with them, we focus on the three key questions to ask to understand what is required to be compliant by April 2020.
Can you identify all your leases that are live as at April 1st 2020?
The first step to preparing for the changes is to identify the leases you have. You’ll need a full and complete oversight of all lease agreements across your organisation. Finding all your leases is not always an easy process. Some organisations will have full lease accounting systems that contain details of all their leases and those that have access to this level of data will have little trouble with the new reporting requirements. Many organisations, however, will be faced with the task of searching high and low for lease documentation and the required data.
The good news is that you can forget about contracts, even if they are leases, with less than 12 months to run on April 1st 2020. These are specifically excluded from the IFRS 16 scope. Subject to specific guidance you may also exclude low value leases from capitalising on your balance sheet – however these will still need to be disclosed.
Where you have already identified and reported embedded leases these will need to be reported in accordance with the new standard from April 1st. But there’s more good news in that you don’t need to re-classify arrangements currently not recognised as leases.
Do you have all the information and the systems you need to report as required?
A good lease adviser can be helpful here. With good leasing industry contacts, they will be able to help you poll lessors for any data they hold on your leases. When we manage this process for new lease advisory clients, we invariably unearth leases for which the client had no data and, in some cases, where they were not aware of the lease at all. With departments often going off-piste to acquire their leases, it’s easy for Finance to have little or no visibility of these contracts.
For your existing leases, there is a whole range of specific information you’ll need which may include the original asset cost, current and any future lease rental or associated commitments, any terms and conditions related to options to extend, the remaining lease duration, residual risk values. Some of this information may be clearly detailed within your lease documentation but it’s likely some information will be quite difficult to find.
From the implementation date will you have a robust process for assessing which new arrangements should be classified as leases and which service contracts?
If the work required by April 1st 2020 appears relatively straightforward, this all changes once the new standard comes into force.
The definition of a lease will change as part of the new standard and, as mentioned above, it is helpful that HM Treasury has said that you won’t need to reclassify contracts existing prior to April 1st to take account of this. But, from that date, you’ll need to assess any arrangement with an asset component and test it against the new definition to determine whether it contains a lease, or whether it can be defined as wholly a service contract. This will require the exercise of judgement, and is an area where organisations may require assistance.
There are two questions you’ll need to answer when assessing an asset-based arrangement:
Does the arrangement include an ‘Identified asset’?
One of the key factors in assessing whether an arrangement includes an identified asset is the degree to which the supplier has substitution rights. It’s unlikely to be enough for there simply to be a right of substitution written into the agreement, there will need to be clear evidence as to why the substitution rights are substantive in practical terms. In the absence of such evidence you would need to conclude that there is an identified asset.
Take the example of a supplier undertaking to carry out blood tests for a hospital. The type of questions that may need to be answered are:
- What does the contract say about the use of an asset?
- Does the supplier have access to multiple assets which can meet the requirement?
- Are there circumstances in which the supplier might benefit from using an alternative asset, or method, to meet his obligations under the contract?
If having concluded, based on the evidence, that the there is an identified asset, then the next question is:
Do you control the asset?
This will involve understanding whether you have the ability to change how and for what purpose the asset is used for the whole of the contracted term, or how the asset is operated or designed.
In our blood test example you might ask the questions:
- Where is the asset located?
- Is it being used to service other parties’ needs?
- How much of the assets’ capacity are we taking up?
Answers to questions such as these will all need to be considered and assessed for all new arrangements from April 1st 2020 and beyond.
Lifecycle is a procurement and contract management company that has helped the NHS procure and manage their leases at best value for 25 years. We are working with our clients to ensure they are fully prepared for IFRS 16. If you think you may need some help with compliance, simply want to understand alternative strategies for leasing post April 2020, or would like a free appraisal of your lease portfolio, call Sara Bowen on 01865 340800.