IFRS 16 …Are you ready yet?

Following the first major overhaul of lease accounting for 30 years and as the introduction of IFRS 16 draws closer (the final CIPFA consultation closes on the 7th of September), we look back at the emergence and growth of operating leasing as a source of ‘off balance sheet’ finance which was particularly attractive to both public and private sector organisations for a variety of reasons. Also, we consider some of the commercial implications of IFRS 16 for all organisations and specifically Local Authorities.

The previous accounting standards IAS 17 (IFRC4 and IFRIC 12) and SSAP 21 (FRS 5) classified and distinguished leases between finance and operating leases. Operating leases where the lessor retained significant asset risk would be classified as revenue expenditure, and the liability for outstanding rental obligations would be kept off balance sheet with a disclosure note buried in the notes to the accounts. Finance leases have always been capitalised and recognised as on balance sheet finance.

Many organisations, including local authorities, were attracted to the off balance sheet features of operating leasing. Although, such benefits were also considered more ‘psychological’ than real as any credit manager worth his or her salt would always seek to identify and calculate ‘off balance sheet’ liabilities when assessing and measuring credit risk.

Operating leases often combined other services costs such as maintenance designed to relieve the lessee of asset management and asset disposal issues. These service features were often seen as an attractive way for local authorities to outsource the management of vehicle fleets, property construction and maintenance, IT resources and grounds maintenance under managed service contracts and PFI.

Local Authorities saw the emergence of operating leasing as a convenient way to avoid the old capital controls to acquire and fund assets, and they made significant use of operating leasing up to and until the introduction of the Prudential Code in 2003. Indeed, the accounting treatment for operating leasing was often a key driver in determing the best way to fund assets which was arguably a questionable strategy. However, post Prudential, operating leasing has seen a decline in use by local authorities with best value for money decisions trumping the accounting treatment as the primary factor for using leasing.

So here we are now with the IASB finally publishing the long awaited IFRS 16 lease accounting standard in January 2016, with an effective date of 1st April 2019. The new standard, designed to provide more transparency and to more accurately reflect the economics of leasing, requires lessees to recognise nearly all leases on the balance sheet which will reflect their right to use an asset for a period of time and the associated liability for payments. 

The new standard will affect virtually all commonly used financial ratios and performance metrics in the corporate world. These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes. Furthermore, these impacts may compel many organisations to reassess certain ‘lease versus buy’ decisions. The scale and scope of the changes at the global level will mean, according to Bloomberg, for listed companies alone $3tn off balance sheet commitments being transferred onto the balance sheet.

For local authorities the new standard will have an impact on the capital financing requirement, minimum revenue provisions and on borrowing limits. IFRS16 will have a substantial practical impact on local authority accounts preparation and it’s likely that local authorities will need to consider both new or amended processes, systems for data gathering and collection to enable and manage the information requirements of the new standard and not least the measurement of the new ‘right to use assets’ calculations. It’s also likely that the changes will impact not only financial reporting but also alternative business operational models including outsourcing.

It’s expected that CIPFA will make some ‘practical expedients’ in the code, for example to include the standards exemptions to small value leases such as tablets and personal computers, small items of office furniture and telephones (assets with a value of $5,000 or less when new). Low value assets meeting this exemption do not have to be recognised on the balance sheet. 

Lessor accounting remains largely unchanged from IAS 17 however, lessors are expected to be affected due to the changed needs and behaviours from customers which impacts their business model and lease products. However, our recent research from the existing Arlingclose local authority lessor panel is business as usual. Lessors consistently absolve themselves from confirming accounting classification of their products to lessees, and they will continue to offer residual value based leasing to maintain operating cash flow budget objectives for local authorities.

In summary, the impact of IFRS 16 on local authority/lessee’s financial reporting, asset financing, IT, systems, processes and controls is expected to be substantial. Are you ready?

Arlingclose is now providing a bespoke consultancy service designed to help clients with leasing portfolios to manage and migrate to IFRS 16. For more information please contact any member of the Arlingclose Leasing and Technical team:  Mark Swallow (mswallow@arlingclose.com), David Green (dgreen@arlingclose.com), Stephen Kelly (skelly@arlingclose.com), Chris Taylor (ctaylor@arlingclose.com), Stephen Kitching (skitching@arlingclose.com), Greg Readings (greadings@arlingclose.com) and Nicole Hodges (nhodges@arlingclose.com).