IFRS16 is the relatively new accounting standard that removes the distinction between an operating lease and a finance lease. As of 1 January 2019, companies are required to recognise their operating (i.e. off-balance sheet) leases on-balance sheet by raising a lease liability against a right of control use asset (RoUA). The lessee will exchange a lease expense for interest on the lease liability, and depreciation on the RoUA. Gearing ratios will increase as debt increases in the balance sheet, and capital ratios will be depressed.
The lease liability is measured as the present value of lease payments (consideration), including the cost of any residual value guarantee, termination costs or the exercise price of a purchase option. The discount rate is the implicit in the lease, and if this is not readily available, the incremental borrowing rate (IBR). The IBR is the rate which the lessee would have to pay to borrow for a similar term, with similar security, in a similar environment and the funds necessary to obtain an asset of similar value to the RoUA. This is where it gets complicated.
IFRS16 follows a handful of new accounting standards that require complex (risk management) modelling techniques, namely IFRS9 (valuation of financial instruments), and IFRS13 (fair value measurement). The implementation of above requires significant effort of risk functions, which are not in place at smaller banks and especially corporates.It is important, therefore, to understand the broader requirements, inter-linkages, and consequences (of not getting IFRS16 right).
Challenges imposed by the new standards. There are several challenges facing companies which have existing operating leases, or are not sure whether they have a lease arrangement (RoUA), including (inter alia):
We are focusing our attention in this article on the discount rate, due to the fact that it is so important for the resultant valuation of the lease liability, the consequent outcome of your gearing and capital ratios, and ultimately the potential credit rating of your business, which will dictate your cost of funding going forward.
The lessees’ discount rate is the interest rate implicit in the lease. It is at the inception of the lease, based on: the lessee’s credit status at the time, the term of the lease, the level of security available, the economic environment etc. If this rate cannot be readily determined, the lessee would need to use its “incremental borrowing rate”.
The IBR is the interest rate that the lessee would have to pay to borrow over a similar term, with similar security, and in similar economic conditions. In sovereign terms, this would be the Treasury rate, dictated by the credit status of the country, or counterparty. This rate draws us back into the realm of the risk management expert, and naturally links this standard to the building blocks of IFRS9:
IFRS 9 uses an “expected loss model” (as opposed to the “incurred loss model” of IAS39) for all financial instruments that are subject to impairment accounting. Expected credit losses (ECLs) are an estimate of losses that an entity expects will result from a credit event, such as a payment default. ECLs are a cost of lending activity. These costs are reflected through:
The reason that this standard, and its measurement of the ECL, or credit status of a corporate, is important for the calculation of the discount rate, is that it enables a risk expert to impute the appropriate corporate-specific IBR (as one would price/plot a yield of a corporate bond).
The world of finance, accounting and risk management are blurring since the global financial crisis and may continue to blend as we emerge from the most recent Black Swan event.
Corporate, SME and other low data risk modelling and credit rating solutions are typically expensive, and expertise is rare. Anchor Point Risk can assist clients with the globally accepted credit rating benchmarks, which we “anchor” to your country, industry, sector, and company specific factors to produce a credible, and defendable, rating. It has also harnessed technology to make available a digital IFRS9 and IFRS16 solution available to the client at accessible cost. The solution will even allow the client to perform its own IFRS9 and IFRS16 calculation and valuation, with a built-in validation function to further reduce the cost of the audit.
We are faced with numerous challenges in the current environment. This accounting standard is a game-changer… make sure you are on top of it.
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