Lessons from lease accounting implementation

With the effective date for the new IFRS lease accounting standard fast approaching, companies are wading through a number of challenging issues related to lease identification, data extraction, and software implementation.

IFRS 16, Leases, comes into effect for companies’ annual reporting periods beginning on or after 1 January 2019.

IFRS 16 replaces the previous standard for leases, IAS 17. It removes the old distinction between operating and finance leases for lessees; all leases now go on the balance sheet.

While there are differences between IFRS 16 and the US Financial Accounting Standards Board’s new lease accounting standard, both sets of rules bring leases onto the balance sheet. As a result, some of the best practices and recommended steps for implementation are universal.

Debbie Hill, ACMA, CGMA, the digital finance transformation director at Unilever who led the company’s implementation of IFRS 16, said the new standard also clarified “embedded leases — that’s where there are assets used as part of a product or service somebody is providing to you, and you are, in effect, controlling those assets”.

She gave the example of uniquely shaped containers made for Unilever by a third-party manufacturer. Under IFRS 16, Unilever would need to assess whether the assets being used to make the containers could constitute a lease.

“In some cases our products fully utilise a particular warehouse. We’re telling the warehouse operator exactly the hours they have to be open, the service level they have to provide, the manning levels we’re prepared to pay for,” Hill said. “So we are, in effect, controlling that warehouse, even though it’s owned and operated by a third party. And then it becomes a lease,” she explained.

One of the criteria to determine whether embedded assets are leases is how much capacity of that asset is being used.

“It’s not just good enough to look at the contract,” advised Hill. “A contract very rarely tells you the capacity of an asset that you’re using. So you need your procurement team to know that … the lawyers [would not know that].

“It starts off with a contract exercise, but then it has to be supplemented by operational practice,” she added.

For Unilever, IFRS 16 has added €1.7 billion ($1.92 billion) of assets and €1.9 billion ($2.15 billion) of liabilities to its balance sheet, said Hill. It has also involved a central multidisciplinary team of around ten and was “a huge data management exercise” across the organisation.

Why a new standard?

Gary Kabureck, CPA, a member of the International Accounting Standards Board (IASB) and former chief accounting officer for Xerox Corp., said transparency was one reason for the standard’s introduction. IASB research had showed that globally in 2016 companies reporting under IFRS and US GAAP had around $3 trillion of lease commitments, of which more than 85% was not on the balance sheet.

It was hard, Kabureck explained, for investors, rating agencies, major lenders, and underwriters to get an accurate picture of total off-balance-sheet commitments.

The IASB had identified ten industries that had substantial off-balance-sheet lease commitments. The top five of these were the airline, retail, travel and leisure, transport, and telecommunications sectors. Kabureck said that within these industries “there is a big range of impacts from very large to nil”.

He said there were further advantages in moving all leases onto the balance sheet. “When something goes on a balance sheet as opposed to off balance sheet, capital budgeting gets a little more attention, which is a good thing,” he said. “Transparency inside a company is a good thing. … Plus you get a little bit better … controls over your lease database.”

Implementation options

IFRS 16 can be implemented in two ways: fully retrospective or a “modified” approach.

A fully retrospective approach, which Unilever took, means prior-year accounts are restated on the IFRS 16 basis. When a company’s 2019 accounts are published, its 2018 accounts will be restated on the same basis. “[This] is a lot more work because you have to go back a lot further in time,” Hill said. “But it means that we can give complete comparability of accounts to our investors, which we felt was important.”

Under the modified approach, restatement of comparative periods is not required, and the preparer fulfils the transition requirements by recording the cumulative effect of applying IFRS 16 as an adjustment to equity as of the date of initial application of IFRS 16.

For Unilever’s fully retrospective approach, Hill said, “there was certainly a cost. And it’s provided us with more transparency over the arrangements. … It may, in time, drive some decision-making.”

She explained that implementing IFRS 16 could affect capital employed ratios and return on capital invested. “The question is by how much and by how much relative to competitors,” she said. “That will become transparent as people publish their first set of accounts under IFRS 16.”

Some of the high implementation costs for Unilever were due to a new software system. Before the new standard was issued, many companies used spreadsheets to handle their lease accounting, and some companies that have few lease obligations may find that spreadsheets continue to be adequate for this task.

Unilever, though, is one of many companies that decided that new software tools would be necessary for lease accounting under the new standard.

“We didn’t want all this done on spreadsheets,” Hill said.

Some companies also are using artificial intelligence to extract the data from lease contracts that’s necessary to perform the accounting. Unilever attempted this tactic in a pilot, but it was unsuccessful. Hill said: “Unfortunately it failed because our contracts were just too complex and too variable. So we ended up on the good, old-fashioned … route of people reading contracts and extracting data.”

Getting the language right

One of the big challenges, Hill said, was to turn the accounting language of IFRS into business language, so that “we could go to our procurement professionals and say, ‘Answer these business questions, and then that will tell you whether you’ve got any embedded leases in your contracts.’”

She said that sets of guidelines were developed for each type of purchase. “For instance, we developed some guidelines for our procurement warehousing team to go away and answer … three or four questions.”

As well as buyers and procurement teams, financial accounting teams have also been involved in the large IFRS 16 education programme at Unilever. At the time there was little off-the-shelf training available, explained Hill, “so we ended up … doing our own training modules for it”.

Implementation tips

Hill warned against delaying IFRS 16 implementation. Here is her advice:

Provide guidance to the different parts of your business on determining whether a contract is in fact a lease. Relevant parts of the IFRS 16 standard have to be put into your business language — so you have a consistent assessment of lease contracts across the business.

Identify the areas of spend in your business that need to be more closely examined, eg, real estate.

Consider implementing a new lease accounting system. This has a cost, and whether or not it is required will depend on the business size and the number and complexity of the company’s lease contracts.

Follow the value. Focus on getting the big leases right. Work out your 80/20; in other words, which 20% of contracts account for 80% of value. For Unilever, 80% of value was in real estate — office and warehouse leases.

Don’t delay. The longer you wait, the more challenges you will create.

Match theoretical with actual lease payments. You may need to have invoices from third parties split between the lease amount for the asset and other service amounts — so you can record your lease liability properly. For example, an invoice from a supplier of a leased car — the rental payment, fuel, insurance, and maintenance — can be itemised separately.

Kabureck said that IFRS 16 has been a “highly visible project” for many years. At this stage, he advised that those who carry out external financial communications for companies “should be well prepared to discuss the amount, the transitions, [and] what the internal ramifications are [if any]”.

He added: “Your total commitments and your total scan and scope of business is unchanged as a result of [IFRS implementation]. Just some pieces are more transparent than they used to be.”

─ Oliver Rowe (Oliver.Rowe@aicpa-cima.com) is an FM magazine senior editor.