Even before the pandemic, many experts anticipated difficulties of implementing IFRS 16. Many of these issues have been further complicated by COVID-19. So, now that the transition is complete, what have the major challenges been?
What is IFRS 16?
IFRS 16 was brought in to replace the lease accounting guidance previously covered under IAS 17. Most companies completed this transition during the 2019 fiscal year — just before the pandemic hit in early 2020.
The aim of IFRS 16 was to increase transparency and comparability in financial reporting. One of the major changes of IFRS 16 was the move to a single model approach, removing the previous distinction between operating and finance leases. Under the new standard, lessees will need to recognise assets and liabilities for all leases, irrespective of prior classification. Required disclosures will be more detailed, and almost all off balance sheet accounting will be eliminated.
The application of IFRS 16 presents several issues. In particular, the definition of a lease and the determination of lease term. There is guidance to help organisations with these issues, however, the process is complex and involves significant judgements that can affect recognition of assets and liabilities.
According to Andrew King (Partner for CFO Advisory with KPMG), companies need more data to accurately report their lease arrangements. Acquiring this data presented a considerable challenge, especially during the pandemic, and many organisations have turned to external expertise to help them comply with the standard. Building an accurate picture of lease portfolios takes considerable time and investment, and King emphasises the need for organisations to transform operations beyond accounting and finance, such as legal, corporate, real estate and human resources.
The challenges to IFRS 16 implementation were, of course, exacerbated by the pandemic. The need for time and investment was undermined by furloughed staff, the difficulties of remote work, social distancing and/or isolation constraints. However, COVID-19 also presented specific challenges to IFRS 16 by way of lease modification and impairment testing.
The original IFRS 16 would have considered rent concessions (which were widespread and necessary during the pandemic) to be lease modifications and, therefore, required the lessee to recalculate liability. This assessment involves using a revised discount rate, which is operationally difficult for many and created the possibility of larger liability being calculated if current discount rates were lower than historical rates. In addition, this posed a particular logistical nightmare to organisations with many leases. As a result, the IASB issued an amendment to IFRS 16, allowing lessees to have the optional exemption from whether a rent concession is considered a lease modification. Instead, the concession could be accounted for as a variable lease payment.
Under IFRS 16, organisations report the asset (future economic benefits) and liability (future cost commitments) associated with every lease. However, it becomes difficult to estimate economic benefits during a time of paused or slowed operations. For example, a retailer who has been forced to close their shops can no longer expect the same economic benefit from their leases. This means that the value of the asset is likely to be over-stated, and the organisation will need to correct this with impairment testing. Impairment testing can be complicated and time consuming. However, COVID-19 and the requirements of IFRS 16 make it more important than ever. Determining the proper level of assessment, appropriate discount rates and ensuring accuracy of disclosures can help to make the process easier.
The combination of a global pandemic and a new standard being applied for the first time has created an unprecedented challenge for accounting teams — and we are still waiting to understand what the full impact of implementation has been. However, it is important to remember the long-term expected benefits of the standard. For example, access to better data benefits both organisations attempting to increase lease efficiency and investors wanting a deeper understanding of financial reports. Now that the worst is hopefully over, companies may start to see the upsides of IFRS 16.