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What is IFRS?

What Changed, and How is It Altering How Companies Must Account for IT Assets?

What is IFRS?

IFRS is short for International Financial Reporting Standards. IFRS is the international accounting framework providing guidance on how to properly organize and report financial information. It is derived from the pronouncements of the London-based International Accounting Standards Board (IASB). IFRS is used primarily by businesses reporting their financial results anywhere in the world except the United States. It is currently the required accounting framework in more than 120 countries. IFRS requires businesses to report their financial results and financial position using the same rules; this means that, barring any fraudulent manipulation, there is considerable uniformity in the financial reporting of all businesses using IFRS, which makes it easier to compare and contrast their financial results.

When Did It Change?

                The International Accounting Standards Board (IASB) issued IFRS 16 (Providing guidance on accounting for Leases) in January 2016, effective for financial periods beginning on or after 1 January 2019. IFRS 16 replaces the previous leases Standard, IAS 17 Leases, and related Interpretations. IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract, i.e. the customer (‘lessee’) and the supplier (‘lessor’).

How is the Introduction of IFRS 16 affecting leases?

                IFRS 16 is proceeding to lead to an increase in the amount of leased assets/financial liabilities on the balance sheets of lessee’s, and with all else equal, EBITDA increases as well. Similarly, companies with (material) off-balance sheet lease commitments are running into the need for alterations of important financial metrics.

Past vs. Present (IAS 17 vs. IFRS 16)

IAS 17

  • Leases were labeled as finance leases/operating leases, the dependent variable being how similar the leasing of an asset is to the actual purchase of the asset at hand.
    • Finance Lease: a lease that transfers essentially all the risks and rewards coming with the ownership of the asset to the lessee. Legal title may/may-not be transferred.
    • Operating Lease: a lease that does not transfer essentially all the risks and rewards coming with the ownership of the asset to the lessee.
      • The main risk retained by Lessors is associated with the value of the equipment at the end of its useful life (“Residual Value”)

IFRS 16

  • IFRS 16 declares that a lessee will no longer distinguish between finance leases/operating leases; all (material) leases will be treated as finance leases, excluding short-term leases/low value leases (see exceptions below). In essence, under IFRS 16, leases will get the same accounting outcome as borrowing funds to acquire the assets.
  • Exemptions
  • IFRS 16 provides two exceptions that lessees may elect use to relieve them from having to recognize the asset and liability on the balance sheet:
    • Short-Term Leases: leases with a lease term of 12 months or lease, unless it contains a purchase option
    • Leases for which the underlying asset is of low value ($5,000 or less)[1]
  • Although IASB provides a $5,000 threshold as guidance, companies will need to use judgement in determining if an asset is of “low value”
  • For short-term leases or leases of low-value items to which this exemption is applied, lease payments are recognized as an expense over the lease term.

How Are Companies Being Impacted by IFRS 16?

IASB estimates that 1 in 2 companies will be affected and that companies using IFRS or US GAAP disclose over US$3 trillion of off-balance sheet lease commitments. As an example the following companies are estimated to be materially impacted by the change: Walgreens (~$33 billion in operating leases), CVS Health (~$27 billion), AT&T (~$26 billion), Amazon (~$23 billion), Verizon Communications (~21 billion)[2]

Ultimately, how these new requirements affect a lessee’s financial statements will depend on the mix of lease agreements in place, and also on which of the Standard’s exceptions and practical expedients are applied. However, the expectation for lessees will be:

  • Within the statement of financial position, the lessee will acknowledge the asset/liability; in the statement of profit and loss, the lessee will acknowledge the interest cost/depreciation.
  • Some Outcomes of IFRS 16:
    • Increase in net-debt affecting leverage ratios
    • Increase in EBITDA. Increase in EBIT (A).
    • Increase in Invested Capital for lessee and decrease Return on Invested Capital

Recommended Alternatives to Leasing

Purchase the Asset (CAPEX)

  • While an outright purchase the asset might seem as the simplest and cheapest alternative, it has substantial disadvantages when compared to other alternatives.
    • Large upfront Capital Expenses. Companies need to be efficient on how and where they use their funds focusing on core assets that drive strategic value to their business.
    •  Managing technology obsolescence and refresh as well as asset disposition. Pay for everything; not only what you use.

As-a-Service (OPEX)

  • As opposed to purchasing or leasing an asset, companies have the option to enter into services contracts where a provider takes full responsibility for acquiring and managing technology assets which are consumed by customers based on outcomes and features. Although as-a-service takes away some of the control companies have with respect to the technology assets they require, it brings substantial advantages not only to how these companies treat services contracts financially but how they view and get impacted by technology as a whole. As a service provides companies with the following benefits:
  • Financial benefits
    • Avoid large upfront Capital Expenses that may be used for
    • Pay monthly based on services being received and avoid having to recognize underlying assets as well as future payment obligations on the balance sheet
    • If applicable, Pay-Per-Use and/or terminate when the services are no longer needed
    • Business benefits
      • Bring business agility as the service provider proactively manages resource requirements for customers to consume as needed
      • Get access to the newest technology as service providers continuously adopt the newest technologies and provide for an easier transition to these

How does LIT achieve off balance sheet, OpEx treatment without being considered a lease?

Customers will evaluate how assets are delivered to them to assure that the structure does not look like an embedded lease. LIT incorporates a number of elements that qualify our approach as a true OpEx as-a-Service based on these example elements and more:

  1. Retaining Risk – Performance SLA’s and on demand consumption (variability) risk held by LIT
  2. Features of our offerings include service elements – Installation, colocation facilities, asset monitoring,
  3. Early Termination for Convenience- The ability for a customer to cancel the contract with a reduced penalty as compared to leases with hell or high water payment terms.
  4. Our offerings include no reference to the specific products in the service. Use of non-product related consumption units such as terabytes of storage.

[1] It is important to note that exclusions related to low value assets are not applicable under US GAAP

[2] LeaseAccelerator