The International Financial Reporting Standard (IFRS) 16 new lease accounting standard is applicable from 1 January 2019 by listed companies, financial institutions and those entities that are group companies of listed or financial institutions or have voluntarily chosen to apply IFRS 16.
In this article, I would like to focus on its effects for a company’s Procurement Department.
Various leasing companies (lessors) have become concerned about the implementation of the new lease accounting guidelines by their customers (lessees). These concerns are voiced mostly by lessors offering full operational leases, thus inclusive of various services.
The concerns are that a leasing proposition is viewed as becoming too complex to arrange, too complex to execute, let alone too difficult to administrate.
The International Accounting Standards Board (IASB), issuer of the IFRS, is of the opinion that sufficient information may be available to make proper decisions about lease contracts. For IFRS 16, it has decided that accounting according to the current finance leases also for operational leases would produce a transparent and comparative footing for all.
The leasing industry still struggles with the details of IFRS 16 for operational leases, even when for lessors, in essence, accounting will not change. Lessees will also soon start struggling with the effects of implementing operating leases; for them accounting will massively change.
And more than that: arranging leases will require new insights as how management decisions affect the process of acquisition/purchase/procurement.
I would like to explore two simple examples:
1. Rented real estate;
2. A fleet of cars
Rented real estate
A listed company is present in multiple countries in Europe. Company policy is that premises outside the home country are rented (leased), not purchased. These rental (lease) agreements need to be presented on balance sheet as of 1 January 2019.
A typical agreement is entered in for a five year period with an option for a five years extension period (with preferred first option right). Rentals are paid quarterly in advance on the basis of a fixed all-in m2 price. In some countries, according to local usages, the leases are indexed at fixed-for-the-term or annual increases, the latter according to the country’s consumer index.
The Procurement Department is engaged in finding A1-locations fitting the stature of the company and has negotiated the all-in prices in the past. In practise, it turns out that in each country a number of floors are hired in a multi-level building with a central reception, shared restaurant facilities, etc.
A fleet of cars
A European Consultancy Group voluntarily applying IFRS engages in an annual fleet renewal of 75 cars, on average. All of the cars leasing activities are outsourced, freeing expensive HR staff.
Around 25 cars are for new young entrants as per 1 September, who are allocated a low budget car. Some 20 Cars are for middle- and another 20 cars are for senior-management, in respective price ranges. The remaining five cars are for the directors in various countries with cars at executive level.
Executive cars are replaced every two years, budget cars every three years and middle- and senior-management cars every four years.
For each group of cars, a fixed mileage per year is agreed, without compensation between individual cars. The monthly lease rental price is fixed for the contracted period.
Petrol is excluded from the lease price and charged quarterly in arrears, as are road tax, etc.
The Procurement Officer negotiates the offerings of at least three different car leasing companies per year for the year’s volume. In practise, for each of the last four years, different leasing companies were awarded the year’s volume of cars.
A recipe for work-out
In order to work out what has to be decided and done, a multi-step approach is needed.
1. For real estate, one has to understand that each individual rental is unique. Even when rental conditions are synchronised between countries. Multiple lessors, real estate agents, per country are contracted;
2. Management has to decide whether to take service elements into the initial value calculation or not. Including service elements leads to higher balance sheet values and higher depreciation costs; excluding service elements results in higher operational costs.
Any decisions affects EBIT(DA) = earnings before interest, tax, depreciation and amortisation. And at the same time, it affects the level of interest shown in the Profit and Loss Accounts and from there, the Cash Flow statement. And not to forget a range of other ratios;
3. The Procurement Department may want to investigate the percentages of service elements in the total rental amount. It may find indications that percentages depend on the aging of the building and renovations made by the landlord. Procurement may suggest management applies fixed breakdowns, dependent on the (renovation) status and age of the building.
For example, per range of years and based on the Life-Cycle-Costing (LCC) model. Each of these decisions is arbitrary, requires judgment and will trigger discussions at start with the external auditors;
4. The Finance Department may want to suggest a reasonable incremental borrowing rate to management, as for real estate, one will not normally be able to secure an interest rate implicit in the lease;
5. Once management has decided on 3) and 4), the finance function can make final calculations as to the annual services, interest and depreciation amounts per ‘asset’.
The above proves that taking on-board former operating leases is not as simple as the IASB suggests.
Yes, in the end, accounting is simple. Yet in order to get there, with the consent of external auditors and the understanding by analysts, using consistent calculation models over time, is far from simple.
And in this example, we didn’t even touch upon transitions issues.
With the above in mind, with no way to circumvent renting of premises, one can understand that car lessors are far from reassured about effects of IFRS 16 on their business.
A fleet of cars
The other example relates to a fleet of cars.
Other than real estate, where in the end one only has a handful of contracts with steady, long-term obligations, operational car leasing is very service rich.
In fact one of the dominant attractions for leasing is not having to bother with day-to-day car details like tyres, repair, insurance, petrol costs, road taxes and the occasional fine.
The work out for car leasing results in similar decisions to make. However, the amounts involved are far smaller than in the case of real estate. In view of the amounts, management may decide that separating services for balance sheet presentation is not worth the extra effort; especially, when the company heavily is engaged in rented real estate.
Yet, the same discussion about using either the rate implicit in the lease or the incremental borrowing rate comes up.
The new standard on leases is written from a single contract perspective, suggesting, that the asset is clearly identifiable and unique and can be attributed to a dedicated interest rate.
For operational leases in general, this, unfortunately, is the weak point in the new standard.
An operational lease is not a finance lease in disguise. Starting from the liability side for calculating the leased asset suggests that life is simple and straight forward.
But when, as in operational leases, wear and tear, either mileage per annum or number of running hours per period, make up for the assessment of maintenance and replacement of parts, one cannot express the outcome in an interest percentage.
Everybody understands that depreciation over five years of an asset that is not used, as is assumed for plant and equipment guidelines in International Accounting Standard (IAS) 16 and to be applied for leased assets likewise, doesn’t fit a car with 10,000 or 25,000 miles per annum. The usage of the car (asset) makes that residual value after the lease period is a function of mileage. And mileage also affects the wear of tyres with replacement costs at certain intervals.
So, as residual value is an integral part of assessing the weighted interest rate, a rate implicit in the lease, at best, is an estimate.
A large impact
To clarify for those puzzled at this stage: more or less ‘residual’ in the contract to be financed, in combination with the total length of the lease period, has a large impact on the final interest rate.
With longer-term interest rates higher than shorter-term rates, the finance (interest rate) outcome of 36 monthly instalments based on a 55% residual value with 10,000 miles per annum compared to 48 monthly instalments based on 45% residual value with 25,000 miles per annum is quite different.
Except when interest rates are almost zero, like we see these days, there is no linearity in interest rates over time. And as we have seen in the past, with interest rates well above zero, we saw yield curves (the plotted curve of interest rates for different time periods for one given moment) not resulting in a linear line either.
The above, too, proves that taking on balance sheet former operating leases is not as simple as the IASB suggests.
Applying an ‘interest rate implicit in the lease’ which is ‘readily available’ as the standard offers as one of the options, in practise doesn’t work out. Why should any lessor inform the lessee about the interest rate it applied in its lease calculation, knowing that the opponent auditor, analyst or customer will only misuse that information for negotiation purposes.
And knowing that the rate he, as lessor, applied, is just one of the elements next to compensating elements like volume discounts, supplier bonuses, etc.
The alternative in the standard, the incremental borrowing rate, can also be a complex item to identify. For sake of simplicity, auditors and analysts should speak out that applying a company-specific incremental borrowing rate best can be linked to the target return on equity, say two-thirds of it.
The resulting P&L entries are as random as one can get anyway.
Or will Procurement negotiate tyre discounts, volume bonus for buying multiple cars instead of leasing the same. And keep track of fines, repair, and maintenance for the same inclusive price?
Henk Uunk held the position of manager financial accounting and reporting at ING Lease Holding from 2004 to 2014. He is chairman of the accounting committee of the Dutch Leasing Association (NVL) and a member of Leaseurope’s accounting and taxation committee since 1992. Uunk is a contributor to the Dutch Accounting Standards Board working group on leases and acts as a consultant to the Dutch Car Leasing Association (VNA).