IFRS 16 – oddities of the transition process

The IASB recently published an “Implementation Update” on IFRS 16 Leases

In the document, “four IASB Members discuss messages they have heard from stakeholders about IFRS 16 implementation over the last year and give advice to companies implementing the new Standard.” Much of this messaging really only consists of emphasizing various bits of the standard, or of saying exactly what you’d expect to be said (“If companies have not yet started their implementation activities, they need to do so soon.”). But two passages caught my interest for various reasons.

First, writing on judgments and interest rates, Darrel Scott says this:

  • “Based on the feedback we have heard, the biggest challenge relating to discount rates is determining an appropriate incremental borrowing rate for long-term leases such as long-term leases of property. Lessees cannot always identify a rate for a similar borrowing to use as a starting point. In these cases, lessees may benefit from thinking about how they assessed the price of the lease at contract inception. For example, at inception, what rate the lessee used to assess whether the long-term lease pricing was reasonable? Alternatively, lessees could think about starting with other observable rates such as relevant property yields, and then consider how those observable rates might need to be adjusted to reflect the lessee’s own risk profile.”

This made me think of similar issues that often arise in allocating the issue price of a convertible instrument  between debt and equity portions, or more generally in separating out the components of various “bundled” financing transactions. Such allocations tend to assume rational negotiations in which every component of an arrangement is individually negotiated and priced. It ought to be an entirely logical assumption, but especially for smaller companies, it’s not always evidenced by the details of what actually gets negotiated. So for example, based on a five minute search, I’m currently looking at a set of financial statements in which the future cash flows attaching to convertible debentures carrying an interest rate of 10% were discounted at 35% for purposes of determining the equity portion. Of course, there was never an alternative negotiation in which the company might have paid such an onerous rate absent the equity “sweetener.” Such calculations, and the financing cost that results from them, are entirely notional.

It probably helps that smaller companies aren’t as likely as larger ones to have entered into long-term leases; still, we can expect variations on this same problem to come up in practice. However scrupulously companies may try in retrospect to analyze transactions they entered into in the past, it’s obvious that an accounting treatment based on numbers they didn’t actually think about at the time will often be a bit shakier than one based on those they did.

Secondly, writing on investor expectations and lease disclosures between now and 2019, Stephen Cooper comments as follows:

  • “A user of financial statements might reasonably expect that the amount of lease liabilities appearing on the balance sheet when IFRS 16 is first applied will be broadly similar to previously reported operating lease commitments, adjusted for the effect of discounting. If the amount of lease commitments on the balance sheet in 2019 is likely to differ from investor expectations, communicating early is the best approach. We know some companies are thinking about this already.
  • Differences could arise because judgements about whether to include particular amounts in lease liabilities become more critical when IFRS 16 is applied. Today, the inclusion of an amount as a lease payment often affects only the operating lease commitment note; when IFRS 16 is applied, it will affect the face of the primary financial statements. Therefore, some companies are expecting to apply a greater degree of rigour to judgements such as whether to include extension and termination options in the lease term and the definition of a lease. This new rigour could lead to the recognition of a different amount of lease liabilities than today’s operating lease commitment note might suggest…”

This took me back quite a while, to a time when I was involved with various Canadian companies that decided to convert from old Canadian GAAP to US GAAP, so as to be more comparable with and thus better compete for capital against US entities (this was quite a theme for a while). Although these companies usually already provided disclosure in their notes purporting to quantify all material differences between US and Canadian GAAP, the process of formally converting their primary reporting from one to the other would inevitably prompt a greater focus on the whole area, generating additional and perhaps previously unsuspected sources of adjustment. Things have evolved a lot since then in terms of technology and attitudes toward access to and engagement with information, and one might have thought the rigour gap, so to speak, between the numbers in the primary statements and those in the notes would have dissipated by now. But Cooper is suggesting not. And there in a nutshell lies I suppose a large part of the argument for bringing leases onto the balance sheet…

The opinions expressed are solely those of the author

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