IFRS 16 Leases – Impact on financial institutions

in Financial Services, 22.01.2016

After extensive consultations that had started with a discussion paper published in 2009, the IASB finally issued IFRS 16 Leases on 13 January 2016.

The new standard replaces IAS 17 with its accounting requirements which were introduced 30 years ago and no longer match today’s economic reality. As leasing is an important and flexible measure of financing, e.g. of the rental of an office building (also for companies in the financial service industry), the new standard will improve the transparency and comparability of information on off-balance sheet leases by bringing them onto the balance sheet.

IFRS 16 defines that a contract is (or contains) a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Compared to the definition in IAS 17, the definition is changed but for most contracts the IASB does not expect an impact on the conclusions if a contract contains a lease. Service contracts (in case of a lease of a property such as cleaning, security and advertising services) which are often combined with leases in a single contract are still not subject to lease accounting.

Impact for Swiss financial institutions with material operating leases such as office building rentals

IFRS 16 significantly changes how a lessee accounts for operating leases. Under the current IAS 17, a financial institution would rent an office building for several years with such a rental agreement being off balance sheet. IFRS 16 does not require a lease classification test as all leases are on balance sheet. The financial institution recognizes a right-of-use (ROU) asset, i.e. the right to use the office building, and a lease liability, which treats the lease as a purchase of an asset on a financed basis. The asset and the liability are initially measured at the present value of unavoidable lease payments. IFRS 16 requires a bank to present lease assets arising from leases of properties as tangible assets. The depreciation of the lease asset and the interest on the liability is recognized in the income statement over the lease term, similar to the treatment of finance lease under IAS 17, which basically leads to higher expenses at the beginning of the term of the lease.

IFRS 16

Financial institutions with material off-balance sheet leases applying IFRS 16 will report higher assets and lower equity which could affect their regulatory capital. The key question for banks is how the ROU asset will be classified for regulatory purposes. In the Swiss regulatory environment, we expect the ROU to be classified as non-counterparty related assets like own property. This will influence the risk-weighted assets and with it, the capital ratios used for the calculation of the regulatory equity.

The IASB carried out extensive consultations throughout the whole due process of IFRS 16. Amongst others, in order to estimate the effects on reported equity of banks, its research showed that the estimated decrease in reported equity will only amount to less than 0.5 percent for a sample of 20 European banks. However, we recommend assessing the estimated effect on an individual basis, considering the characteristics of the Swiss real-estate market.

Excluded from the scope of IFRS 16 are assets leased for a short term of 12 month or less or leases of low-value assets. Therefore, financial institutions will not have to recognize leased coffee machines, office equipment and furniture on their balance sheet.

Accounting for lessors

There is no significant change of lease accounting for lessors. Consequently, the lessor will continue to classify leases as either finance or operating leases. However, IFRS 16 introduces additional disclosure requirements for assets subject to operating leases and how the lessor manages risks relating to residual values.

Significant transition reliefs for lessees

As a practical expedient, a financial institution does not need to reassess whether a contract is, or contains, a lease at the date of initial application of IFRS 16 on or after 1 January 2019. A financial institution will not be required to restate prior year’s financial figures but will be allowed to recognize the cumulative effect of initially applying IFRS 16 as an adjustment to the opening balance of equity on 1 January 2019.

Swiss financial institution are well-advised to consider effects of IFRS 16 on the financial statements of their customers with significant lease commitments, including impacts on covenants and key financial metrics, such as leverage ratio. Finally, due to the requirements in the new standard, financing models like sale and-leaseback are expected to cease to be relevant which may lead to changes to business practices.

 

 

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