In the past, we have seen Swiss financial institutions selling their office buildings to investors and leasing them back. The main goal of these sale-and-lease back transactions was to save regulatory capital. With IFRS 16, lessees will now bring most leases on balance sheet. For this reason, financial institutions have to recognize 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 key question for banks is how the ROU asset will be classified for regulatory purposes. In the Swiss regulatory environment, we expect the ROU asset to be classified as non-counterparty related assets like own property. This classification is supported by the decision of the IASB that ROU assets should be disclosed either as property, plant and equipment or as stand-alone asset. This will influence the risk-weighted assets and with it, the capital ratios used for the calculation of the regulatory capital.
What should a Swiss financial institution do to get a first sense of how it could be impacted?
In our view, it is important that a Swiss financial institution gets an idea of how it could be impacted on transition date (1 January 2019). However, the standard grants significant transition reliefs for lessees – but the preparer needs to find its way through the different optionalities.
In its webcast in March 2016, the IASB identified the following 5 main decisions / expedients that a lessee needs to take and is able to exercise, respectively:
Source: Webcast IASB, 17 March 2016
1. Identifying a population of contracts for transition
Under IAS 17, the lessee disclosed in its notes the operating lease contracts. Going forward, a financial institution needs to decide if it prefers to review all contracts that could be concerned by IFRS 16 or apply the new definition of IFRS 16 only to newly entered contracts starting 1 January 2019 and therefore transition all IAS 17 operating lease contracts (grandfathering the previous assessments).
Another decision the lessee will have to take not only concerns the transition but also its future accounting, i.e. whether to apply the recognition exemption for short-term leases and leases of low-value. Electing to account for leases with a lease term of 12 months or less as an operating lease is made by class of underlying assets, whereas leases where the underlying asset is of low value when it is new (even if the effect is material if aggregated) is made on a lease-by-lease basis.
2. Deciding on a transition method
A lessee is either allowed to apply the standard retrospectively and to restate the comparative period or to recognize the cumulative effect at the initial application of the standard as an adjustment to the opening equity on transition date. In the latter transition method, the comparatives are not restated.
In applying the so-called cumulative catch-up approach, the lessee needs to decide whether:
a) To apply transition reliefs to leases ending within 12 months after 1 January 2019 (date of initial application). If, for example, the financial institution entered into a 10-year lease for an office building in 2009 and the lease ends on 30 June 2019, the financial institution could decide to not account for the ROU asset and lease liability on balance sheet but account for and disclose it similarly to short-term leases on transition date.
b) To use practical expedients in measuring lease liabilities such as (a) apply a single discount rate to leases with similar characteristics and not to determine the applicable interest rate for each contract or (b) use hindsight in determining the lease terms (e.g. exercise of extension option, purchase option, etc.).
c) To use practical expedients in measuring the ROU assets. Such a decision is made on a lease-by-lease basis. In applying this relief, the ROU asset is measured at an amount equal to the lease liability with the consequence that the ROU asset will be too high at transition date and which results in higher depreciation (and smaller interest expense). Additionally, the lessee could rely on the previous assessments of whether a lease is onerous and therefore does not need to perform an impairment review for the ROU asset. The lessee also has the possibility to exclude initial direct costs from the measurement of the ROU asset at the date of initial application of the new standard.
IFRS 16 Leases – a new standard with more importance to Swiss financial institutions than you might think at a first sight…
Applying IFRS 16 for the first time will be a time-consuming and a costly process for many companies. Therefore the IASB sought to reduce implementation costs by granting transition reliefs. Some expedients are accounting policy choices, some apply by class of underlying assets,some can be elected on a lease-by-lease basis: in short, there is a bewildering choice of combinations and permutations! In effect, financial institutions will have a range of possible outcomes depending on the transition solution chosen – directly impacting their regulatory capital. Financial institutions wishing to complete a detailed modelling of different transition options in order to understand how their opening balance will look like in each case should start now!