Collecting and classifying contracts is perhaps one of the biggest challenges facing organisations in their journey to become compliant with the new IFRS 16 accounting standard. Ensuring that this master data is collected, collated and recorded is paramount to a successful IFRS 16 project.
Contracts (Leases) are entered into by various departments across a business such as Legal, Finance, Procurement, IT and Facilities. Contract documentation is either stored in digital format, or old fashioned hard copies are filed or kept by respective departments. Where issues arise is when the integrity of this storage is compromised or lost. The difficulty in collating these documents is further exacerbated for global organisations, where contract information is spread around various jurisdictions, and where they are executed in different languages and currencies.
The biggest challenge we have evidenced revolves around how companies actually classify the contract as a lease. In our experience, Technology related Contracts have proved to be the most challenging because they are invariably written in technical language which can prove difficult in classifying without input from IT.
To begin the IFRS 16 compliance process for companies today, management should answer the following questions:
- Do you know where all contract agreements are stored?
- Do you know which of your organisation’s contracts contain leases or not?
- Are your systems and processes actually capturing all required information?
- Are your systems and processes capable of monitoring leases and keeping track of events that impact on Rights of Use (ROU) and Lease Liability Values?
The IFRS 16 standard allows organisation to select one of two transition approaches: modified retrospective approach or the fully retrospective approach. The amount of data to be collected will largely be determined by which approach is selected.
- If a modified retrospective approach is adopted, the organisation is required to collect all the data applicable from the consideration start date (namely, the date the organisation officially adopts the IFRS 16 standard). Importantly, two practical expedients are available to the organisation, being low value and contract term less than or equal to 12 (twelve) months. This allows the organisation to classify and report these contracts as operational leases. The organisations accounting policy regarding what a low value contract will need to be determined. In our experience clients have deemed low-value contracts to be anything ranging from $5,000 AUD to $10,000 AUD.
- If a fully retrospective approach is adopted, the organisation needs to collect all historic data regarding the contracts. This can be highly onerous and time consuming especially if contracts are not in electronic format. It is also pertinent to note that no practical expedients are available to the organisation adopting this transition approach.
An IFRS16 project is more about data than accounting, as ‘dirty data’ will impact on the accuracy of the right of use and liability values. Therefore, it is important for organisations to collate and capture the correct data points. To help our customers capture this data, Bluleader have developed a data collection template. Data points populated into this template can then be checked, transformed (minimised) and loaded into the system.
In addition to lease payments amounts and the payment frequency (such as weekly, monthly, quarterly) the following data points need to be collected and captured:
- Start and End Dates which will need to be aligned to the contract term.
- Payment Term – In Arrears, In Advance or Mid Cycle
- Note: Payment Cycles can prove problematic specifically where the cycles start on 30thor 31stof every month.
- Residual Values – Motor Vehicle or Equipment Leases.
- Purchase Options
- Renewal Options – Number, Period and Notification
- The probability to renew is important to note, as it impacts on Right of Use calculations.
- Renewal Options, for example 2 x 3 year option with 3 month notification term.
- Make Good Provisions for Property – impact on the ROU asset amount
- Rent Free Periods at the start of the contract and/or on anniversary of the contract.
- Impairments – Onerous Leases
- Upfront Charges (paid to the Vendor and paid to a 3rdParty)
- Incentives – provided by the Lessor to the Lessee.
- Review Dates – CPI, Market Review etc
- Fixed Increases in the amounts due
- Discount Rate – used for the initial calculation (applied individually to each lease or portfolio of leases), and during the lease term
- Additional information stored on Fixed Asset Master Record, such as License Plate Numbers, Serial or Inventory Numbers and other specific Fixed Asset Fields such as evaluation groups.
- Sub Leasing arrangements
All of the above data points has a direct impact on the calculation of the ROU Asset Value and the Lease Liability amounts per lease.
To conclude, gathering data for the transition to IFRS 16 compliance is not the end of the process but a fundamental step in setting an organisation up for success in ensuring adherence to the new Lease accounting standard. It is fundamental that systems and processes are put in place to record, store and update this information.
The flow on impact of incomplete data and/ or incorrect data would lead to an organisation either under or overstating their reported Right of Use asset, lease liability, depreciation and interest expense amounts initially and throughout the life of the leases. Furthermore, key financial metrics will be distorted; impacting on loan covenants, market valuations, and the remuneration of executives and senior management.