Don’t Underestimate the Commercial Impacts of Your Business’s IBR
Quadrent recently presented on a webinar hosted by CPA Australia in partnership with Deloitte. The webinar focused on the importance of having a current and correct incremental borrowing rate (IBR), the treatment of modifications, and the commercial impacts of a business’s IBR. The wide-ranging commercial impacts of a company’s IBR make accuracy critical, especially as the IFRS 16 guidelines have now been in place for two years.
This article outlines the commercial impacts of a business’s IBR and how companies can ensure they implement an accurate calculation methodology. As a process that’s important to get right year-round and not just at year-end, businesses should look to implement effective lease accounting systems and processes, which the webinar outlined as well.
How your business’s IBR affects your balance sheet
A business’s IBR, the interest rate a lessee would be charged to borrow with a secured loan, is the most important variable in IFRS 16. This is because the IBR is used to arrive at the borrowing rate, but it is also involved in calculating the balance sheet and profit and loss components of lease accounting. These components include lease liability, right-of-use (ROU) assets and related interest and depreciation, which are all based on the present value calculation of lease payments.
A company’s IBR is calculated using its reference rate, financing spread adjustment and lease-specific adjustment. Leases accounted for on a company’s balance sheet are used in the IBR calculation processes. These leases may include but are not limited to property leases, advertising leases, marine leases, retail leases, and equipment and plant leases.
Under the IFRS 16 standards, the IBR can be used as the discount rate for determining the present value of lease payments when the implicit rate is unavailable, which is typically the case for operating leases. Once calculated, the IBR is used to discount future cash flows, reflecting the impact of time on future lease payments. A lease’s discount rate and IBR must be reviewed whenever a lease modification is made, as this affects all lease accounts. Given the wide-reaching commercial impacts of lease accounting calculations, your IBR can affect large numbers on your balance sheet, which, in turn, impacts all the business’s financial stakeholders
Did you know that a 1% increase in a company’s IBR can increase interest expenses by 39%?Correctly calculating your business’s IBR is important for two key reasons:
- increasing scrutiny and compliance requirements from regulators, auditors and investors.
- the financial impacts if your IBR is incorrect.
Finance and accounting experts expect regulators and auditors will begin to look closer at a company’s IBR calculations and movements. In 2019, when the guidelines were introduced, it was estimated that listed companies worldwide would transfer $3 trillion worth of assets to their balance sheets. With many companies having more leasing debt on their balance sheets than traditional debt, the heavy impact of leasing on a company’s current and future financial position shouldn’t be overlooked.
In 2020, after a year of the IFRS 16 guidelines being in place, auditors and regulators looked at a company’s calculations and rate changes. However, there still wasn’t enough data within companies to provide comparison points. This year will provide another comparison point for auditors, with next year onwards providing clear trends for auditors and regulators. If it looks like your business’s IBR may be inaccurate, it will likely attract an auditor’s attention.
While it may not seem like a high priority issue for organisations now as inaccuracies may not be detected for at least another year, the potential financial impact of an incorrect IBR highlights why it’s important to get it right now. This is not only about avoiding regulatory scrutiny and the cost of reputational damage, but the potential for unintended impact on your balance sheet. For example, it’s estimated that a one per cent increase in a company’s IBR can increase interest expenses by 39 per cent and decrease depreciation expenses by 5 per cent on ROU assets.
While the cash flow impact of leases hasn’t changed considerably for organisations since the introduction of the IFRS 16 guidelines, the balance sheet and profit and loss impact have grown. This impact can change investor and financier appetite for investing in or lending to your organisation, as getting the timing and judgement right on your IBR impacts your target financial ratios. These ratios affect your company’s:
- strategic direction
- bank covenants
- credit rating
- ability to negotiate its rate with financiers.
The commercial impacts of your IBR calculation methodology
Having a robust IBR calculation methodology can have tangible impacts on a company. Not only can it help you pre-empt interest rate discussions with your business’s financiers, but it will put your organisation in a proactive position, especially if your business doesn’t have a dedicated treasury function.
The IFRS 16 guidelines have impacted businesses of all sizes around the world, making lease accounting increasingly important as it affects a business’s:
- Balance sheet: Increasing assets and liabilities which impact gearing. This is initially measured at the present value of unavoidable lease payments.
- Income statement: Growing EBITDA and impacted profit profile, which will typically be lower in the earlier years of a lease when interest and depreciation expenses are higher.
- Cash flow statement: An increase in operating and financing cash inflows affecting the repayment of principal finance activities, interest finance and operating activities.
For listed companies, the financial impacts are sizeable. Tesco, for example, experienced a $400 million impact on its profit, and its assets decreased by $1.3 billion (net difference between ROU asset and lease liability) when IFRS 16 took effect. The company knew the importance of understanding the impact and a thorough explanation to the markets. Smaller organisations can do the same by establishing an accurate IBR calculation methodology and implementing strong lease accounting systems and processes.
Under the new lease accounting standards, operating costs on leases go below the line, which improves EBITDA, but your company’s assets and liabilities change, which can impact key stakeholders, including your investors and financiers. When your business is calculating and modifying its IBR, your company, no matter its size, should use this as an opportunity to engage your financial stakeholders proactively. Accounting for low-value leases can also provide good opportunities to engage your financial stakeholders, as moving these to your balance sheet can improve your EBITDA over time. Further, this makes the time required in accurately recording and accounting for low value leases a worthwhile investment. There can also be some real cost savings by properly controlling this spending.
Reduce your balance sheet risk with Quadrent
With robust lease accounting software, accounting for leases of all types and values doesn’t need to be an administrative burden. If your company is still using spreadsheets to manage its lease accounting, LOIS, can assist. Quadrent’s team, who has in-depth leasing knowledge, along with the LOIS team’s specialised accounting backgrounds, will ensure your company has the systems and processes to accurately manage its leases and improve the data inputs used in calculating your business’s IFRS 16 impacts.
At Quadrent, we can help you establish the systems you need to accurately record your lease data and extract valuable insights for your business. Click here for more information.