uunk henk

Due to Volkswagen’s “diesel-gate” and the Tesla software update enabling cars to drive autonomously, we know that software is a substantial component in automobiles.

The Volkswagen story is still developing and, so far, it looks like there are no safety issues involved. Volkswagen’s smart software contributes to environmentally “ill” output, however. An observation in this respect is that residual values of automobiles may become impacted.

Tesla’s business model includes centrally pushed software updates for all models on the road. It enables the manufacturer to upgrade cars, smart and cheap.

And as we have seen, technology inspired legislation: Europe-wide, countries have to indicate whether the new, suddenly available technique, is legal - or at least, is not forbidden.

Being able to upgrade on an on-line basis is one thing, another element is that feed-back from users (anonymously gathered) allows to improve the (software) product.

The two recent events mentioned above have been spotted by a large number of people, yet perhaps not appreciated in the context that I wish to highlight.

My observations are about the circular economy and leasing - and whether International Financial Reporting Standard (IFRS) 16 Leases, to be published later this year, might help.

Circular economy

Over the past year, more and more publications have emerged mentioning change in economic models and mentioning benefits of a circular economy.

A circular economy is an economy re-using basic materials at the end of a ‘usable’ period in contrast to the ‘old’ linear economy that acquires an item, uses it for its useful lifetime and then disposes of it (as garbage or dumped material) or at a low residual (scrap) value.

In a circular economy, the manufacturer is playing another type of role compared to the linear economy. Most especially, the manufacturer that produces goods containing rare minerals or expensive metals is keen on controlling the future return of these basic materials. All manufacturers applying a sustainability concept want to continuously control materials through their ownership.

The user of the product, unless speculating on future increased values of the basic materials, will be looking for the added benefit from the product in its production process. This user merits the use rather than the ownership.

Other aspects of sustainability and circular economy are that current accounting, as well as the current perception from bank risk management, may need to be reviewed.

Manufacturers retaining ownership of basic materials may be faced with higher levels of assets, thus balance sheet totals, and therefore be liable to more expensive financing arrangements - and all this while trying to work on a better, more-sustainable environment.

Accounting and (bank) risk models apparently do not yet consider the full benefits associated with a circular economy.

Leasing - the alternative

It’s too easy to suggest that leasing is the one and only alternative for products containing re-usable basic materials. But a form of financing that takes into account manufacturers’ continued ownership of the goods produced is needed. And the ‘old’ form of operating leasing might be the answer: the lessor being the in-between financier, securing the return of basic materials.

IFRS 16 Leases

We started this article by referring to Volkswagen, the largest car manufacturer in 2014 and Tesla, the innovative car manufacturer producing only electric vehicles.A major part of the value of a car is located in its software: without software, the car is useless. One could even argue that a car without working software has a nil-value.When specifying the asset value of a car in its components, the software component appears to be in a section of the residual value.

Evidence of this is that drivers of a lease car don’t care about value risk of their car because of malfunctioning or cheating software; it simply doesn’t affect their wallet.

Owners of these cars, to the contrary, are worried about reduced residual values and may seek compensation from the manufacturer.

Tesla drivers pay a price beyond regular car value for the ability to drive an innovative car that has on-line software updates. They actually pay extra for a feature for which the manufacturer has less costs. Upcoming competition in this area, of course, will reduce the benefit of the first-mover in this market.

Disruptive business models therefore are becoming ‘normal’ models when competition catches up.

So how are IFRS 16 Leases, to be applied as of 2019, in this respect?

Poorly unfortunately!

IFRS 16 is constructed (to remain in car terms) on a platform that was designed back in the 1990s when it was stipulated that ‘all leases need to be on-balance sheet’.

When starting the project Leases in 2006, the International Accounting Standards Board (IASB) in one of its first decisions, decided that the scope of the new lease standard should be the same as current IAS 17. Which means that leases of intangibles and rights held under licensing agreements are excluded from being treated as leases; perhaps one of the real fatal flaws of IFRS 16.

For example consider the usage of a car as consisting of two contracts. The first with the lessor for the use of the identified, unique, mechanical equipment - and the second with the car manufacturer for applying the use of ‘common’ software (common for certain types of Minis/BMWs or Audis/Seats/Volkswagens, etc.).

Will this lead to one lease plus one service contract (not containing a lease as it relates to an intangible) - with the tangible (lease) part only consisting of the bare materials value and a service contract representing the high-value license usage?

Using the format of a license would be disruptive (compared to current practise) as it doesn’t only apply to cars. Printing equipment, as solid as it may look, easily has 25% of its value embedded in its software.

And like Tesla, other car manufacturers will provide on-line software upgrading in the near future. And with upgrading available – so downgrading (even to nil) is available, as well.

Already before 2019 a complete new world is opening - the year of introduction of IFRS 16.

Getting everything on balance in a world where the internet of (every)thing only emerged after the start of the Leases project is so 2006 (and before)!Redrafting IFRS 16 is too late; withdrawal a last opportunity!

Henk Uunk held the position of manager financial accounting and reporting at ING Lease Holding from 2004 to 2014. He is chairman of the accounting committee of the Dutch Leasing Association (NVL) and a member of Leaseurope’s accounting and taxation committee since 1992. Uunk is a contributor to the Dutch Accounting Standards Board working group on leases and acts as a consultant to the Dutch Car Leasing Association (VNA).