IFRS 16 adopted modified retrospective, policies, certain disclosures

Novartis AG – Annual report – 31 December 2019

Industry: pharmaceuticals

1. Significant accounting policies (extract 1)
Leases and right-of-use assets
From January 1, 2019, with the adoption of IFRS 16 Leases, the Group adopted the following accounting policies for leases and right-of-use assets:

As lessee, the Group assesses whether a contract contains a lease at inception of a contract and upon the modification of a contract. The Group elected to allocate the consideration in the contract to the lease and non-lease components on the basis of the relative standalone price.

The Group recognizes a right-of-use asset and a corresponding lease liability for all arrangements in which it is a lessee, except for leases with a term of 12 months or less (short-term leases) and low-value leases. For these short-term and low-value leases, the Group recognizes the lease payments as an operating expense on a straight-line basis over the term of the lease.

The lease liability is initially measured at the present value of the future lease payments as from the commencement date of the lease to end of the lease term. The lease term includes the period of any lease extension that in management’s assessment is highly probable to be exercised by the Group. The lease payments are discounted using the interest rate implicit in the lease or, if not readily determinable, the Novartis incremental borrowing rate for the asset subject to the lease in the respective markets.

The Group remeasures the lease liability (and makes a corresponding adjustment to the related right-of-use asset) whenever there is a change to the lease terms or expected payments under the lease, or a modification that is not accounted for as a separate lease.

The portion of the lease payments attributable to the repayment of lease liabilities is recognized in cash flows used in financing activities, and the portion attributable to the payment of interest is included in cash flows from operating activities.

Right-of-use assets are initially recognized on the balance sheet at cost, which comprises the amount of the initial measurement of the corresponding lease liability, adjusted for any lease payments made at or prior to the commencement date of the lease, any lease incentive received and any initial direct costs incurred by Novartis, and expected costs for obligations to dismantle and remove right-of-use assets when they are no longer used.

Right-of-use assets are depreciated on a straight-line basis from the commencement date of the lease over the shorter of the useful life of the right-of-use asset or the end of the lease term.

Right-of-use assets are assessed for impairment whenever there is an indication that the balance sheet carrying amount may not be recoverable using cash flow projections for the useful life.

In arrangements where the Group is the lessor, it determines at lease inception whether the lease is a finance lease or an operating lease. Leases that transfer substantially all of the risk and rewards incidental to ownership of the underlying asset to the counterparty (the lessee) are accounted for as finance leases. Leases that do not transfer substantially all of the risks and rewards of ownership are accounted for as operating leases. Lease payments received under operating leases are recognized on a straight-line basis over the lease term in the consolidated income statement in either “net sales” or “other income,” depending on the nature of and underlying asset to the lease arrangement.

Prior to January 1, 2019, the Group applied the following accounting policies for leases:

Leases that transferred substantially all of the risks and rewards of ownership were recognized as finance leases, with the leased asset measured initially at an amount equal to the lower of their fair value and the present value of the minimum lease payments. Minimum lease payments were the payments over the lease term that the Group, as leasee, was required to make, excluding contingent rent. The underlying asset was accounted for in accordance with the accounting policy applicable to that asset.

Leases that did not transfer substantially all of the risks and rewards of ownership were accounted for as operating leases and were not recognized in the consolidated balance sheet. Payments made under operating leases were recognized in the consolidated income statement on a straight-line basis over the term of the lease. Lease incentives received were deferred and recognized as a component of lease expense over the term of the lease. The future undiscounted lease payments under operating leases were disclosed as commitments in the notes to the consolidated financial statements.

Lessor accounting policies were not substantially different from those applied upon the adoption of IFRS 16 Leases, as described above.

The section “—Impact of adopting significant new IFRS standards in 2019” in this Note 1 provides additional disclosures on the impact of adoption of IFRS 16 Leases.

1. Significant accounting policies (extract 2)
Impact of adopting significant new IFRS standard in 2019
The following new IFRS standard has been adopted by Novartis from January 1, 2019:
IFRS 16 Leases
IFRS 16 Leases substantially changed the financial statements, as the majority of leases for which the Group is the lessee became on-balance sheet liabilities with corresponding right-of-use assets also recognized on the balance sheet. The lease liability reflects the net present value of the remaining lease payments, and the right-of-use asset corresponds to the lease liability, adjusted for payments made before the commencement date, lease incentives and other items related to the lease agreement. The standard replaces IAS 17 Leases and related interpretations.

Upon adoption of the new standard, a portion of the annual operating lease costs, which was previously fully recognized as functional expenses, as a component of operating income, is recorded as interest expense. In addition, the portion of the lease payments that represents the reduction of the lease liability is recognized in the cash flow statement as an outflow from financing activities, which was previously fully recognized as an outflow from operating activities. Given the leases involved, these effects are not significant to the consolidated income statement and consolidated statement of cash flow.

The Group implemented the new standard on January 1, 2019, and applied the modified retrospective method, with right-of-use assets measured at an amount equal to the lease liability, adjusted by the amount of the prepaid or accrued lease payments relating to those leases recognized in the balance sheet immediately before the date of initial application and did not restate prior years.

Results of our impact assessment:
The undiscounted operating lease commitments as of December 31, 2018, amounted to USD 3.6 billion. This includes approximately USD 0.1 billion of leases with a commencement date in 2019, as well as short-term leases and low-value leases that are recognized from January 1, 2019, upon adoption of IFRS 16, on a straight-line basis as expense in profit and loss. This also includes USD 0.2 billion lease commitments related to the Alcon Division, which is attributable to discontinued operation in 2019. For the remaining undiscounted lease commitments attributable to continuing operations of USD 3.3 billion, the Group recognized on January 1, 2019, lease liabilities of USD 1.74 billion and right-of-use assets of USD 1.55 billion (after the reclassification of USD 0.1 billion from property, plant & equipment, and net adjustments for the USD 0.3 billion recognition of sublease receivables, prepayments, and accrued lease payments recognized as at December 31, 2018). For the lease commitments attributable to discontinued operations, the Group recognized on January 1, 2019, lease liabilities and right-of-use assets of USD 0.2 billion. This does not include the discontinued operations right-of-use assets and lease liability on finance lease agreements of USD 75 million and USD 89 million, respectively. There was an insignificant increase to retained earnings upon adoption of IFRS 16 of USD 3 million that arose from subleases that were accounted for as operating lease agreements under IAS 17 and are accounted for as finance leases under IFRS 16.

As a lessor, the Group had no significant impact upon adoption.

For further information on the impact of adoption and additional disclosures of IFRS 16 Leases, see Note 10.

10. Right-of-use assets and lease liabilities
Impact of adoption of IFRS 16 Leases
Note 1 explains the changes and new accounting policy introduced on January 1, 2019, resulting from the adoption of the new accounting standard IFRS 16 Leases.

On transition to IFRS 16, the Group elected to apply the practical expedient to not reassess whether a contract is, or contains, a lease at January 1, 2019, the implementation date of IFRS 16. As a result, at the date of implementation, the Group applied IFRS 16 only to contracts that were previously identified as leases under IAS 17 Leases and related interpretations, and the definition of a lease under IFRS 16 was applied only to contracts entered into or changed on or after January 1, 2019.

The impact on retained earnings upon implementation of IFRS 16 was USD 3 million arising from subleases that were accounted for as operating lease agreements under IAS 17 and are accounted for as finance leases under IFRS 16.

The Group has entered into various fixed-term leases, mainly for vehicles and real estate.

The lease liabilities recorded in continuing operations on January 1, 2019, were USD 1.7 billion and the right-of-use assets were USD 1.6 billion.

Reconciliation of lease commitment disclosed on December 31, 2018, and lease liability recorded in continuing operations on January 1, 2019, is as follows:

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1 As reported in Annual Report 2018 Note 27
2 The weighted average incremental borrowing rate at January 1, 2019, the date of implementation of IFRS 16 Leases, was 3.5%.

The right-of-use assets of continuing operations at January 1, 2019, by underlying class of asset comprise the following:

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1 Right-of-use assets were lower than the lease liability at the date of implementation of IFRS 16 by USD 182 million, due to adjustments made for recognition of sublease receivables, prepayments and accrued lease payments and transfers from leased assets recorded in property, plant and equipment at December 31, 2018.

The adoption of IFRS 16 on January 1, 2019 had an impact on the classification of the annual lease expense in the consolidated income statement, the recognition of right-of-use assets and lease liabilities in the balance sheet and the classification of the annual lease payments in the consolidated statement of cash flows.

The adoption of IFRS 16 on January 1, 2019 did not significantly impact the individual lines of the consolidated income statement.

The following table shows the adjustments to the line items of the January 1, 2019, consolidated balance sheet, due to the implementation of IFRS 16:

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As a result of applying the modified retrospective method at the date of implementation of IFRS 16 on January 1, 2019, whereby the right-of-use assets were measured at the amount equal to the lease liabilities, there is no impact to the reported deferred tax assets and deferred tax liabilities on the consolidated balance sheet, as the corresponding deferred tax assets and deferred tax liabilities attributable to the lease liability and right-of-use asset relate to income taxes levied by the same taxation authority within the same legal entity, and were therefore offset.

The adoption of IFRS 16 on January 1, 2019 had no significant impact on the individual lines of the consolidated statement of cash flows, except for the principal portion of the lease payments (USD 0.3 billion for the year ended December 31, 2019) that is recognized as an outflow in the cash flow from financing activities and the interest portion of the lease payment (USD 0.1 billion for the year ended December 31, 2019) is recognized as an outflow in the cash flow from operating activities. Prior to the adoption of IFRS 16, the full amount of the lease payments was recognized as an outflow in the cash flow from operating activities.

Current year disclosures
The following table summarizes the movements of the right-of-use assets of continuing operations:

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No impairments were recorded in the period.

1 Lease contract terminations also includes modifications to existing leases that result in reductions to the right-of-use assets, and reductions due to sub-leasing.

The right-of-use assets carrying value and depreciation charge of continuing operations at December 31, 2019, are shown below by underlying class of asset:

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The lease liabilities of continuing operations at December 31, 2019, by maturity are as follows:

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At January 1, 2019 and December 31, 2019, there were no material future cash outflows, including extension options, excluded from the measurement of lease liabilities. The Group’s most material lease with a lease term extension, representing a lease liability value of USD 0.6 billion, has a determined lease term end date of 2071.

In 2019, the Group completed sale and leaseback transactions for certain property, plant and equipment as part of its plans to consolidate sites. Transactions resulted in net cash inflows of USD 0.7 billion and the recognition of USD 96 million of lease liabilities, and USD 37 million of right-of-use assets. The right-of-use assets value reflects the proportion of the property, plant and equipment retained for a period of one to five years, with two five-year extension periods for certain right-of-use assets. The liabilities reflect the net present value of future lease payments. The net gain on the sale and leaseback transactions amounted to USD 478 million.

The following table provides additional disclosures related to right-of-use assets and lease liabilities of continuing operations:

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1 The weighted average interest rate is 3.9%.
2 Cash flows from short-term and low-value leases are included within total net cash flows from operating activities. The portfolio of short-term leases to which the Group is committed to at December 31, 2019, is similar to the portfolio of short-term leases the Group entered into during 2019.
3 Included within total net cash flows from operating activities.
4 Reported as cash outflows used in financing activities net of lease incentives received of USD 33 million.

The net investment held and the income from subleasing right-of-use assets was not significant.

Note 30 provides additional disclosures on discontinued operations.