Financial Reporting Brief
Our featured article for June is The Challenges of a New Leasing Standard with Brendan Sheridan commenting on the challenges to be dealt with in the implementation of IFRS 16 on Lease Accounting.
The Challenges of a New Leasing Standard
For the first time, €3 trillion worth of lease commitments that are currently off balance sheet will under IAS 17 be included on balance sheets of companies globally as assets and liabilities.
IFRS 16 will change lease accounting substantially, with the new requirements bringing much needed transparency, with off balance sheet lease accounting no longer lurking in the shadows. This will change the need for investors to make adjustments to gain an overall picture of a company’s financial position. It will improve comparability between companies that lease and those that borrow to buy by providing further insight into a company’s operations and funding.
This article focuses on the way in which accounting will change for lessees, particularly those with operating leases. Very little changes for lessors, other than some additional disclosure requirements.
Change in Principles
IFRS 16 applies a control model to the identification of leases, distinguishing between leases and service contracts on the basis of whether there is an identified asset controlled by the customer.
A lease will recognise at commencement a right of use asset and an equivalent lease liability. The IASB concluded that a lessee’s right to use an underlying asset meets the definition of an asset, with exceptions from IFRS 16 of specific items covered by other standards, namely:
- leases to explore for or use minerals, oil, natural gas and similar resources
- contracts within the scope of IFRIC 12 Service Concession Arrangements
- for lessors, licenses of intellectual property
- for lessees, leases of biological assets and rights held under licensing agreements within the scope of IAS 38 Intangible Assets.
In response to concerns expressed by constituents, the IASB decided to allow short-term leases and leases of low value assets to be excluded by companies from the scope of IFRS 16 and to be recognised as an expense on a rentals basis. A short term lease is defined as one that does not include a purchase option and has a lease term at commencement date of 12 months or less, with the exception to be applied consistently by a company to all such leases. The ‘low value’ exception is in absolute terms rather than by reference to the size of the reporting entity and may be applied on a lease by lease basis.
The new standard, IFRS 16, requires lessees to account for all of their leases in a manner similar to how finance leases are currently accounted for under IAS 17. Accordingly, entities affected will see:
- the assets and liabilities on their balance sheets increase significantly
- direct impact on such financial metrics as leverage and performance ratios
- the nature of the costs in the income statements change, with a positive impact on EBIDTA but a greater weighting to finance costs and depreciation.
It is important for companies with material amounts of off balance sheet leases to check their agreements and possibly consult with lenders and others in advance of the standard being effective. Changes to lease accounting could have an impact in such areas as debt covenants, management incentives, cash sweeps and other such financial matters.
Focus on Property Leases
Some sectors will be more affected than others, with those that use off balance sheet leases extensively being particularly exposed. These include, for example, airlines, travel and leisure, telecommunications, retailers and other major property occupiers. Deloitte’s global website www.iasplus.com includes a series of IFRS industry insights highlighting issues from the new leasing standard that will be of interest in those sectors.
Property leases are likely to be one of the most significant areas of impact. Some of the many questions that may be addressed in relation to property leases include: -Should assets be bought rather than leased?
- Should services be procured in a way that does not meet the definition of a lease?
- How should the business manage its property portfolio and negotiate its property leases, including lease terms, incentives and structures?
- How will you educate those responsible for leasing strategy in the implications of lease structures for corporate performance reporting and financial metrics?
For example, companies that occupy lease properties should carry out an assessment of the impact of the new Standard on their results and develop a plan for explaining this to their shareholders and stakeholders. Some of the many accounting issues that may arise include: -
- The treatment of variable rentals and their measurement as part of the right of use asset and lease liability
- The inclusion of lease incentives in the measurement of the right of use asset
- The determination of the lease period, including consideration of whether or not a termination option will be exercised
- The changed cost recognition model and the positive or negative impact that may have on such financial metrics as profit before tax, earnings per share and return on capital employed
- The unbundling of the service and lease components
- Determining the discount rate i.e. the rate implicit in the lease, which requires knowledge of the underlying asset’s residual value and its fair value.
Businesses with substantial lease portfolios are likely to find the adoption of IFRS 16 a data-heavy task, and will need to consider whether their lease databases are robust enough to facilitate analysis by the finance team. Such businesses are likely to find spreadsheet analysis inefficient and poorly controlled and will require a realistic evaluation of existing system capabilities and the desired end-state control environment. This will be a considerable challenge for many.
US GAAP Different
The U.S. Financial Accounting Standards Board (FASB) issued its new Standard on accounting for leases in March – ASU 2016-02. Although the IASB and the FASB began the lease accounting project as a joint convergence project some years ago, the Boards have issued separate standards and there are several notable differences between the two. One of the more notable differences being that two approaches are used under US GAAP for amortising the right of use asset - (1) the 'finance lease' approach, and (2) the 'operating lease' approach – while only the first is permitted under IFRS 16.
There are a number of other significant differences, but these should not overshadow the significant achievement that both GAAPs provide for practically all leases to be accounted for on balance sheet which was a major objective of the process.
The new Standard is effective for accounting periods beginning on or after 1 January 2019. It may be implemented either by a full retrospective approach or a modified retrospective approach whereby an entity is not required to restate the comparative information and the cumulative effect of initially applying the Standard must be presented as an adjustment to the opening balance of reserves. The Standard also includes a number of specific transition requirements.
Commitment to ensuring that resources and systems are available for implementing the new Standard will pay dividends in terms of avoiding any unwelcome surprises with implementation.
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