IFRS116 Leases, which is set to replace its predecessor IAS 17 Leases, will radically alter how leases are accounted for
Background and introduction
In January 2016, the International Accounting Standards Board (IASB) issued a major standard that had been in the works for years. IFRS 16 Leases, which is set to replace its predecessor IAS 17 Leases, will radically, alter how leases are accounted for in the financial statements for lessees, whereas lessors may breathe a sigh of relief from escaping largely unscathed.
Not long after, in June 2016, the Accounting Standards Council (ASC) in Singapore issued the SFRS equivalent of FRS 116 Leases. Due to full convergence with IFRS, the effective date of FRS 116 will coincide with its international counterpart. Companies will have to adopt this new standard from financial year beginning 1 January 2019. Forerunners may early adopt provided that FRS 115, Revenue from Contracts with Customers, is also applied.
With the advent of FRS 116, gone are the days when the standard allows for an option of designating a lease as either operating or financing. To recap, FRS 17 defines leases that transfer substantially all the risks and rewards of ownership of an asset as finance lease, and all other leases may be classified as operating. As such, there will be an incentive for accountants to justify that leases meet the criteria to be classified as operating so as to greatly simplify the accounting treatment by not recording the leased assets and liabilities on the balance sheet. Instead, a periodic charge will be recorded in the profit or loss from the usage of the asset.
What were the drivers for change?
Leasing is an important activity and source of financing for many entities. The criticisms of IAS 17 were that it resulted in substantial off balance sheet lease commitment, the financials of two companies that lease assets may be vastly different had they accounted for the leases differently, and it does not paint an accurate picture of an entity’s assets and liabilities position.
It was for this reason that IFRS 16 was introduced.
So what are the key changes?
A single lessee accounting model was introduced. In the balance sheet, the company will recognise a right-of-use asset and a corresponding lease liability. In the income statement, the entity will recognise depreciation of the right-of-use asset and interest on the lease liability. In the statement of cashflows, repayments made will be split into principal and interest payments.
What are the impacts of these changes?
Previously by assessing the terms of the lease contract, the lessor and lessee may come up with a congruent classification of the lease. However, FRS 116 may cause asymmetrical accounting treatment between lessee and lessor. Even if the lessor concludes that the lease is operating in nature, the lessee will account for it basically in the same way as a finance lease now.
FRS 17, generally, will result in a constant charge in the profit or loss. FRS 116 will cause a front loading of expenses as the right-of-use asset will be depreciated over its lease term (or useful life, if shorter) and simultaneously interest expense will be recorded on the lease liability. Over the life of the lease, the company will see a higher charge to the profit or loss in the initial years and this will reduce over time as the interest portion diminishes.
This may be good news for companies that evaluate performance based on EBITA as the depreciation and interest elements will be disregarded. Hence, EBITA will be presented in a more favorable outlook. With the onset of the lease liability on the balance sheet, companies will see higher debt hence affecting both gearing and debt equity ratios, and they would need to keep a close eye on these indicators as often loan covenants are benchmarked against them. Companies that lease significant assets may preempt their bankers and renegotiate the loan terms, if necessary, to prevent any potential breaches.
Identifying a lease
A lease is a contract between a lessor and a lessee for the right to use a specific asset. Hence, it is imperative that the asset in question be defined, typically identified by being explicitly specified in a contract.
A lease conveys the right to control the use of an identified asset for a period of time in exchange for lease payments. A customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. Simply stated, the contract is not a lease if a customer does not control the asset.
To establish control, the entity should meet both criteria below:
(a) the right to obtain substantially all of the economic benefits from use of the identified asset; and
(b) the right to direct the use of the identified asset.
The right to obtain substantially all of the economic benefits should hold true throughout the entire period (for example, exclusive use of the asset). When assessing, an entity shall consider the economic benefits that result from use of the asset within the defined scope of a customer’s right to use the asset.
A lessee has right to direct the use only if either:
(a) the customer has the right to direct how and for what purpose the asset is used; or
(b) the relevant decisions about how and for what purpose the asset is used are predetermined.
Accounting for leases, initial measurement
At the lease commencement date, the lessee would have to recognise a right-of-use asset and a lease liability. The right-of-use asset will be measured at cost.
• Cost = Amount of lease liability + prior lease payments (less lease incentives) + initial direct costs + estimated cost of dismantling/ restoration
As for the initial measurement of lease liability, it will equate to the present value of future lease payments. The discount rate should be implicit in lease. However, this may be difficult to ascertain in practice hence the surrogate incremental borrowing rate of the lessee may be used.
Initial direct costs are the incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained. They may include commissions, legal fees, the costs of negotiating lease terms, the costs of arranging collateral and payments made to existing tenants to obtain the lease.
Accounting for leases, subsequent measurement
After the commencement date, typically a lessee shall measure the right-of-use asset applying a cost model, unless the leased assets are property, plant and equipment using the revaluation model or investment property measured at fair value.
Depreciation is charged over the shorter of useful life of the underlying asset and the lease term, unless ownership transfers. Where there are ownership transfers, the depreciation period is the useful life of the underlying asset.
As for the lease liability, it will be increased by the interest on the lease liability and reduced by the lease payments made. In other cases, it may also be remeasured to reflect any reassessment or lease modifications.
Are there any exemptions?
Up to this point in time, it is clear of the rigour required in the change in requirements. Fortunately, the standard offers some respite by allowing simplified accounting for short term leases or low value assets. Short term lease has a term that is 12 months or less. The standard did not prescribe the quantum for low value assets, although the basis of conclusion mentioned US$5,000 as a point of reference, companies can define the amount in their accounting policies. However, the examples include personal computers, small items of office furniture and telephones. It is important to note that this value refers to the asset when it is new. For example, leases of cars would probably not qualify for this exemption as a new car typically would not be of low value.
The simplified accounting means the entity may recognise the lease rentals on the above two categories of assets as an expense over the lease term rather than capitalising the right-of-use asset and lease liability in the balance sheet.
Sale and leaseback transaction
While companies frequently lease assets for their business operations, sale and leaseback transactions may be more uncommon. To consider the impact of FRS 116, one would also have to take into account whether the “sale” constitutes the satisfaction of a performance obligation under FRS 115.
In a sale and leaseback transaction, an asset is sold by a vendor and then the same asset is leased back to the same vendor. The accounting treatment depends on whether the transfer of the asset is a sale, determined based on FRS 115. If transfer is not a sale, it is in substance a loan and therefore recognised as a financing transaction.
If the transfer is not a sale,
The vendor-lessee continues to recognise the asset in the balance sheet and recognise the financial liability.
The buyer-lessor does not recognise the asset in the balance sheet but recognise a financial asset.
If the transfer is a sale,
The vendor-lessee will:
1. Derecognises the underlying asset in the balance sheet
2. Recognises a right-of-use asset in respect of the rights to the asset that are retained
3. Recognises a lease liability
4. Recognises a gain or loss on transfer of the rights to the asset that are not retained.
The buyer lessor will:
1. Recognises the purchase of an asset
2. Applies FRS 116 lessor accounting
Accounting for sales and leaseback transactions remains a complex area both under FRS 17 and FRS 116. The clear distinction is the new leases standard will eliminate this arrangement as a mean to achieve off balance sheet financing as the vendor-lessee will be required to record the corresponding asset and liability in its balance sheet unless it satisfies the exemption criteria.
While 2018 may appear to be a watershed year with the introduction of a wave of new major standards, there is not much room for respite as accountants grapple with the new leases standard which is expected to have far reaching effects. For companies with significant leases, ample time would have to be set aside to analyse their existing lease arrangements to prepare for the transition. Consideration has to be made for the impact on financial ratios and loan covenants. Management may also wish to rethink their business practice of leasing versus buying assets. With less than a year to go, there is no better time to start than now.
For more information, please contact:
Loh Ji Kin
Associate Director, Assurance