LEASE ARRANGEMENTS - A SIGNIFICANT SHIFT FOR LESSEES IFRS 16

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1 LEASE ARRANGEMENTS - A SIGNIFICANT SHIFT FOR LESSEES IFRS 16 Lease arrangements have existed for decades and have evolved over the years. Increase in innovative ways to structure business arrangements has kept accounting regulators busy with reforming the accounting rules to reflect the real substance of the arrangement. Leasing of assets has been a strategy for the user of the asset to avoid blocking of their funds in assets and also maximize tax benefits available. For example, many companies provide incentive to its employees by way of vehicles on operating lease and pass on the tax benefit by charging lease expense in the income statement. Lease accounting has been under discussion between the global accounting bodies (IASB and FASB) for quite some time. The two bodies have jointly been evaluating the existing accounting treatment for lease arrangements, in particular, by lessee or the user of the asset. In January 2016, the International Accounting Standard Board (IASB) issued IFRS 16 Leases effective from annual periods beginning on st or after 1 January 2019 with early adoption permitted under certain circumstances. The new standard replaces the existing guidance on leases i.e. IAS 17, IFRIC 4, SIC-15 and SIC 27. Correspondingly, FASB issued the IFRS 16 equivalent (ASC 842) in February There are some differences in the application of the two standards but largely these are similar in substance, in particular, with respect to the principle of recording the Right-of-use assets on the balance sheet, in case of operating leases, by the lessee. The effects of IFRS 16 will be pervasive across all sectors. According to the effect analysis of new lease standard issued by the IASB, over 14,000 listed companies (out of 30,000 listed Companies surveyed across all regions) disclose information about off balance sheet leases in their annual reports. Also, the IASB compared off-balance sheet leases to the total assets of about 1,022 companies. The analysis showed that present value of future payments for off balance sheet leases is approximately 5.4% (USD 1.66 trillion) of total assets. Major impact is for airlines, retail and travel sector where these payments constitutes above 20% of total assets. Other sectors significantly impacted are transport, telecommunication, media and energy (oil, gas and mining). This publication briefly discusses the key accounting changes under new standard and also how it is likely to impact businesses as a whole, including the transition provisions. Internal Audit, Risk, Business & Technology Consulting

2 Key provisions and changes under IFRS 16 Under the existing accounting rules, a lessee is required to account for lease transactions either as an operating lease or a finance lease, depending on various rules and tests, which results in all or nothing being recognized on balance sheet for sometimes economically similar transactions. The user of an asset (lessee) is able to avoid capitalizing the asset on its balance sheet in case of an operating lease and only disclose its future lease commitments. Further, under the current standard, there is no requirement of segregating lease and non-lease portion in a contract. The key provisions and changes in the new standard include: Lease Definition Right-of -use asset Separation of lease and non-lease portion IFRS 16 requires lessees in all cases (irrespective of the lease being classified as a finance of operating lease) to record the asset on its balance sheet with a corresponding financial obligation. The asset recognized will reflect their right to use an asset for a period of time. This requirement is exempt for short term lease or lease of low value items. The definition of lease focuses on the requirement for a lease arrangement to have a specific identified asset and right to control the asset with the lessee. This is quite similar to the current requirement under IFRIC 4 except that the right to control is determined based on primarily two conditions instead of three under IFRIC 4. Taking the analogy of IFRS 15, the new standard requires both lessee and lessor to separate lease and non-lease components out of a contract and only account for the lease component under the new standard. This is subject to the practical expedient provided to a lessee, in case impractical to separate. Except for the need to separate the lease and non-lease component, the accounting by lessors under IFRS 16 is substantially unchanged from IAS 17. However, the changes under the new standard could challenge the business model of lease arrangements in case, operating leases become less attractive for the lessees. In this document, we discuss the key changes in more detail with some relevant examples. We also share our perspective on some key considerations for business as a whole including the impact on the business model, key ratios impacting bank covenants, and the impact on IT and other business processes. New definition of lease: Under the new standard, a contract is, or contains, a lease if the contract conveys a right to control the use of an identified asset for a period of time in exchange of consideration. IDENTIFIED ASSET + Whether substantive right to substitution present? Whether supplier has practical ability to substitute alternative asset? Whether supplier would benefit economically from substitution? RIGHT TO CONTROL THE USE OF ASSET Right to obtain all the economic benefits Right to direct the use of identified asset. The standard clearly states that for an arrangement or a contract to contain a lease of an asset, there has to be a specific identified asset that cannot be substituted (neither contractually nor practically) and the lessee has the right to receive the economic benefits from the asset as well as right to direct the use of the identified asset (i.e. right to control the use of the asset). The new requirement is in principal similar to the requirement under IFRIC 4 except that the new standard does not assume control over an asset in case the lessee obtains more than insignificant amount of output and the price is not fixed or the market price for each unit of output (which is the case under IFRIC 4). 2 Lease Arrangements - A Significant Shift For Lessees

3 As such, under the new standard, there could be contractual arrangements that may not qualify as a lease and vice versa. Example: A customer purchases all the output out of a plant but has no right of access to the plant or decision making rights. Price charged is variable per unit and supplier owns and operates the plant with no involvement of customer. The said contract conveys a right to use under IFRIC 4 and hence is likely to be a lease. However, as per IFRS 16, the contract does not contain a lease since customer's rights do not extend beyond those of a customer in a typical supply or service contract. Right-of-Use Model for Lessees IFRS 16 eliminates the classification of a lease either as an operating lease or a finance lease for a lessee. All leases are capitalized by recognizing the present value of the lease payments along with any initial direct costs and restoration costs, presenting them as right-of-use assets. If lease payments are made over time, a company also recognizes financial liability representing its obligation to make future lease payments. Contingent rentals or variable lease payments will need to be included in the measurement of leased assets and liabilities when these depend on an index or a rate or where in substance they are fixed payments. As such, any other variable lease payments (such as lease rental linked to sales) will be excluded from the calculation of lease liability. Subsequently, the lease liability is measured at amortized cost using the e ective interest rate method (EIR). Right-of-Use assets are subsequently measured at cost less accumulated depreciation and accumulated impairment loss. Tables below show the impact of new lease accounting on Statement of financial position as well as Income Statement: Statement of financial position Assets Liabilities Finance Lease IAS 17 Operating Lease IFRS 16 All Types of Leases Right of Use Asset Financial Liability Statement of Profit or Loss IAS 17 IFRS 16 Finance Lease Operating Lease All Types of Leases Revenue Operating Costs Single Expense EBITDA Increases Depreciation Operating Profit Increases Finance Cost Profit Before Tax Unchanged (Over period of lease) 3 Internal Audit, Risk, Business & Technology Consulting

4 Applying the new standard will result in acceleration of the P&L charge (front loading of expenses) due to constant depreciation charge on the right-of-use asset coupled with declining interest expense on lease liability over the lease period. The front loaded expense pattern may average out across a portfolio of leases in a large and stable business. However, there may be significant e ects in aggregate for a growing business or a business that is undertaking a major refresh of its portfolio of leased assets. Further, the charge in the income statement shall be below EBITDA under the new standard and hence also likely to impact key balance sheet and P&L ratios. This requirement of capitalizing the Right to Use the asset is similar under both IFRS and US GAAP. However, under US/GAAP, in case of a finance/capital lease (Type A lease), the Right-of-use shall be amortized separately from the finance cost and in case of an operating lease (Type B lease), the two amounts shall not be separated but accounted for as one rental expenditure i.e. the accounting impact shall continue to be similar to an operating lease arrangement. Separating lease and non-lease component/s Many contracts contain a lease along with commitment to purchase or sell other goods or services (nonlease components such as maintenance, insurance etc.). These are excluded from the lease liability if, they can be reliably estimated and allocated. Alternatively, as a practical expedient, an accounting policy choice (individually applied to each class of underlying asset), not to separate such components is available to the lessee (the option is not available to the lessor). The lessor allocates the consideration in the contract in accordance with the requirements of IFRS 15 i.e. according to the stand alone selling prices of the goods or services included in each component. There is no guidance under existing IAS 17 around the separation of lease and non-lease components. For Example: A lessor has obtained a space in the warehouse for storing of goods and pays $ 10,000 p.a. which includes rental for the year as well as annual maintenance. The lessee can obtain warehouse next door for $ 9,000 per year without maintenance service, and need to pay $ 1,500 per year for its maintenance. The lessee needs to allocate $ 8,571 ($ 9,000/ ($ 9,000+ $1,500)) to the lease element and account for that as for the lease; and allocate $ 1,429 ($ 1,500/ ($ 9,000+$ 1500)) to the service element and in this case, recognize it in profit or loss as an expense for maintenance. IFRS 16 also impacts accounting for: Sale and Leaseback transactions Under previous GAAP, sale and leaseback transactions were accounted for in lessee books on the basis of whether the underlying lease of asset is operating lease or financing lease, and does not require seller (lessee) to determine whether the sale and leaseback transaction meets the condition for the sale of the asset. However, under the new standard, the seller (lessee) and the buyer (lessor) will use the definition of sale from IFRS 15 to determine whether a sale transaction has occurred in a sale and leaseback transaction. If the transaction is to be a sale, seller (lessee) derecognizes the underlying asset and recognizes a rightof-use asset at the retained portion of previous carrying amount. If the transaction is not a sale, the seller (lessee) continues to recognize the asset and recognizes a financial liability as per IFRS 9. Thus, IFRS 16 largely eliminates sale and lease back transaction as a potential source of o -balance sheet financing as the seller (lessee) will always recognize the asset in its balance sheet. Sub Leasing arrangements Sub lease is a transaction in which a lessee (or intermediate lessor) sells its right of use to an underlying asset to Sub lessee, while the lease between the parent lessor and intermediate lessor remains intact. Intermediate lessor classifies sub lease as operating lease or finance lease, on the basis of right-of-use asset arising in his books. Intermediate lessor derecognizes right-of-use asset from its books and recognizes net investment in sub lease. Thus, it continues to recognize asset in its books with regard to sub lease. Practical Expedients: Recognition and measurement exemption for short term leases and leases of low value is available as a policy choice. Lessee may choose not to recognize assets and liabilities for leases with a lease term of 12 months or less. This exemption is required to be applied by class of asset. Similarly, lessees are not required to recognize assets or liabilities for leases of low value assets such as tablets, personal computers etc. This exemption is applied on lease by lease basis. If a lessee elects to apply these recognition exemptions, then it recognizes the related lease payments as an expense on either straight line basis over the lease term or another systematic basis is more representative of the lessee s benefits. 4 Lease Arrangements - A Significant Shift For Lessees

5 Potential impacts and considerations for companies Change in Key financial matrices, ratios and debt covenants: Financial matrices undergo a change due to recognition of additional assets/liabilities in balance sheet and di erence in timing of lease income/expense Return On Capital Employed EBITDA Debt/equity Ratio Gearing Ratios Net Debt Current Ratio Asset Turnover Ratio Interest Coverage Ratio Net Profit (in initial years) Net Assets Total Assets Earnings before depreciation heaves up as lease charges are recorded as depreciation and finance expense under new lease standard. Additional assets and liabilities are recorded in balance sheet leading to change in debt equity and asset ratios. Return on Capital employed is a ected due to front loading of expenses and increase in capital employed. Further, application of IFRS 16 could result in some companies no longer complying with debt covenants if those covenants are linked to a company s IFRS financial statements and are not applied on a frozen GAAP basis. Tax Implication: Adoption of new standard is likely to have tax implications for lessee. These include the impact on existing tax position/s and initial adjustments to deferred tax liability. Contractual arrangements and business model: One of the key business reason for a lessee to opt for an operating lease over financial lease is to avoid recording an asset and liability for something that is not owned by the company. Especially, in case of sectors and businesses with significant operating lease exposure (airlines, retail, energy), the new requirement could challenge the fundamental model of operating leases. In certain circumstances, a right of substitution by the lessor can be su cient for there to be no identified asset. Hence, if there is no identified asset over which the customer has a right of control, the contract must be a service agreement rather than a lease. Lessees may call upon changing of lease structures so that arrangements can be treated as service contracts rather than recognizing right of use asset for example through specifying the capacity of installed equipment alongside a right of substitution. Lessors need to consider the e ect such a change would have on their own accounting. Companies would want to carefully examine the impact of the new standard on their existing contractual arrangements, including the split of lease and non-lease components within the arrangements. For example, lessee and lessor may agree to separately price lease and non- lease components to minimize the financial impact of IFRS 16 on their financial position. Lessees may like to review the term of existing or new leases to leverage the exemption provided for short term leases. Cost of borrowings: IFRS 16 might have an impact on cost of borrowing because companies with material o balance sheet leases are expected to report higher financial liabilities (and higher assets) applying IFRS 16. E ect on the cost of borrowing is most likely to result from the availability of more accurate information about lease liabilities applying IFRS 16. Lenders are expected to be better informed about a company s credit risk and thus will be equipped to better understand and price that risk. Impact on business processes and IT systems: To satisfy the new financial statement presentation and disclosure requirements, Companies will need to evaluate whether to update their existing systems or to implement a new system. Entities need to think about implementing sustainable technology based solutions that are capable of dealing with the new lease accounting requirements. Timely assessment of system gaps and business and IT requirements will support the software vendor selection process for a lease software solution. 5 Internal Audit, Risk, Business & Technology Consulting

6 Transition date considerations The IASB has sought to provide certain transitional date reliefs to Companies. On transition, Companies can choose to apply practical expedient to grandfather their previous assessment of contracts which are, or contain, leases. Thus if a Company chooses to apply practical expedient, it shall apply new definition of lease under IFRS 16 to contracts entered into after the initial application. Transition provisions for Lessee: A lessee is permitted to either adopt the standard retrospectively or follow a modified retrospective approach. Retrospective Approach Modified Retrospective approach for lessee Lessee shall apply IAS 8 for retrospectively applying IFRS 16 on all its leases and adjust the amounts relating to periods before those presented in the financial statements to the opening balance of retained earnings of the earliest prior period presented Under this approach, Lessee recognizes the cumulative e ect of initially applying the standard as an adjustment to equity at the date of initial application. For operating leases, Lease liability is measured at the present value of remaining lease payments. ROU asset is measured either at an amount equal to lease liability or as if IFRS 16 had always been applied. Certain practical expedients are also available for operating leases. For finance leases, previous carrying amount of finance lease asset and finance lease liability shall be carried forward. The Companies face a choice of combination of expedients to choose from considering their possible outcomes and costs. The companies also need to consider the comparability of financial statements over the periods due to application of practical expedients. Because comparative information is not restated (in case of application of practical expedients and modified retrospective approach, additional disclosures is required to help users of financial statements understand the e ects of financial statements for the first time. Conversely, a full retrospective approach would provide better information to users of financial statements by increasing comparability. Transition provisions for Lessor: No adjustment is required on transition. Lessor shall continue accounting for leases in accordance with IFRS 16 from the date of transition. Next Steps Collect data for each leasing contract Reconsider sale and leaseback cases Renegotiate existing lease contracts towards lower base leasing rates and higher services provided by lessor Adjust covenants terms and conditions Analyze leasing portfolio to assess the impact to different KPI s Use short term leases as a measure to reduce lease liability Fine-tune Investor relations communication Analyze additional information required for disclosure requirements 6 Lease Arrangements - A Significant Shift For Lessees

7 How we can help Protiviti s Financial Reporting consultants help companies on various financial reporting matters. The conditions in today s global business market, such as rapidly changing regulations, increased scrutiny of company financials, complex, nonrecurring business transactions, and complex accounting standards, strain the capabilities of many finance organizations. This amplified stress increases an organization s exposure to mistakes, lost synergies and inability to maintain base-level financial processes. Risk of these errors is typically higher during the adoption of new accounting standards; embarking on significant business transactions; implementation of new IT/enterprise resources planning (ERP) systems; restructurings, acquisitions and divestitures; and expansion into new markets or new businesses. Our Financial reporting professionals are qualified Chartered Accountants with extensive practical experience in financial reporting across multiple jurisdictions and under various accounting frameworks (including IFRS and US GAAP). We at Protiviti, proactively monitor new accounting rules, alert our clients to changing requirements and under assistance with addressing complex accounting or reporting challenges, including conversion to new International Financial Reporting Standards (IFRS) such as IFRS 9, 15 and IFRS 16. Establish a Steering Committee Update Critical Accounting Policies and materiality thresholds for lease accounting Update financial reporting controls Update financial statements and disclosure requirements along with other reports Training and workshop for employees Implement Our Solutions for IFRS 16 Analyze Determine available transition methods and evaluate various transition related choices available Perform Gap analysis (both accounting and non-accounting impact) and establish execution framework Assess reporting system capabilities- to capture new data elements for recognition, measurement and disclosures Design Prepare detailed roadmap along with timelines Prepare Performa financial statements Develop the new accounting policies Discuss and determine e orts required for system changes (including the chart of accounts) 7 Internal Audit, Risk, Business & Technology Consulting

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