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

2 Key provisions and changes under IFRS 16 Under e existing accounting rules, a lessee is required to account for lease transactions eier as an operating lease or a finance lease, depending on various rules and tests, which results in all or noing being recognized on balance sheet for sometimes economically similar transactions. The user of an asset (lessee) is able to avoid capitalizing e asset on its balance sheet in case of an operating lease and only disclose its future lease commitments. Furer, under e current standard, ere is no requirement of segregating lease and non-lease portion in a contract. The key provisions and changes in e 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 e lease being classified as a finance of operating lease) to record e asset on its balance sheet wi a corresponding financial obligation. The asset recognized will reflect eir 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 e requirement for a lease arrangement to have a specific identified asset and right to control e asset wi e lessee. This is quite similar to e current requirement under IFRIC 4 except at e right to control is determined based on primarily two conditions instead of ree under IFRIC 4. Taking e analogy of IFRS 15, e new standard requires bo lessee and lessor to separate lease and non-lease components out of a contract and only account for e lease component under e new standard. This is subject to e practical expedient provided to a lessee, in case impractical to separate. Except for e need to separate e lease and non-lease component, e accounting by lessors under IFRS 16 is substantially unchanged from IAS 17. However, e changes under e new standard could challenge e business model of lease arrangements in case, operating leases become less attractive for e lessees. In is document, we discuss e key changes in more detail wi some relevant examples. We also share our perspective on some key considerations for business as a whole including e impact on e business model, key ratios impacting bank covenants, and e impact on IT and oer business processes. New definition of lease: Under e new standard, a contract is, or contains, a lease if e contract conveys a right to control e use of an identified asset for a period of time in exchange of consideration. IDENTIFIED ASSET + Wheer substantive right to substitution present? Wheer supplier has practical ability to substitute alternative asset? Wheer supplier would benefit economically from substitution? RIGHT TO CONTROL THE USE OF ASSET Right to obtain all e economic benefits Right to direct e use of identified asset. The standard clearly states at for an arrangement or a contract to contain a lease of an asset, ere has to be a specific identified asset at cannot be substituted (neier contractually nor practically) and e lessee has e right to receive e economic benefits from e asset as well as right to direct e use of e identified asset (i.e. right to control e use of e asset). The new requirement is in principal similar to e requirement under IFRIC 4 except at e new standard does not assume control over an asset in case e lessee obtains more an insignificant amount of output and e price is not fixed or e market price for each unit of output (which is e case under IFRIC 4). 2 Lease Arrangements - A Significant Shift For Lessees

3 As such, under e new standard, ere could be contractual arrangements at may not qualify as a lease and vice versa. Example: A customer purchases all e output out of a plant but has no right of access to e plant or decision making rights. Price charged is variable per unit and supplier owns and operates e plant wi 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, e contract does not contain a lease since customer's rights do not extend beyond ose of a customer in a typical supply or service contract. Right-of-Use Model for Lessees IFRS 16 eliminates e classification of a lease eier as an operating lease or a finance lease for a lessee. All leases are capitalized by recognizing e present value of e lease payments along wi any initial direct costs and restoration costs, presenting em 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 e measurement of leased assets and liabilities when ese depend on an index or a rate or where in substance ey are fixed payments. As such, any oer variable lease payments (such as lease rental linked to sales) will be excluded from e calculation of lease liability. Subsequently, e lease liability is measured at amortized cost using e e ective interest rate meod (EIR). Right-of-Use assets are subsequently measured at cost less accumulated depreciation and accumulated impairment loss. Tables below show e 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 e new standard will result in acceleration of e P&L charge (front loading of expenses) due to constant depreciation charge on e right-of-use asset coupled wi declining interest expense on lease liability over e lease period. The front loaded expense pattern may average out across a portfolio of leases in a large and stable business. However, ere may be significant e ects in aggregate for a growing business or a business at is undertaking a major refresh of its portfolio of leased assets. Furer, e charge in e income statement shall be below EBITDA under e new standard and hence also likely to impact key balance sheet and P&L ratios. This requirement of capitalizing e Right to Use e asset is similar under bo IFRS and US GAAP. However, under US/GAAP, in case of a finance/capital lease (Type A lease), e Right-of-use shall be amortized separately from e finance cost and in case of an operating lease (Type B lease), e two amounts shall not be separated but accounted for as one rental expenditure i.e. e 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 wi commitment to purchase or sell oer goods or services (nonlease components such as maintenance, insurance etc.). These are excluded from e lease liability if, ey 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 e lessee (e option is not available to e lessor). The lessor allocates e consideration in e contract in accordance wi e requirements of IFRS 15 i.e. according to e stand alone selling prices of e goods or services included in each component. There is no guidance under existing IAS 17 around e separation of lease and non-lease components. For Example: A lessor has obtained a space in e warehouse for storing of goods and pays $ 10,000 p.a. which includes rental for e year as well as annual maintenance. The lessee can obtain warehouse next door for $ 9,000 per year wiout 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 e lease element and account for at as for e lease; and allocate $ 1,429 ($ 1,500/ ($ 9,000+$ 1500)) to e service element and in is 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 e basis of wheer e underlying lease of asset is operating lease or financing lease, and does not require seller (lessee) to determine wheer e sale and leaseback transaction meets e condition for e sale of e asset. However, under e new standard, e seller (lessee) and e buyer (lessor) will use e definition of sale from IFRS 15 to determine wheer a sale transaction has occurred in a sale and leaseback transaction. If e transaction is to be a sale, seller (lessee) derecognizes e underlying asset and recognizes a rightof-use asset at e retained portion of previous carrying amount. If e transaction is not a sale, e seller (lessee) continues to recognize e 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 e seller (lessee) will always recognize e 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 e lease between e parent lessor and intermediate lessor remains intact. Intermediate lessor classifies sub lease as operating lease or finance lease, on e 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 wi 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 wi a lease term of 12 mons 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 ese recognition exemptions, en it recognizes e related lease payments as an expense on eier straight line basis over e lease term or anoer systematic basis is more representative of e 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. Furer, application of IFRS 16 could result in some companies no longer complying wi debt covenants if ose 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 e impact on existing tax position/s and initial adjustments to deferred tax liability. Contractual arrangements and business model: One of e key business reason for a lessee to opt for an operating lease over financial lease is to avoid recording an asset and liability for someing at is not owned by e company. Especially, in case of sectors and businesses wi significant operating lease exposure (airlines, retail, energy), e new requirement could challenge e fundamental model of operating leases. In certain circumstances, a right of substitution by e lessor can be su cient for ere to be no identified asset. Hence, if ere is no identified asset over which e customer has a right of control, e contract must be a service agreement raer an a lease. Lessees may call upon changing of lease structures so at arrangements can be treated as service contracts raer an recognizing right of use asset for example rough specifying e capacity of installed equipment alongside a right of substitution. Lessors need to consider e e ect such a change would have on eir own accounting. Companies would want to carefully examine e impact of e new standard on eir existing contractual arrangements, including e split of lease and non-lease components wiin e arrangements. For example, lessee and lessor may agree to separately price lease and non- lease components to minimize e financial impact of IFRS 16 on eir financial position. Lessees may like to review e term of existing or new leases to leverage e exemption provided for short term leases. Cost of borrowings: IFRS 16 might have an impact on cost of borrowing because companies wi material o balance sheet leases are expected to report higher financial liabilities (and higher assets) applying IFRS 16. E ect on e cost of borrowing is most likely to result from e 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 us will be equipped to better understand and price at risk. Impact on business processes and IT systems: To satisfy e new financial statement presentation and disclosure requirements, Companies will need to evaluate wheer to update eir existing systems or to implement a new system. Entities need to ink about implementing sustainable technology based solutions at are capable of dealing wi e new lease accounting requirements. Timely assessment of system gaps and business and IT requirements will support e 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 grandfaer eir 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 e initial application. Transition provisions for Lessee: A lessee is permitted to eier adopt e 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 e amounts relating to periods before ose presented in e financial statements to e opening balance of retained earnings of e earliest prior period presented Under is approach, Lessee recognizes e cumulative e ect of initially applying e standard as an adjustment to equity at e date of initial application. For operating leases, Lease liability is measured at e present value of remaining lease payments. ROU asset is measured eier 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 eir possible outcomes and costs. The companies also need to consider e comparability of financial statements over e 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 e e ects of financial statements for e 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 wi IFRS 16 from e 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 e 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 e 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 ese errors is typically higher during e 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 wi 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 wi 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 resholds for lease accounting Update financial reporting controls Update financial statements and disclosure requirements along wi oer reports Training and workshop for employees Implement Our Solutions for IFRS 16 Analyze Determine available transition meods and evaluate various transition related choices available Perform Gap analysis (bo 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 wi timelines Prepare Performa financial statements Develop e new accounting policies Discuss and determine e orts required for system changes (including e chart of accounts) 7 Internal Audit, Risk, Business & Technology Consulting

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