EMBARKING ON A NEW ERA OF LEASE ACCOUNTING

EMBARKING ON A NEW ERA OF LEASE ACCOUNTING BDO AS YOUR COMPANION NEW: BDO LEAD AS WEB-BASED APPLICATION

3 CONTENT EDITORIAL.... 4 INTRODUCTION... 5 IFRS 16 AFFECTS YOUR FINANCIAL STATEMENTS AND KEY PERFORMANCE INDICATORS... 5 LEASING FACTS AND FIGURES... 6 IFRS 16 IMPLEMENTATION ACCEPTING THE CHALLENGE... 8 ACCOUNTING... 8 IDENTIFICATION AS THE BASIC CHALLENGE.... 8 RECOGNITION EXEMPTIONS UNDER IFRS 16 LOW-VALUE AND SHORT-TERM LEASES... 9 INITIAL MEASUREMENT...11 SUBSEQUENT MEASUREMENT...11 TECHNICAL AND ORGANISATIONAL QUESTIONS.... 12 DATA CAPTURING... 12 HANDLING OF CONTRACT DATA... 12 BDO LEAD.... 13 THE LEASING TOOL OF YOUR CHOICE... 13 BDO LEAD MODULES... 16 BDO MAKES THE DIFFERENCE... 17 CASE EXAMPLES OF OUR SERVICES... 17 PROJECT DESIGN BDO LEAD IMPLEMENTATION.... 17

4 EDITORIAL Given the endorsement of the new leasing standard by the European commission, IFRS 16 is mandatory on or after January 2019 and replaces IAS 17 and IFRIC Interpretation 4. The main changes apply to lessees lease accounting. The new standard requires lessees to recognise all leases on the balance sheet, with recognition exemptions only applying to low-value and short-term leases. The IASB estimates that - because of IAS 17 - about 85 per cent of the lease commitments with a value of US $ 3,3 trillion do not appear on companies balance sheets worldwide. US-GAAP reporting firms are also facing a new leasing standard. With the release of ASC 842, the Financial Accounting Standards Board (FASB) put an end to the off-balance accounting of leases, like the IASB with regard to IFRS 16. For lessees, compliance with the new leasing standard poses quite a challenge. In practice, the members of BDO s Department of Accounting Advisory Services observe an increasing gap between the accounting requirements and - in particular by medium-sized firms - the possibilities to react to them. Firms cannot shun the requirements of the application of IFRS 16 and ASC 842. The only option would be to forfeit tenancies as a whole. The new leasing standard is applicable across companies and sectors; thus it does not only affect companies with complex transactions. As a consequence, all firms need to address the accounting and implementation challenges of the new leasing standard if they are lessors and/or lessees. Generally, this is a more complex task for large than for small firms because of their complex IT system landscape. For all firms, a lack of personnel resources will be the bottleneck of the successful implementation of the new leasing standard. Thus, an early adoption of IFRS 16 together with the challenges of IFRS 15 is unlikely for many firms. On the next pages, we would like to inform you about the importance of leasing in Germany and Europe and the upcoming challenges from a practical point of view and simultaneously introduce BDO s solutions for the implementation of IFRS 16 in your company. We as BDO do not only assist you in the implementation of the new leasing standard. We also offer you the opportunity to entirely restructure your lease accounting with our IT supported tool BDO LEAD, thereby lifting your lease accounting to unprecedented levels. I wish you an interesting and stimulating read. Yours, Dr. Jens Freiberg

5 INTRODUCTION IFRS 16 affects your financial statements and key performance indicators The application of the new lease accounting rules affects lease transactions, previously classified as operating lease (offbalance lease) under IAS 17. According to IFRS 16, most lease transactions have to be brought onto the companies balance sheets. The distinction between operating and finance leases is no longer valid for lessees unless one of the exemption rules for ( as if ) operating lease accounting is made use of. For companies with a great share of operating and hence offbalance lease commitments the adoption of the new leasing standard leads to a significant increase in assets and liabilities. The associated balance sheet extension is going to have a great impact on the lessees balance sheet picture in particular if there are leases with long economic lives (e.g. leasing of property) and mass transactions (e.g. car fleet leasing). In contrast, lessor accounting continues to be guided by IAS 17 which is why for lessors excluding interdependencies with the requirements for revenue recognition (IFRS 15) there should be no great changes due to the new lease accounting principles set out by IFRS 16. The implementation of the new leasing standard will most closely correspond to a profit neutral adjustment, i.e. not be reflected in the income statement, particularly if the modified retrospective approach is applied for practicability considerations. However, key performance indicators are impacted by the changed balance sheet picture. The main effects are: y Increase of operating profits (EBITDA) as lease payments are made up of amortisation and interest rate payments. The latter are part of the financial results. y Increase of the level of indebtedness because of the firsttime recognition of currently off-balance leases in the balance sheet. The increase in the level of indebtedness depends on the number of lease contracts and their respective contractual conditions. y Increase in the operating cash flow. Recognition of part of the lease expenses (i.e. interest expenses) within the finance activities (interest rates) relieves operating cash flow in the cash flow statement. Net cash flow remains unaffected.

6 Leasing Facts and figures Leasing in Germany In Germany, the leasing ratio, i.e. the share of leasing investments in equipment investments has steadily increased for many years. A quarter of equipment investment is expected to be realized through leasing in 2017, which is the highest value achieved so far. The leasing of moveable assets increased by 6,5% (Euro 57,3 bn) this year, an increase much larger than the increase in total equipment investments (+2,3%). Leasing ratios in Germany in percent: Share of leasing in equipment investments 26 24 22 20 18 16 14 12 10 2006 2008 2010 2012 2014 2016 Leasing total Mobile leasing Source: ifo Institut, Bundesverband Deutscher Leasing-Unternehmen, Stand 11/2017 The service sector, ranging from the hospitality industry to banks, insurances, broadcasters, film companies, Internet providers, car rentals and self-employed does not only make the largest contribution to Germany s gross national product (GDP) from all economic sectors, it is also ranked first among all sectors with regard to its lease engagement since 1996. Service sector number one in leasing 10% 10% 7% 3% 2% 37% Service sector Manufacturing sector Private households Storage and communication 11% 20% Trade Construction Industry Agriculture, energy and water supply, mining Public sector Source: ifo Institut, Bundesverband Deutscher Leasing-Unternehmen, Stand 11/2017

7 Cars and commercial vehicles are the dominant leasing objects in Germany. 1% 2% 8% 6% 6% Cars and commercial vehicles Production machinery Office machines and IT 77% Communication, signal engineering and other equipment Aircrafts, rail vehicles, vessels Real estate Source: ifo Institut, Bundesverband Deutscher Leasing-Unternehmen, Stand 11/2017 Leasing in Germany In 2016, total new leasing volumes worth Euro 333,7 bn were granted in Europe. Compared with the previous year, the leasing volume grew by 10,3 per cent and, thus, exceeded the German leasing volume growth. The UK is the greatest leasing market in Europe; the second and third largest are Germany and France respectively. As in the German lease market cars and commercial vehicles make up for the largest share of the European leasing volume (2016, 67% per cent) (Leaseurope, Key Facts and Figures 2016). Top 5 European leasing markets (in Euro) 90 bn 80 bn 77 bn 70 bn 60 bn 60 bn 50 bn 44 bn 40 bn 30 bn 20 bn 10 bn 20 bn 13 bn 0 bn UK DE FR IT SE Source: Leaseurope Annual Survey 2016, Germany: ifo Institute, Federal Association of German Leasing Companies.

8 IFRS 16 IMPLEMENTATION ACCEPTING THE CHALLENGE Accounting Identification as the basic challenge The application of the new leasing standard assumes that a contract meets the requirements of a lease under IFRS 16. A lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration (IFRS 16.9). To qualify for a lease, the lessee must have the right to obtain substantially all economic benefits from the use of the asset (IFRS 16.B22). In addition, the lessee has the right to direct how and for what purpose the asset is used throughout the period of use (IFRS 16, B24). Substantial substitution rights of the lessor may, however, disqualify the contract as a lease (IFRS 16.B14). Example: Supplier A offers electronic data processing services using a central data centre. For the provision of his services, one of several available servers is used. The server is located at an accessible space. The server can be substituted by A anytime, thereby allowing A to more flexibly plan capacities. The lessee cannot prevent A from substituting the server against an alternative server. The contract does not contain a lease because A is able to substitute the server and derive economic benefits from exercising the substitution rights. BDO your advantage BDO assists you in understanding your lease contract constellations by analysing them thoroughly. The classification of your lease contracts carried out by us (lease vs. non-lease) makes the identification of future contracts as non-lease easier. In leasing-intensive industries this is particularly valuable as resources are set free for alternative use. Furthermore, we assist in the identification of leases embedded in continuing obligations and the demarcation of non-lease components in a contract.

9 Recognition exemptions under IFRS 16 Low-value and short-term leases Under IFRS 16, lessees may choose not to recognise a rightof-use asset (ROU asset) and a leasing liability for shortterm and low-value leases. The new leasing standard thus allows for a (quasi) operating lease depiction of the leases if the lease is of 12 months or less or the underlying asset is of low value, i.e. less than US $ 5000. Example: Lessee B enters into a fixed eight-month contract, covered with an option to extend the lease by ten months, with lessor L. The exercise of the option is not reasonably certain as the monthly lease payments during the extension are equal to market rates. The lease has a lease term of eight months and, thus, qualifies for the short-term recognition exemption under IFRS 16.

10 The decision for the recognition of a contract, conveying the right to use a physical resource, as a lease is schematically depicted as follows: Contracts conveying the right to use an asset for a period of time within the scope of IFRS 16 Yes Yes Lessee has the right to direct how and for what purpose the asset is used throughout the period of use. Short-term lease (lease term < 12 months) No Yes Yes Low-value lease (US $ 5000) Yes The lease is not material. Not recognised as a lease Yes Recognition as a lease An essential way to simplify lease accounting under IFRS 16, is to group leases with similar characteristics into a lease portfolio. However, the formation of a lease portfolio is only allowed if there is no material difference in the effects on the financial statements compared to the recognition of the individual leases. A lease portfolio is recognised as a single lease under IFRS 16, i.e. one ROU asset and one lease liability are recognised. Because of this, one discount rate, one lease term etc. can be used to calculate the present value of the lease liability and the carrying amount of the lease portfolio. Such a portfolio of leases highly qualifies for the predominantly leased asset in Germany and Europe: cars and commercial vehicles due to their high degree of homogeneity. BDO your advantage BDO assists you in the evaluation of your contracts likely to qualify for the short-term and low-value lease recognition exemptions. In this context, BDO helps you understand the complex interplay of the requirements to recognise ROU assets as a lease under IFRS 16. Analysing the entirety of your contracts, allows us to give you advice on the recognition of lease portfolios. In this way, we help you downsize your lease contract numbers to a manageable number of leases (portfolios), concurrently reducing the complexity of the recognition of your leases.

11 Initial Measurement All contracts, identified as a lease under IFRS 16, are recognised in the balance sheet as a ROU asset and a leasing liability, equal to the present value of future lease payments, at the commencement date (IFRS 16.26). The ROU asset is recognised at acquisition costs which are largely equal to the recognised amount of the lease liability but supplemented by costs that would not have been incurred if the lease had not been obtained (initial direct costs) and asset retirement obligations (IFRS 16.24 (b)-(d)). Payments made by a lessor to a lessee associated with the lease reduce asset acquisition costs. Initially measured, the lease liability is equal to the present value of the future lease payments and the present value of possible payments at the end of the lease term. For the calculation of the present value of the lease liability, an interest and repayment schedule needs to be constructed out of the lease payments, the lease term and the respective interest rate. The lease term is the non-cancellable period for which a lessee has the right to use the asset underlying the lease, together with the periods covered by extension and termination options reasonably certain to be exercised (IFRS 16.18). The interest rate to be used to discount the lease payments is the interest rate implicit in the lease; if this rate cannot be readily determined, the incremental borrowing rate of the lessee is to be used instead. If there is a change in the lease term or a change in the assessment of an option to purchase the underlying asset, the lessee is required to remeasure the lease liability using a revised discount rate for the revised lease payments (IFRS 16.40). As a consequence of the remeasurement, the ROU asset and the lease liability need to be adjusted by equal amounts on the balance sheet date. Example: A change in the assessment of a termination option leads to a reduction of the lease term by five years causing a decrease in the lease liability due to less lease payments. The carrying amount of the ROU asset is reduced and an income affecting expense booking is taken into consideration. BDO your advantage BDO assists you with the full competence and experience of its experts of the Technical Department of Financial Reporting in the first and subsequent measurements of your leases to ensure an efficient and technical transition to the new leasing standard. BDO is able to provide professional and organisational advice as both the initial and subsequent measurement generally underlie increasing complexity. Subsequent measurement After the commencement date, the subsequent measurement of the ROU asset is within the scope of IAS 16, outlining the accounting treatment of most types of property, plant and equipment. For the subsequent measurement, the ROU asset is amortised on a straight-line basis over the lease term. The carrying amount of the lease liability is increased reflecting interest on the lease liability and reduced by the agreed-upon repayments between the lessor and the lessee (IFRS 16.36). For compounding, either the implicit but mostly not readily determined - interest rate is to be used or as a fallback option the incremental borrowing rate of the lessee.

12 Technical and organisational questions Data capturing Due to the large number of leases in most companies, the digital capture of contract data relevant for IFRS 16 accounting, in particular OCR (optical character recognition), is the most efficient solution. However, OCR often cannot be conducted or only at great expenses as leasing contracts frequently lack standardisation and exhibit great heterogeneity. The contract language as well as the layout of the original contract can be factors inhibiting the digital capture of lease contract data. Thus, the manual capture of the contract data and data field additions within existing contract databases appear to be the last resort to meet the requirements of the new leasing standard. BDO your advantage The experts of BDO s Technical Department of Financial Reporting and IT are happy to advise you in the project design and the contract evaluation process, particularly with regard to the best practice choice. We would like to support you in the manual capture of your leases or the data fields missing in your databases if digital capture is not or only partially feasible. Handling of contract data In most cases, the changes in lease recognition under IFRS 16 require a conversion of your accounting engine to the new leasing standard or the use of an IT based accounting tool. In close collaboration with your accounting department, we develop a detailed accounting delta concept which provides the basis for the adaption of your accounting engine to the new leasing standard. With our IT supported tool, BDO LEAD, you are, however, able to capture your relevant lease contract data and perform lease accounting under the new leasing standards both IFRS 16 and ASC 842 - without great conversion expenses. In this case, your accounting engine does not need to be adapted. BDO LEAD is able to conduct all first and subsequent measurements of your leases both under IFRS 16 and ASC 842. In addition to the presentation in the balance sheet and the profit and loss statement, BDO LEAD assists you in the generation of the notes of the financial statement. Additionally, BDO LEAD offers several functions for the efficient management of your lease contract data. For instance, different permissions can be assigned to different users and focused statistical analyses can be carried out.

13 BDO LEAD The leasing tool of your choice To ease the transition to IFRS 16 and the subsequent measurement of your leases in the balance sheets, BDO developed a targeted IT supported accounting tool, enabling safe storage and contract maintenance. With BDO LEAD, lease recognition under IFRS 16 and ASC 842 is automatised, transparent and easier to handle for the user, thereby significantly increasing the efficiency of lease accounting. BDO LEAD is specifically orientated towards the needs of the customer. Thus, we developed a clear and user-friendly tool. All BDO LEAD features, e.g. the input mask for entering the data, revolve around this objective. As a user you will appreciate this advantage from the creation of your contracts to the final output of the entry posting. BDO LEAD, thus, saves you time-consuming training into the details of the new leasing standards. IT supported tool User IT supported tool Transaction implementation Please find below the functions of BDO LEAD: Contract creation In addition to the new accounting requirements faced by companies, the organisational arrangements for implementing the new leasing standard should not be underestimated. Faultless lease recognition requires capturing all parameters relevant for IFRS 16 accounting. Only with a complete database, a standard-conform recognition of the leases can be assured. BDO LEAD offers a (semi)-automatic solution, enabling the capture and analysis of lease contracts. In addition, our IT supported tool enables the import of existing lease contract data via an import interface. The back-up of the data as well as the calculation is not performed in a spreadsheet program. BDO LEAD assures that the history of data inputs can be retrieved at any time. In contrast to a spreadsheet program, unintentional overwriting of information is not possible. Given the transparent and user-friendly design of our tool, the entry of recognition exemptions (low-value and short-term) and the standard s measurement rules can be performed even by non-ifrs 16 and ASC 842 experts.

14 Measurement Apart from the recognition exemptions for short-term and lowvalue leases, all lease contracts are recognised in the balance sheet as a ROU asset and a leasing liability under IFRS 16. Thus, the ROU asset and the lease liability need to be measured. BDO LEAD assists you - with the help of targeted entry control routines - in entering the parameters relevant for measuring the lease liability in line with the effective interest rate method. The measurement of the ROU asset is based on the lease liability and adjusted by costs such as initial direct costs or asset retirement obligations. These additional payments are part of BDO LEAD s data queries. For a better comprehension of the calculation logic underlying BDO LEAD, we provide use cases, i.e. lease contract constellation, in a spreadsheet program.

15 Analysis Data analyses are automatically performed in line with the new leasing standard. All relevant data needed at the balance sheet reporting date or in-between dates can be retrieved and exported. The basic version of BDO LEAD offers several possibilities to analyse your lease data that can be supplemented by additional modules to customise your needs and the requirements of a certain industry. BDO LEAD also automatically provides the respective note entries required under the new leasing standard at the reporting date. In addition, the effect of the transition to IFRS 16 on key performance figures (KPIs) is continuously simulated and automatically exported.

16 Entry IT-supported tool Databases i Storage Accounting Analysis/ Notes Programm settings We integrate your manual of accounting into our IT supported tool. Thus, uniform, intragroup accounting is guaranteed. BDO LEAD MODULES BDO LEAD is offered in a modular system enabling you to select the functions you need. The minimum module of BDO LEAD contains the IFRS lease accounting package. Basic module lessee The basic module enables you (as a lessee) to store your lease contracts and perform lease accounting under IFRS. The possibility of considering individual company accounting policies is given. The integration of individual accounting policies facilitates the automatic selection of preset recognition exemptions and other company accounting guidelines (e.g. treatment of portfolio leases or the separation or non-separation of leases and services). In addition, this feature is important for lease classification and the interpretation of legal terms on the side of the lessor. The basic module also offers an extensive possibility to analyse your lease data and the notes. Add-on module US-GAAP The add-on module US-GAAP provides you the possibility to perform - next to IFRS accounting - US-GAAP accounting. A new entry of the database or data fields is not necessary, only delta data fields, i.e. fields required for US-GAAP accounting, are to be entered. Add-on module authorisation This add-on module ensures confidentiality of your lease data by implementing different authorisation levels. In addition to read and write rights, your employees can be assigned different roles so that e.g. contract amendments can only be stored with prior consent by a higher instance. Customer specific add-ons We offer customer-specific adaptations of, and additions to BDO LEAD e.g. the provision of additional software interfaces or languages other than English and German set as the default languages. Basic module lessor The basic module enables you (as a lessor) to store your lease contracts and perform lease accounting under IFRS. Like the basic module for lessees, this module facilitates the automatic selection of preset recognition exemptions and allows for the integration of company-specific accounting policies. In the context of lease contract classification and the interpretation of legal terms on the side of the lessor, this function gains importance as the lessor s lease accounting continues to differentiate between operating and finance leases. The module also affords the user to analyse the notes of the financial statements.

17 BDO MAKES THE DIFFERENCE Case examples of our services We currently support a variety of companies in capturing their lease contracts, previously classified as operating lease and, hence, off-balance lease under IAS 17, and conducting lease contract analyses. We examine whether our clients` accounting policies are in line with IFRS 16 and assist in the adaption of our clients lease accounting engine to IFRS 16. Our services include the development of a delta concept, providing the basis for the adaption of the clients accounting engine. As a central reference serves our client-specific sample collection of use cases, by which the functionality of the lease database and the faultless recognition of the leases in the balance sheets can be comprehended. Case example: How can the accounting engine be adapted to the new leasing standard? In a project with one of the world s leading telecommunication groups, BDO leads the way. The majority of the group s leases are co-location, rooftop or ground leases. The core of our services is the capturing of all intragroup off-balances leases and the provision of expert advice with regard to the adaption of the client s lease accounting engine to IFRS 16. Several members of staff of our Technical Department of Financial Reporting are on-site at the group s national subsidiaries to assist in the capturing of the lease contracts and the import in a data warehouse, developed by the experts of our IT department. In close collaboration with our client s accounting department, we prepared a detailed accounting delta concept. Based on our concept, the client s accounting engine is adapted by a professional software firm to perform the lease accounting under IFRS 16. With the help of continuous simulations, conducted in parallel to the on-site data capturing, we estimate the effects of IFRS 16 on our client s key performance indicators. This way, we assure a smooth and faultless transition to the new leasing standard. Project design BDO LEAD implementation If you opt for lease accounting with BDO LEAD, it is not at all long and stony way into the new era of lease accounting. BDO LEAD is designed user-friendly and under consideration of the latest insights with regard to the new leasing standard IFRS 16 and technical possibilities. The implementation of BDO LEAD comes in a three-step process. In the analysis and planning phase, we analyse depending on your requests your lease contracts, e.g. with regard to contract particularities. In addition, your company s specific situation and its technical landscape is analysed. We discuss the results of our analyses with you and advise you if necessary on accounting-related and technical adaptations of BDO LEAD to adjust BDO LEAD to your needs. In the adjustment phase, BDO LEAD is with the help of BDO IT and the continuous involvement of our experts of the Technical Department of Financial Reporting implemented at your company to assure a smooth transition into application. On-going communication Kick Off Initial analysis and planning Adjuistment phase Smooth transition into application On-going quality assurance

Information for the reader This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO AG Wirtschaftsprüfungsgesellschaft to discuss these matters in the context of your particular circumstances. BDO AG Wirtschaftsprüfungsgesellschaft, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it. 2017 BDO AG Wirtschaftsprüfungsgesellschaft

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CONTACT BDO AG Wirtschaftsprüfungsgesellschaft WP Dr. Jens Freiberg Partner, Head of Technical Department of Financial Reporting Public Auditor Georg-Glock-Str. 8 40474 Düsseldorf Phone: +49 211 1371-0 Fax: +49 211 1371-120 duesseldorf@bdo.de BDO AG Wirtschaftsprüfungsgesellschaft, a German company limited by shares, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. 12/2017