Countdown to MFRS 16 Are you ready?

Volume 6 - Issue 3 8 June 018 Countdown to MFRS 16 Are you ready?

MFRS 16 sets a new turning point for lease accounting. With the requirement for most operating leases to be recognized on the balance sheet, the challenge is in the complete and accurate identification of lease arrangements. The resultant effect of bloated assets and liabilities will require corporates to evaluate how MFRS 16 affects their enterprise-wide regulatory compliance and decisions on whether to buy or lease assets. Ong Chee Wai Malaysia Assurance Leader FAQs Will MFRS 16 turn companies into assetand-liability-heavy entities? Is the adoption of MFRS 16 purely a compliance exercise? What are the business implications? Are contracts that provide drilling services in the oil and gas industry a lease, a service contract or both? Are services rendered by a data or service outsourcing center that provides manpower, hardware and software support, considered a lease? Are retail store lease contracts that are bundled with related services (such as security services) considered a single lease component or two separate components?

Countdown to MFRS 16 implementation Effective 1 January 019, MFRS 16 Leases 1 ( MFRS 16 or the Standard ) will take effect. It impacts most lessees regardless of industry. The impact of this new Standard will be more pronounced in asset-intensive industries where the business model involves operating leases - from airlines, banking, retailers, oil and gas to telecommunications and transportation industries. Under MFRS 16, lessees are to recognize assets and liabilities for most leases. This new requirement will lead to a gross-up of assets and liabilities on the balance sheet which will impact an entity s debt ratios, other financial metrics and deferred tax position. Entities will now need to evaluate how MFRS 16 affects the way stakeholders view their financial position and performance, and address potential stakeholders concerns. To support lease accounting, entities need to consider enhancing their internal data management processes and IT systems to better capture financial and non-financial data. With less than six months to MFRS 16 s implementation date, this alert can serve as a checklist of your entity s readiness. Snapshot of MFRS 16 What? Lessees will apply a single accounting model for all leases (with limited exceptions). Replaces existing accounting standard MFRS 117: Leases and its related interpretations Why? Greater transparency as lessees are to recognize assets and liabilities arising from operating leases on the balance sheet Improved comparability between entities that lease assets and entities that borrow to buy assets Who? All entities, regardless of industry, with significant off-balance sheet leasing activities How? Full retrospective or a modified retrospective approach. Options for certain transitional reliefs are available. When? Effective for annual periods beginning on or after 1 January 019. Early application permitted. Impact to lessees versus lessors Lessees are required to recognize all leases on their balance sheets unless exemptions are applied. Two recognition exemptions for lessees: leases of low-value assets and short-term leases, on a lease-by-lease basis Lessor accounting is substantially unchanged. Notes: 1 MFRS 16 is equivalent to IFRS 16 Leases as issued by the International Accounting Standards Board. Provided the new revenue standard (MFRS 15 Revenue from Contracts with Customers) has been applied or is applied on the same date as MFRS 16

MFRS 16: The universe of impact is beyond accounting Granular examination of what constitutes a lease Balance sheets get bigger Establish that a contract entails the: Use of an identified asset explicitly or implicitly specified; and Power to control the use of the underlying asset for a period of time Identify an embedded lease by distinguishing between lease and non-lease components; and allocating a consideration amount for each component according to observable prices or information Will be challenging e.g. separating a lease component from bundled services arrangements involving an asset Decide whether to apply the Practical Expedient 1 option treat the multiple lease elements as a single lease All leases (with limited exceptions) to be recognized at commencement date: Right-of-use (ROU) assets at cost Lease liabilities at the present value of future lease payments Requires judgement as the measurement process can be complex for the following: Lease incentives Initial direct costs incurred Estimated costs for dismantling, removal and restoration Lease payments Lease term (including periods covered by an option to extend or terminate) Discount rate Weigh the impact of having a bigger balance sheet versus the accounting complexity of separating the lease and non-lease components Accounting implications A true picture of leasing activities A true picture allows users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee. This will require a greater degree of rigor in judgements when deciding the information to be disclosed, particularly qualitative disclosures. MFRS 16 does not provide a prescriptive list of qualitative disclosures. Mandatory to disclose when practical expedients and recognition exemptions are applied Notes: 1 A lessee may elect, by class of underlying asset, not to separate non-lease components from lease components, and instead to account for each lease component and any associated non-lease components as a single lease component. Cannot be applied to embedded derivatives that meet the criteria in paragraph 4.3.3 of MFRS 9 Financial Instruments An asset that represents a lessee s right to use an underlying asset for the lease term 3

Tax impact on leases Changes to business model of leases Malaysian income tax impact for lessees: ROU assets are not considered qualifying expenditures for capital allowance purposes. Interest expenses (on accretion of lease liabilities) and depreciation (arising from ROU assets) are disallowed for tax deductions. Annual contractual lease payments are tax deductible as incurred. Track the accounting/tax differences and the impact to deferred tax Decisions to buy or to lease may change for entities with a business model of entering into operating leases. Some lessees may consider restructuring their leasing terms such as by having: A higher proportion of variable lease payments (which do not depend on an index or rate) compared to fixed payments; or Shorter lease terms When restructuring, take into account business risks and potential costs Tax considerations Operational consequences Impact on data, systems and processes (DSP) Existing lease management systems may require review and modification because they lack the capacity and computational ability to: Address the Standard s data burden Calculate the effect on the balance sheet for operating leases Determine the effect of lease renewal, termination or purchase options, as well as reassessment requirements Parallel reporting may be necessary for comparative periods presented upon transition Re-computation of debt and other financial metrics Assess the implications to financial position, performance and metrics particularly for those ratios related to regulatory compliance This may also affect the regulatory calculations of regulated entities (including banks, insurers, brokers and dealers). 4

MFRS 16: Implementation factors - scale of complexity The new lease standard will impact lessees across all industry sectors. The extent of MFRS 16 s impact will depend on the entity s volume of operating leases, whether they are of short or long-term duration, and other specific considerations as follows: MFRS 16: Implementation factors 1 Nature of current leases Majority finance leases Majority operating leases Duration of leases Short-term contracts (1 months or less without a purchase option) Long-term contracts (more than 1 months) 3 Structure of operations/ processes Highly centralized or local operations Decentralized or global operations 4 Accessibility of all relevant lease contract data Digitized Manual 5 Composition of contracts Does not contain non-lease components Contains both lease and nonlease components 6 Structure of lease portfolio Similar assets, terms and conditions Dissimilar assets, terms and conditions Less complex More complex 5

Transitioning to MFRS 16: Five checkpoints Preparing for an accounting change of this magnitude requires a strategic and integrated approach to ensure a smooth transition. Set out below are five checkpoints to facilitate your entity s MFRS 16 implementation actions: 1 3 Ensure a comprehensive stock-take of all leases Analyze the impact of MFRS 16 on the balance sheet and income statement Conduct detailed assessment of lease contracts Evaluate existing leasing terms and strategy Calculate the impact to EBIT or EBITDA, debt covenants, regulatory capital, KPIs and remuneration schemes On debt arrangements, engage early with lenders to avoid surprises Take advantage of practical reliefs that could provide cost savings Consider the benefits of recognition exemptions, practical expedients and transitional reliefs As entities dive deeper into complying with MFRS 16 s requirements, they will realize the scale of what needs to be done cannot be underestimated there are many operational implications, particularly to data, systems and processes. Lee Pei Yin Partner, Financial Accounting Advisory Services 4 Ascertain that data, systems and processes are capturing the relevant set of lease information Contemplate having an IT system that can handle the MFRS 16 lease data burden and multiple computational scenarios 5 Prepare communication of MFRS 16 impact to stakeholders Communicate the implications of the new standard to all stakeholders (internal and external) 6

EY contacts Ong Chee Wai Malaysia Assurance Leader Tel: +603 7495 8776 chee-wai.ong@my.ey.com Lee Pei Yin Partner, Financial Accounting Advisory Services Tel: +603 7495 8648 pei-yin.lee@my.ey.com Ng Kim Ling Partner, Assurance EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Global Limited, each of which is a separate legal entity. Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. 018 All Rights Reserved. APAC no. 0700138 EDNone This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com/my Tel: +603 7495 8655 kim-ling.ng@my.ey.com Tan Boon Yow Partner, Advisory Advisory Services Sdn. Bhd. Tel: +603 7495 8880 boon-yow.tan@my.ey.com Julie Thong Partner, Tax Global Compliance and Reporting Tax Consultants Sdn. Bhd. Tel: +603 7495 8415 julie.thong@my.ey.com