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A New Era In Lease Accounting!

Published on Wed, Jan 27,2016 | 22:21, Updated at Wed, Jan 27 at 22:21Source : 

By Jigar Parikh, Partner in Indian member firm of EY Global

On January 13, 2015, The International Accounting Standards Board® (the Board) issued a new accounting Standard, called IFRS 16 Leases. It replaces accounting requirements introduced more than 30 years ago that are no longer considered fit for purpose and is a major revision of the way in which companies account for leases. The new standard is result of extensive deliberation with the US Financial Accounting Standards Board (FASB), with both IASB and FASB, agreeing to align the central issue of bringing leases onto balance sheets, and on the definition of a lease and how lease liabilities should be measured. FASB is also expected to issue the standard shortly. This is a landmark event and is likely to improve financial reporting and comparability for all stakeholders. Amongst other benefits, this new standard would bring higher comparability between companies that lease and those which borrow to buy.

India will embark its journey to start reporting under IFRS converged framework from April 1, 2016 in phased manner. It is expected that ICAI will issue and MCA will soon notify IND AS equivalent standard to align with IFRS 16. Even though the new standard may not be applicable for first IND AS reporting period ending March 2017 or 18, companies will need to understand accounting and business implications to ensure smooth transition when IFRS 16 gets mandated under IND AS.

Key Changes in Lease accounting
Previous lessee accounting
Under IFRS, IAS 17 focused on classifying lease arrangements either as finance lease or an operating lease.  When a lease was determined to transfer all significant risk and rewards with respect to the underlying asset, the lease was classified as a finance lease and reported on a company’s balance sheet. All other leases were classified as operating leases and not reported on a company’s balance sheet. Operating leases were accounted for similarly to service contracts, with the company reporting a rental expense in the income statement on straight-line lease expense. IND AS 17 also prescribed similar accounting principles except that it provided option to straight line expense if escalations in lease pay-outs represent inflation.  

Impact on company’s Balance Sheet
IFRS 16 eliminates the classification of leases as either operating leases or finance leases for a lessee. Instead all leases are treated in a similar way to finance leases applying IAS 17. Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as lease assets (right-of-use assets) or together with property, plant and equipment. If lease payments are made over time, a company also recognises a financial liability representing its obligation to make future lease payments. The most significant effect of the new requirements will be an increase in lease assets and financial liabilities. Significance of this change can be gauged from estimation of lease commitments which are not recorded on the balance sheet but are disclosed only in notes to accounts. The IASB has calculated that listed companies using IFRS Standards, or US GAAP, have around US$3.3 trillion of lease commitments.  More than 85 per cent of these don’t appear on their balance sheets.

Impact on company’s income statement
For companies with material operating lease arrangements, IFRS 16 changes the nature of expenses related to those leases. IFRS 16 replaces the straight-line operating lease expense for those leases applying IAS 17 with a depreciation charge for the lease asset (included within operating costs) and an interest expense on the lease liability (included within finance costs). This change aligns the lease expense treatment for all leases.

Lessees accrete the lease liability to reflect interest and reduce the liability to reflect lease payments made. The related right-of-use asset is depreciated in accordance with the depreciation requirements of IAS 16 Property, Plant and Equipment. For lessees that depreciate the right-of-use asset on a straight-line basis, the aggregate of interest expense on the lease liability and depreciation of the right-of-use asset generally results in higher total periodic expense in the earlier periods of a lease. Lessees remeasure the lease liability upon the occurrence of certain events (e.g., change in the lease term, change in variable rents based on an index or rate), which is generally recognised as an adjustment to the right-of-use asset. The difference in the expense profile between IFRS 16 and IAS 17 is expected to be insignificant for many companies holding a portfolio of leases that start and end in different reporting periods.

IFRS 16 principles do not apply to short-term leases (12 months or less) and leases of low-value assets (such as a personal computer).

Impact on lessor’s accounting
The accounting by lessors under the new standard is substantially unchanged from today’s accounting in IAS 17. Lessors classify all leases using the same classification principle as in IAS 17 and distinguish between two types of leases: operating and finance leases.

A seller-lessee and a buyer-lessor use the definition of a sale from IFRS 15 to determine whether a sale has occurred in a sale and leaseback transaction. If the transfer of the underlying asset satisfies the requirements of IFRS 15 to be accounted for as a sale, the transaction will be accounted for as a sale and a lease by both the lessee and the lessor. If not, the transaction will be accounted for as a financing by both the seller-lessee and the buyer-lessor. The new determination of whether a sale has occurred in a sale and leaseback transaction is a significant change from current practice. For example, IAS 17 focuses on whether the leaseback is an operating or finance lease, and does not explicitly require the seller-lessee to determine whether the sale and leaseback transaction meets the condition for the sale of the asset. Consequently, fewer transactions are likely to meet the prescribed criteria to be accounted for as sales and leasebacks under the new standard.

Business Consequences
IFRS 16 will have significant implications on financial matrices of the company. Currently, the annual rent expense appears in the lessee’s income statement and is included in common performance measures such as “operating profit” or EBITDA (earnings before interest, tax, depreciation and amortisation). However, under the new leases standard, this rent expense is replaced with two different expenses – interest expense (on the lease liability) and depreciation expense (on the lease asset).  For some companies, this might make their reported operating profit or EBITDA figures look better. But the reported net profit after tax may reduce in the early years of the lease.

Recognition of lease assets and liabilities can have wider commercial effects.  For example, banking covenants and other contractual arrangements that are tied to the company’s financial statements (eg debt to equity ratios in banking covenants and interest coverage ratio) might need to be revised before the standard becomes effective.

Reflection of lease assets and obligations provides a more faithful representation of the financial position of a company and greater transparency about the company’s financial leverage and capital employed. This is expected to enable investors and analysts to better assess the financial position and financial performance of a company. The IASB expects IFRS 16 to improve the information available to all investors when making investment decisions. This is because; when companies applied previous lease accounting requirements, some investors adjusted for off balance sheet leases (using varied techniques) whereas others did not.

Effect Analysis paper prepared by IASB provides a good summary of impact of IFRS 16 on key financial metrices of the company

Concluding remarks

IFRS 16 is a significant change from current IFRS, in particular for lessees. Entities should perform a preliminary assessment as soon as possible to determine how their lease accounting will be affected. Entities should not underestimate the effort involved in doing this assessment as it will entail reviewing all significant leasing arrangements. Entities will also need to ensure that they have the processes (including internal controls) and systems in place to collect the necessary information to implement the new standard. Indian companies should diagnose implications of new standard to enable them to make representations to ICAI and MCA on practical challenges they forsee to ensure that they are adequately addressed by ICAI and MCA.

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