A Significant Shift for Lessees – Ifrs 16

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

Internal Audit, Risk, Business & Technology Consulting 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:

IFRS 16 requires lessees in all cases (irrespective of the lease being classified as a finance of Lease operating lease) to record the asset on its balance sheet with a corresponding financial obligation. Definition 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 ‘Right-of identified asset and right to control the asset with the lessee. This is quite similar to the current -use’ asset requirement under IFRIC 4 except that the right to control is determined based on primarily two conditions instead of three under IFRIC 4.

Separation Taking the analogy of IFRS 15, the new standard requires both lessee and lessor to separate of lease and lease and non-lease components out of a contract and only account for the lease component non-lease under the new standard. This is subject to the practical expedient provided to a lessee, in case portion 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.

Whether supplier Whether has practical ability Whether supplier IDENTIFIED ASSET substantive right to to substitute would beneﬁt economically substitution present? alternative asset? from substitution? +

RIGHT TO CONTROL Right to obtain all Right to direct the THE USE OF ASSET the economic beneﬁts 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 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 eective 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

All Types IFRS 16 ‘Right of Use’ Asset Financial Liability of Leases

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

Unchanged Proﬁt Before Tax (Over period of lease)

3 Internal Audit, Risk, Business & Technology Consulting 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 eects 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 (non- lease 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 Sub Leasing arrangements

Under previous GAAP, sale and leaseback transactions were Sub lease is a transaction in which a accounted for in lessee books on the basis of whether the underlying lessee (or intermediate lessor) sells lease of asset is operating lease or financing lease, and does not its right of use to an underlying require seller (lessee) to determine whether the sale and leaseback asset to Sub lessee, while the lease transaction meets the condition for the sale of the asset. between the parent lessor and intermediate lessor remains intact. However, under the new standard, the seller (lessee) and the buyer (lessor) will use the definition of sale from IFRS 15 Intermediate lessor classifies sub to determine whether a sale transaction has occurred in a sale lease as operating lease or finance and leaseback transaction. If the transaction is to be a sale, seller lease, on the basis of ‘right-of-use’ (lessee) derecognizes the underlying asset and recognizes a ‘right- asset arising in his books. of-use’ asset at the retained portion of previous carrying amount. Intermediate lessor derecognizes If the transaction is not a sale, the seller (lessee) continues to ‘right-of-use’ asset from its books recognize the asset and recognizes a financial liability as per IFRS 9. and recognizes net investment in sub lease. Thus, it continues to Thus, IFRS 16 largely eliminates sale and lease back transaction recognize asset in its books with as a potential source of o-balance sheet financing as the seller regard to sub lease. (lessee) will always recognize the asset in its balance sheet.

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 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 dierence in timing of lease income/expense

Return On Capital Employed

EBITDA Current Ratio

Asset Turnover Ratio Debt/equity Ratio Interest Coverage Ratio Gearing Ratios Net Proﬁt (in initial years)

Net Debt 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 aected 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: arrangements. For example, lessee and lessor may agree to separately price lease and non- lease Adoption of new standard is likely to have tax components to minimize the financial impact of implications for lessee. These include the impact IFRS 16 on their financial position. on existing tax position/s and initial adjustments to Lessees may like to review the term of existing or deferred tax liability. new leases to leverage the exemption provided for short term leases. Contractual arrangements and business model: Cost of borrowings: One of the key business reason for a lessee to opt IFRS 16 might have an impact on cost of borrowing for an operating lease over financial lease is to because companies with material o balance sheet avoid recording an asset and liability for something leases are expected to report higher financial that is not owned by the company. Especially, in liabilities (and higher assets) applying IFRS 16. case of sectors and businesses with significant Eect on the cost of borrowing is most likely to operating lease exposure (airlines, retail, energy), result from the availability of more accurate the new requirement could challenge the information about lease liabilities applying IFRS 16. fundamental model of operating leases. Lenders are expected to be better informed about a In certain circumstances, a right of substitution by company’s credit risk and thus will be equipped to the lessor can be sucient for there to be no better understand and price that risk. “identified asset”. Hence, if there is no identified asset over which the customer has a right of Impact on business processes control, the contract must be a service agreement and IT systems: rather than a lease. Lessees may call upon changing of lease structures so that arrangements can be To satisfy the new financial statement presentation treated as service contracts rather than recognizing and disclosure requirements, Companies will need to right of use asset – for example through specifying evaluate whether to update their existing systems or the capacity of installed equipment alongside a to implement a new system. Entities need to think right of substitution. Lessors need to consider the about implementing sustainable technology based eect such a change would have on their own solutions that are capable of dealing with the new accounting. lease accounting requirements. Timely assessment of system gaps and business and IT requirements Companies would want to carefully examine the will support the software vendor selection process impact of the new standard on their existing for a lease software solution. contractual arrangements, including the split of lease and non-lease components within the

5 Internal Audit, Risk, Business & Technology Consulting 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 Under this approach, Lessee recognizes the cumulative eect of initially applying retrospectively applying IFRS 16 the standard as an adjustment to equity at the date of initial application. on all its leases and adjust the  For operating leases, Lease liability is measured at the present value of amounts relating to periods before remaining lease payments. ROU asset is measured either at an amount those presented in the financial equal to lease liability or as if IFRS 16 had always been applied. Certain statements to the opening balance practical expedients are also available for operating leases. of retained earnings of the earliest prior period presented  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 eects 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

Reconsider sale Renegotiate existing Adjust covenants Collect data for and leaseback cases lease contracts towards terms and conditions each leasing contract lower base leasing rates and higher services provided by lessor

Analyze leasing Analyze additional portfolio to assess Use short term Fine-tune information required the impact to leases as a measure Investor relations for disclosure different KPI’s to reduce lease liability communication requirements

6 Lease Arrangements - A Signiﬁcant Shift For Lessees 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 Determine available transition methods and evaluate various Policies and materiality Implement thresholds for lease accounting transition related choices available   Update ﬁnancial reporting Perform Gap analysis (both controls accounting and non-accounting

Our Solutions impact) and establish execution  Analyze Update ﬁnancial statements and framework disclosure requirements along for IFRS 16  with other reports Assess reporting system capabilities- to capture new data  Training and workshop for elements for recognition, employees measurement and disclosures Design  Prepare detailed roadmap along with timelines

 Prepare Performa ﬁnancial statements  Develop the new accounting policies  Discuss and determine eorts required for system changes (including the chart of accounts)

7 Internal Audit, Risk, Business & Technology Consulting About Protiviti

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