New Accounting Requirements bring Leasing into the 21st century

IFRS 16 is an International Financial Report Standard (IFRS) promulgated by the International Accounting Standards Board (IASB) providing guidance on accounting for leases.

It is expected to give many enterprises a significant headache during its initial implementation phase – as teething problems are a common occurrence when it comes to new robust financial regulations.

However, on-hand to help businesses navigate their way around all these tricky implementation issues, is Nithin NK, Director, Audit at HLB HAMT.

NK explained: “IFRS 16 can initially cause trouble to the entities as there are huge changes in the lessee’s books of accounts. It was issued in January 2016 and will be applicable for financial periods starting January 1st, 2019 or later.”

IFRS 16 in a snapshot:

According to NK, these are the five implementation issues enterprises can face:

1.Identification of lease

Whether there is an identifiable asset – Supplier has no right to substitute the asset.

Whether there is a right to control the use of asset.

IFRS 16 contains a slightly revised definition of a lease but in practice this is likely to only cause differences at the margins. Where previously there were difficult judgments as to whether a contract contained a lease, those past conclusions may need to be revisited.

However, while the definition might lead to very similar conclusions, it could still cause problems in practice.

For example, whether a contract was an operating lease or a contract for services did not make a big difference under IAS 17; the expense was generally recognized straight line over the term of the contract.

Under IFRS 16 however, if it is a lease, it will affect the balance sheet. One area this could have a practical effect on would be some IT contracts.

For example, software service contracts might contain leases of equipment, such as a dedicated fiber optic connection. Finding and reviewing all these contracts and then applying the standard’s definition of a lease could be time-consuming.

2. Completeness of lease information

Many companies with several subsidiaries would find it difficult to identify the leases where regular payment happens. Data analytics are required to identify such leases.

3. Gathering all the documentation

Gathering contracts from several departments like property, IT, legal team etc. Some of these documents can be very long, and occasionally poorly drafted. This can add considerable time to the analysis process.

4. Determining estimates

The standard requires a very large number of estimates to be made, including the stand-alone selling prices of lease and non-lease components; the length of the lease term where the lessee has either an extension or termination option; the interest rate implicit in the lease; and amounts payable under residual value guarantees.

Stand-alone selling prices are to be used to allocate the payments under the contract to the lease and non-lease components pro-rats. For example, a lease contract might contain both the right to use a floor in a property, the lease component, and a payment for services such as cleaning and reception services, the non-lease component.

A practical expedient provides, by class of underlying asset, an election not to separate lease and non-lease components. Although if selected, this election requires all payments to be capitalized as though the entire contract was a lease.

Estimating the interest rate implicit in the lease could also be problematic. If the interest rate implicit in the lease cannot be determined readily, the standard does allow the incremental borrowing rate to be used but estimating this could also be challenging.

When the entity’s incremental borrowing rate is used, it is not simply the entity’s WACC or overall incremental borrowing rate. The incremental borrowing rate is supposed to be asset specific (i.e, what rate would be obtained to borrow the same amount as the right-of-use asset over a similar term and with the same security).

5. Modifications

Modification in lease are accounted either as new lease or adding to the existing lease. Determining this requires obtaining information about whether the modification increases the scope of the lease by adding the right to use one or more underlying assets and whether the consideration for the lease modification represents the stand-alone sales price for the modification.

Nithin.N. K
Director
nithin@hlbhamt.com