(Source: BusinessWorld Online | 10 October 2016)
(Second of two parts)
In last week’s article, we discussed how the International Accounting Standards (IAS) Board released the new accounting standard on leases, International Financial Reporting Standards (IFRS) 16, Leases, early this year. We also highlighted that the standard will have an impact on different industries, and perhaps even different companies in the same industry. We focused our discussion on lessees in the retail industry, and talked about the requirements for identifying a leased asset and the considerations for determining the commencement of the lease date. We will now look at the other lessee accounting implications of IFRS 16.
IAS 17 requires lessees that account for their lease contracts under the operating lease model to generally recognize lease expenses on a straight-line basis. On the other hand, IFRS 16 requires lessees to recognize a right-of-use (ROU) asset and a lease liability for its right to use the identified asset and its liability to make the lease payments, respectively. A discussion of these assets and liabilities, their subsequent accounting and the key impact of this change in lessee accounting, can be found in our January 2016 column titled “IFRS 16, Leases: Increasing Transparency on Lease Assets and Liabilities.”.
Among the requirements of IFRS 16, the requirement to measure and to recognize the ROU asset and the lease liability is perhaps the one that will demand the most time and effort from lessee retailers, particularly those that enter into a significant number of lease contracts with different lessors. For one, these lessee retailers will be required to determine the rate implicit in each lease contract, although there is a reprieve if this is not possible. Moreover, these entities will have to initially measure the ROU asset and lease liability for each and every lease contract using the guidance under IFRS 16. This means not only completely capturing all the needed information, but also applying certain assumptions to ensure that the amounts are properly and, to the extent possible, accurately calculated and reflected on their respective balance sheets.
Although IFRS 16 provides a practical expedient in that lessees may apply its requirements using the portfolio approach for leases with similar characteristics, the lessees still have to ensure that they meet the criteria stated in the standard before they can apply this approach.
LESSEE ACCOUNTING: APPLYING THE LEASE EXEMPTION
One thing that lessee retailers may consider when applying the lessee accounting requirements of IFRS 16 is whether they can avail of the exemptions provided for under IFRS 16. Availing of these exemptions will mean that the entities shall recognize their lease expenses on a straight-line basis (or another systematic method if such method better reflects the pattern of benefits derived from the leased asset) similar to the accounting for operating leases under IAS 17.
The first exemption is for short-term leases or lease contracts with a lease term of one year or less. To be able to avail of this exemption, the lessee will need to consider not only the actual term of the lease but also the certainty of exercising any option to extend the lease term or to terminate the lease term. This may mean that lease contracts that have lease terms of one year or less may not actually be short-term leases as defined by IFRS 16 if there are options to extend the lease terms and there is an economic incentive to avail of this renewal option (e.g., a significant amount of costs will be incurred by the lessee to dismantle, move or re-build its facilities or properties if the lessee does not extend or renew the contract).
The second exemption is for lease contracts where the underlying assets are of low values. The value pertains to the value of the asset when it is brand new, irrespective of the size of the entity. The standard does not provide a specific threshold for low values. However, its application guidance does provide certain directions to help entities determine what a “low value” asset is.
Lessee retailers will need to carefully assess whether they will qualify for the above exemptions as these will give them relief from applying the lessee accounting requirements of IFRS 16.
LESSEE ACCOUNTING FOR VARIABLE LEASE PAYMENTS
In addition, there is some difference in the lessee accounting for variable payments between IFRS 16 and IAS 17.
Under IAS 17, variable lease payments are recognized by the lessee as expense in the period the event that triggers these payments occurs. On the other hand, IFRS 16 distinguishes different types of (and correspondingly, different accounting methods for) variable lease payments. Variable lease payments that are linked to an index or a rate are included as part of the lease payments (i.e., included in the calculation of lease liability and ROU asset). However, other variable lease payments usually under the control of the lessee (e.g., based on percentages of sales) are not included as part of the minimum lease payments and therefore, do not have an impact on either the lease liability or ROU asset as they are expensed as incurred.
Lessee retailers will need to properly assess what type of variable lease payments they have as this assessment will have an impact on the amounts reflected on their balance sheets and income statements. In many cases, the lessee retailers would have lease arrangements where the lease payments are, in substance, partly fixed and partly variable.
In summary, IFRS 16 may have a significant impact on lessee retailers. This is not only confined to their financial statements but also to their businesses or operations. Certain key metrics will be affected due to the initial recognition of the ROU asset and lease liability (as well as their subsequent accounting), particularly for those lessee retailers that lease a large number of their stores and/or those that have stores located in high-rent areas. Some lessee retailers may also find themselves changing or even developing new processes and systems to ensure that they are properly tracking and accounting for these lease contracts. The significant impact on the financial statements and these key metrics will also mean that the lessee retailers need to communicate such changes to their key stakeholders at the soonest possible time.
Although the standard will be effective for annual periods beginning or on after Jan. 1, 2019, lessee retailers should start preparing for the implementation of the standard. At the very least, these entities should start performing a preliminary assessment to determine how IFRS 16 will affect them. Performing an inventory of all lease contracts, as well as gathering all required information needed for accounting purposes, are critical first steps toward facilitating and even easing the challenges of adopting IFRS 16.
– By Ma. Emilita L. Villanueva
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Ma. Emilita L. Villanueva is a Senior Director of SGV & Co.