Change is coming . . . for leases

Majority of businesses are either renting or leasing property. Lease implies a contract to use the property belonging to another party over a period of time for a specified payment.
Leasing is mainly a financing medium used by a lessee to possess and use property and equipment as the cash outflow is made over the lease term. Leasing, in effect, allows companies to use their cash to finance their operations, instead of tying such funds up in the purchase of property and equipment. Moreover, leasing allows companies to avoid the issue of obsolescence and to some degree, its maintenance.

The current lease accounting standard differentiates between finance lease and operating lease based on lease provisions, such as the length of lease period or market value of asset vis-à-vis the total lease amount over the lease term. Finance lease accounting is used when the lease provisions clearly indicate that the asset is “owned” by the lessee. As the substance of the finance lease transaction is ownership of the leased assets, the lessee recognizes in its accounting records the subject’s assets and correspondingly, the liabilities. Accordingly, the lessee no longer records the rental expense but instead, the depreciation expense of the leased property. Otherwise, operating lease accounting is used. Currently, under operating lease accounting, leased assets are not reported on the lessee’s balance sheet; hence, the assets subject of the lease and the corresponding liabilities are not recognized and are considered “off-balance-sheet.” The lessee also recognizes the monthly rental payments as rental expenses.

All these differentiations between finance lease and operating lease, however, will change once the new lease accounting standard is adopted. International Financial Reporting Standard (IFRS) 16, the new leases standard, due to take effect in 2019, is said to be the first major overhaul of lease accounting standards in more than 30 years. This new standard provides, among other things, a single lessee accounting model, where all leases are to be treated in a similar way as finance leases. Accordingly, with the adoption of IFRS 16, all leases (other than short-term of one year or less and low value asset lease of assets like a photocopier) will be accounted for “on-balance-sheet.”

How is this change going to affect the businesses? If you are a lessee, how will this new standard affect you? How about its effect if you are a lessor? For both lessee and lessor, what will be the tax implication?

Since virtually all businesses are into leasing, these businesses, particularly the lessees, will be affected. Of course, some will be affected more heavily and others not so.
Companies in certain industries that currently use operating lease accounting or “off-balance-sheet” lease extensively, like banks, airlines, retailers, and travel and leisure, will dramatically show far different financial statements under this new standard as the leased assets and lease liabilities will be recognized. The issue goes beyond the mere recognition of assets and liabilities—the “new” financial statements will now have significant changes in financial metrics. And financial metrics are critical to companies that are subject to contractual (e.g. loan covenants), regulatory and/or industry specific requirements and regulations. For example, a company with an agreed gearing ratio (debt-to-equity ratio) with a creditor bank may find itself suddenly non-compliant with such loan provision, making the loan suddenly past due and demandable.

Of equal importance to the financial accounting and the impact on financial metrics is the readiness of the company or the establishment of its systems, processes and procedures. While the effectivity of the new standard is still over two years away, the company should already look at these systems and processes as these are critical to the identification, capture, summarization and reporting of each lease transaction for the accounting recognition and disclosure requirements. This is particularly important for lessee companies with large, several, and/or complex lease agreements as the implementation can be difficult and costly.

The company should also identify the manpower component of the change—the executive or officer driving the change and maybe the development of the systems and processes, and the staff responsible for ensuring that these are operating as designed.

The new standard has significant impact on the side of the lessee from the accounting point of view, but has minimal impact on the lessor. The standard will not have an impact on the flow of cash between the lessee and the lessor. However, even if the lessors are not significantly affected, they have to prepare for a possible change in behavior and mindset of the lessees. With the requirement of the new standard, lessee companies might have to think hard and reconsider whether outright acquisition makes more sense than leasing.

As the requirements of the new standard differ from the current tax provisions on leases, this may have significant effects on the recorded deferred income tax, but has no impact on the company’s tax dues.

Sheng Llovido is a Partner, Audit & Assurance of P&A Grant Thornton. P&A Grant Thornton is one of the leading Audit, Tax, Advisory, and Outsourcing firms in the Philippines, with 20 Partners and over 700 staff members.

As published in The Manila Times, dated 01 June 2016