To lease or not to lease? A quantitative analysis of the new lease standard

It is quite a famous line in the accounting industry that the then chairman of the International Accounting Standards Board (IASB), Sir David Tweedie, usually joked about wanting to see the aircraft he’s riding on the balance sheet, and now, here it is. The new lease standard issued in January 2016 provides a new wave of interest for accounting professionals not certain of the impact of the new accounting standard.

International Financial Reporting Standards (IFRS) 16 ‘Leases’ is the new lease standard replacing International Accounting Standards (IAS) 17 ‘Leases’ among others. The new lease standard is not getting the spotlight needed since most of the companies are still focussed on understanding the implications of IFRS 15 ‘Revenue from contracts with customers’ and probably IFRS 9 ‘Financial instruments’. Although news articles accompanying the release of IFRS 16 is often marred by the huge amount expected to be put on balance sheet when the new lease standard kicks in on 1 January 2019, probably, it is more of a matter of understanding what the financial effects will be than being shocked with big numbers reported.

This article will not focus on the technical requirements of the new lease standard, rather, this article will be focussed on the financial implication of the new lease standard. Also, just to highlight, the focus of this article will just be on the impact on lessee accounting for operating leases since accounting for finance leases (or capital leases) and lessor accounting remains similar, albeit with some clarifications but are mostly nitty-gritty.

The new lease standard requires operating leases to be reflected in the balance sheet as both an asset and a liability. Under IAS 17, operating leases are recognised using the straight-line lease recognition principle in which lease expenses other than contingent rent are recognised evenly throughout the lease-term (in contrast to the requirement under UK GAAP to consider the first break-clause) with the difference between actual lease payment and straight-line lease expense taken to balance sheet.

On initial recognition the asset (i.e., right of use asset) and the lease obligation will be recognised at present value using the incremental borrowing rate if the rate implicit in the lease is not readily determinable (in practice, the rate implicit in the lease in an operating lease is usually not readily determinable in contrast to a finance lease). For business readers, the rate implicit in the lease is basically the effective discount rate (or internal rate of return for simplicity) if cash payment will be made for the leased asset (which is usually indicated as the cash purchase value in a finance lease), while the incremental borrowing rate is the market interest rate if the company is to obtain financing to acquire the leased asset.

To put it into perspective, assume that Company A obtains a 5-year lease for Php10,000 per year with annual increment on Php1,000. The incremental borrowing rate for the lease is 6.04% which gives a present value of Php50,000 for the leased asset. Under IFRS 16, Php50,000 will be recognised as a right of use asset and a lease obligation on the first day of the lease (or zero impact on balance sheet) in which under IAS 17, nothing will be recognised on the first day.

Under IAS 17, the lease would then be recognised using the straight-line method over 5 years (assuming that years is the rational basis for straight-line allocation) amounting to Php12,000 each year. The following table summarises the accounting impact of this approach:

In contrast, adopting the new lease standard will require the recognition of the right of use asset and the lease obligation on day-1 with the right of use asset amortised over the term of the lease (or asset life if shorter) using straight-line method and the lease obligation amortised using the effective interest rate over the settlement period. Continuing on the above example, the table below summarises the accounting implication of this requirement:

As can be seen in the table above, total expense recognised over the lease term will be the same (i.e., Php60,000) but the expense recognition profile is radically changed. Under the new lease standard, the straight-line lease expense is now split between the asset amortisation expense and financing expense which results to different amount of lease expense being recognised.
 
The chart below is helpful in understanding the impact of the new lease standard on a company’s profit or loss statement:

As seen in the lease expense profile graph above, the lease expense is under IAS 17 represents a straight-line lease expense which remains equal throughout the lease term while adopting the requirement of IFRS 16 will result to a declining amount of lease expense due mainly to the impact of the lease obligation amortisation using the effective interest rate method.

Effectively, the straight-line lease expense is still recognised under IFRS 16 through the asset amortisation model as can be seen in the graph above. This approach is consistent with the current accounting treatment of finance leases (or capital leases) in which expense is recognised through depreciation and interest.

As these are new financial statement captions, it is good to know that the right of use asset is considered non-monetary asset while the lease obligation is considered a monetary liability for foreign-exchange denominated transaction purposes. So if there are leases denominated in foreign-currency, additional complexity should be considered since the expense profile could materially swing due to the revaluation of the lease obligation at period-end.

The new lease standard can be a game changer for some industries and could have potential significant impact on balance sheet and income statement, but for most of the companies, this new requirement will not be really relevant due to the low-value nature of the leased assets.