Elections are over, finally! This year’s elections have brought the nation to a different level of political and social consciousness, with every concerned voter and non-voter alike engaging willingly and passionately in debates and discussions, especially on social media. In fact, since the start of the election season, my daily newsfeed has turned into a litany of political, social and economic issues, which unsurprisingly, are the same old issues that have beset the country for ages. And so Filipinos placed their bets on candidates whom they saw as true agents of change.
In the financial reporting world, a wave of change is coming, too, with the implementation of new accounting rules in the Philippines. One of the major rule changes will be on accounting for leases.
Leasing is a widely used financing solution that allows a company to gain use and access to a property or asset without shelling out large cash at the onset. For some entities, leasing could be a major activity for the business, as it can involve big-ticket assets such as real estate, manufacturing equipment, aircraft, ship or even technology.
Current accounting by lessee
Under the existing accounting rules, the lessee classifies the lease arrangement either as operating or as finance lease based on rather complex criteria. The lease classification can be a tricky process, which entails judgment on the part of the management of the entity.
In an operating lease arrangement, the leased asset is not recognized in the books of the lessee. Rental expense is charged to operations evenly over the period of the lease, which may not necessarily be equal to the actual periodic cash rental payment as stipulated in the lease contract. Future rentals are likewise not recorded as a liability but are disclosed instead in the notes to the financial statements for non-cancelable leases.
On the other hand, in a finance lease, the lessee presents both the leased asset and the related finance lease liability in its balance sheet as if it has purchased the asset via a loan. The finance lease liability is the discounted amount of all future rental payments. After initial recording, the lessee recognizes depreciation expense on the leased asset and at the same time records interest expense on the finance liability for the time value of money.
What will change?
The current accounting model for operating leases is criticized for failing to meet the needs of users of financial statements because it does not always provide a faithful representation of leasing transactions due to the so-called “off-book” treatment of the lease.
With the upcoming Philippine Financial Reporting Standards (PFRS) 16, Leases—operating and finance leases will be a thing of the past for a lessee. This is because for all types of leases, the new rules will require the lessee to set up a “right-of-use” asset and a liability equal to the discounted payments required over the term of the lease (similar to a finance lease today as explained earlier).
The new standard, which will take effect from Jan. 1, 2019, however, exempts short-term leases (those with lease term of 12 months or less) from the asset and liability recognition requirements. In such cases, the lessee recognizes the lease payments as expense on a straight-line basis over the lease term. Likewise, lessees are not required to recognize assets and liabilities for leases of low value assets such as tablets, personal computers, small items of office furniture and telephones.
What about accounting by lessors? Current lessor accounting will remain largely unchanged. Lessors will continue to reflect the underlying asset subject to the lease arrangement on the balance sheet for leases classified as operating. For financing arrangements, the balance sheet reflects a receivable and the lessor’s residual interest, if any.
Impact on industries
The effects of the new standard will be felt across all industries, although the impact may differ depending on the type and volume of assets they lease, and the terms and structures of the lease agreements. Retailers who are heavy users of real estate leases for their stores are likely to experience significant impact when implementing the new standard. Also, business process outsourcing (BPO) companies that currently hold a number of leased assets would be significantly affected.
Certainly, the new standard will gross up balance sheets and change income statement and cash flow presentations. Rent expense will be replaced by depreciation and interest expense in the income statement (similar to finance leases today). This can also result in a front-loaded lease expense, which for some might reduce earnings and equity immediately after entering into a lease compared to an operating lease today. These changes in presentation will impact key financial ratios such as gearing, current ratio, asset turnover, interest cover, etc. The effect on financial ratios (such as gearing or leverage) may trigger breaches of loan covenants. Financial institutions, therefore, should consider any impact on regulatory capital needs, as the new lease standard might lead to an increase in risk-weighted assets.
The accounting changes could likewise potentially trigger changes in the lessee’s behavior, which may require a shift in the business model of real estate lessors. Real estate lessors should be ready for requests for shorter lease terms that would bring about changes in the economics of leases and put pressure on pricing.
Yes, change is coming. Are you ready?
The accounting change for leases is just the tip of the iceberg. Companies will need to undertake an in-depth review of the proposed changes and assess the impact on financial ratios and performance metrics (including debt covenants), business operations, systems and data, business processes and controls to understand the implementation issues and costs of complying with the new lease standard.
The new lease accounting is developed as response to the call for transparent reporting, one that reflects a faithful representation of leasing transactions. This brings me back to the clamor for transparent and responsive government that every Filipino hopes to experience from the newly elected national and local leaders.
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Zaldy D. Aguirre is a Partner from Assurance and Cebu Office Lead of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.