In May 2016 (nearly a year ago), we introduced the new lease accounting standard, Philippine Financial Reporting Standard (PFRS) 16 Leases, which will take effect on January 1, 2019. We discussed how this would change companies’ balance sheets and income statements, particularly for lessees.
We want to take that discussion further as we emphasize the need to prepare for PFRS 16 implementation.
If you are a business owner, an executive, an accountant, or a shareholder/investor and leasing is an important part of your business, this article will be relevant to you. This will also be a good and interesting discussion point in your next management, finance, compensation or board meeting.
Let’s review: The new standard will require (1) recognizing right-of-use asset and lease liability in the balance sheet for almost all leases (including those currently being accounted for as operating leases) and (2) accounting for these leases in the income statement, similar to current accounting for capital leases. Exemptions are allowed for low-value leases (using a US$5,000 threshold, or about P250,000) and short-term leases (lease term period of 12 months or less).
How do we then start preparing for it?
Management starts with an assessment on how significant lease arrangements are to the company’s operations. We said that the retail industry would be one of the significantly affected industries, considering the number of retail stores and warehouses leased by a retail company for its operations. Real estate, airline, transportation, services companies would also be affected.
Let us take, for example, a lease arrangement for a manufacturing company for the land where its manufacturing plant is located. Is the present value of the total lease payments for the entire lease term significant to total assets and liabilities? How will the new lease accounting affect the Key Performance Indicators (particularly financial KPIs) that are relevant to management’s compensation/bonuses, important debt covenants (financial ratios) and the expected/committed dividends?
If your answers to these questions require you to sit down with your finance team to discuss and make conclusions on the impact of the new standard, then perhaps you should give top priority this year to the preparations needed to implement PFRS 16.
P&L impact of the new lease standard
Let us discuss further the profit and loss (P&L) impact of PFRS 16 – Lessees on present interest expense related to lease liability, and on depreciation of the right-of-use asset in the income statement.
Comparing that with the current accounting for operating leases, the new standard will not only affect the classification of expenses (rent to depreciation and interest expense) but also the total expenses recognized for each period of the lease term.
The straight-line depreciation of the right-of-use asset and the effective interest rate method applied to the lease liability will result in a higher total charge to P&L in the earlier years of the lease, then will decrease in the latter part as the lease liability is effectively settled. This pattern affects your P&L in many forms – your gross profit, your earnings before interest and taxes (EBIT) and earnings before interest, taxes and depreciation and amortization, and your net income.
In the above discussion, one important challenge of the new standard is identifying the appropriate discount rate to determine the present value of the lease liability. The lessee discounts the total lease payments using the interest rate implicit in the lease, if that rate can be readily determined. I’m sure everyone will agree that it is seldom that a rate is implicit in a lease contract, or unlikely to be stipulated in the agreement. In the absence of such implicit rate, the lessee will instead use available information – but does the lessee have access to such information?
PFRS 16 gives an alternative for the discount rate to use: the lessee will be allowed to use its incremental borrowing rate when the implicit rate cannot be readily determined. No way that this is an easier task – maybe doable, but not at all easy. The incremental borrowing rate (1) is the rate at which the lessee would borrow to acquire the right-of-use asset, and (2) should reflect the rate of a secured borrowing for a similar term and for an asset with a similar security and arrangement, indicating the lessee’s credit rating (it is, therefore, entity-specific!).
Imagine the discussions that should happen between management and finance, treasury and also us, auditors, to agree on the appropriate discount rate for the company’s lease contracts. We should be able to conclude on the fairness of the accounting for leases under PFRS 16 and the discount rate will definitely be an important assumption in accounting for leases.
Make your move now
Also, more than the financial impact, companies need to assess if the change will require implementing a new lease system and related processes and controls. The company’s ability to get this right will depend on its ability to gather the required information on existing leases and to capture the data as it enters into new lease arrangements.
In our PFRS 16 training sessions, there is a consistent realization of the challenges that it may bring as companies prepare for its implementation. A recent PwC survey notes that while most companies are already aware of the forthcoming changes, only a small percentage of them have started to prepare for PFRS 16 implementation.
We hope that your company is among those that have started to plan on how to go about the implementation, which should have already been agreed with relevant persons within your organization. The impact could be significant and you should start working on it now to ensure a smooth transition – it’s definitely one good move for you.
Gina S. Detera is an assurance partner, corporate responsibility leader and accounting consulting services co-leader 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 substitute for consultation with professional advisors.
GINA S. DETERA