LKAS 17 - Leases

Accounting standard study group CIMA Sri Lanka Division Study of LKAS 17 – Leases New lease accounting standard: Is your organisation prepared to cope with the new standard?

1. Introduction A New Sri Lankan lease accounting standard has been developed in a joint project between the International Accounting Standards Board (IASB) and the Institute of Chartered Accountants of Sri Lanka (ICASL) that could result in a complete overhaul of the way in which leases are reported in financial statements, commencing 1 January 2012.

Industry projections estimate over $1.3 trillion would be transferred to U.S. corporate balance sheets, with roughly 70% being real estate leases. The impact on the Sri Lankan leasing industry had not been quantified yet and the objective of this paper is to enlighten the reader of the consequences arising from the new standard to corporate financial statements.

Presented below are the significant changes that are anticipated in the new standard, some issues and impact they create, and some of the ways the management accountant can add value to the organisation in coping with these changes.

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2. Synopsis of the standard reviewed A. What is the area of application of this standard?

This accounting standard would deal with the accounting treatment that would be necessary for a leasing company (i.e. the lessor) and the entity that had obtained the lease, (i.e. the lessee). As it is common for any accounting standard, LKAS 17 also would contribute to fulfil the accounting concept of consistency in financial statements, with regard to accounting treatment of a lease.

B. What is the scope of the standard?

The standard excludes application to non-regenerative resources and certain licensing agreements such as films, manuscripts, patents etc. Also the standard cannot be applied as a basis of measurement for property held by lessees that is accounted for as investment property or for investment property provided by lessors under operating leases or for biological assets held by lessees under finance leases. Such exclusions would be dealt under separate accounting standards.

Scope covers the following standards: Leases – LKAS 17 Determining whether an arrangement contains a lease – IFRIC 4 De-recognition of finance lease receivables – LKAS 39 Embedded derivatives in lease contracts – LKAS 39 Impairment o LKAS 36 (for leased assets) o LKAS 39 (for recognised lease receivables) Disclosures – SLFRS 7 Investment property – LKAS 40 C. Definition of terms The standard would define the following key terms inherent to leases: Lease; finance lease; operating lease; non-cancellable lease; inception of a lease; commencement of the lease term; lease term; minimum lease payments; fair value; economic life; useful life; guaranteed residual value; unguaranteed residual life; initial direct costs; gross investment in the lease; net investment in the lease; unearned finance income; interest rate implicit in the lease; lessee’s incremental borrowing rate of interest; contingent rent.

D. Regulatory framework for lease The leasing industry in Sri Lanka is regulated via the Finance Leasing Act (FLA), No 56 of 2000, with the Central Bank of Sri Lanka acting as its regulator. It is interesting to note that only the finance leases that gets regulated under this statute (and not the operating leases). However the hire purchase transactions are regulated via the Consumer Credit (Amended) Act No 7 of 1990.

3. Impact on Management Accounting Key issues arising from the standard which are relevant to management accountants 1) Transfer of the right to use the assets.

This is a common area where the management accountant would be confused as to the extent to which the right to use the asset had got transferred. On the other end of the spectrum would be contracts for services that provide the services provided by assets, but does not substantially transfer the right to use the asset.

This area of confusion usually drives the management accountant to consider a contractual service for example a vehicle hiring company that provides transportation services, to be a lease. This mere arrangement to hire, could be distinguished easily when one examines the arrangement in the light of the following section, i.e. transfer of risks and rewards.

2) The locus of risks and rewards incidental to the right to use Together with the right to use the asset, what gets transferred (or not transferred) would be the risks and rewards arising from the leased asset. The difficulty of identifying the locus would also be an issue for the management accountant in the quest for disseminating the appropriate management information to the management.

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3) Income and cost recognition The most burgeoning issue that stems up from the leases accounting standard is the income and cost recognition pertaining to leases, in the books of the lessor and lessee, respectively.

4) Asset and liability recognition Similar to the above, the distinguishing of leased items between assets and liabilities is a point where the management accountants would ponder.

5) Provision of collateral for loans This would be an issue mostly for the management accountants employed in leasing companies (i.e.lessor), as the ability to borrow after providing the lease receivables, would depend on the extent of classification of the lease as per the standard.

6) Sale and lease back The scenario of a sale and lease back of an asset as well as arrangements which contain leases should be looked in the following ways: when assets sold are leased back under operating leases, the gain on sale should reflect any off-market interest rates.

Outsourcing arrangement that is a lease or contains a lease in substance should be identified and recorded either as an operating lease or a finance lease.

7) Determining whether an arrangement contains a lease (IFRIC 4) Fulfilment of the arrangement depends upon a specific asset. The asset need not be explicitly identified by the contractual provisions of the arrangement. Rather it may be implicitly specified because it is not economically feasible or practical for the supplier to fulfil the arrangement by providing use of alternative assets. The arrangement conveys a right to control the use of the underlying asset. This is the case if any of the following conditions is met: (i) The purchaser in the arrangement has the ability or right to operate the asset or direct others to operate the asset (while obtaining more than an insignificant amount of the output of the asset). (ii) The purchaser has the ability or right to control physical access to the asset (while obtaining more than an insignificant amount of the output of the asset). (iii) There is only a remote possibility that parties other than the purchaser will take more than an insignificant amount of the output of the asset and the price that the purchaser will pay is neither fixed per unit of output nor equal to the current market price at the time of delivery.

8) Elimination of operating leases The new standard would effectively eliminate all ‘operating leases’ and require them to be capitalised on the company’s balance sheet. It would also replace rent payment expense reporting with interest and depreciation expense reporting.

9) ‘Recognition of assets and liabilities relevant to a lease agreement’ Lessee recognises ‘right-of-use’ as an asset and the ‘obligation to pay rentals’ as a liability. Right-of-use asset is initially recorded based on the present value of lease payments plus initial direct transaction costs, but less distinct operating expenses and property taxes.

10) The lease term to be considered for accounting treatment The accounting lease term will be the longest possible lease term that is more likely than not to occur.

11) Contingent rents Contingent rentals (e.g.retail percentage rents) are required to be estimated and included in the initial measurement of the ‘right-of-use’ asset and the ‘obligation to pay rentals’.

Lease term and payments are reassessed each reporting period to include changes in projected renewals and contingency rents. Present value interest rate generally utilises the lessee’s ‘incremental borrowing rate’.

Contingent rents that are based on an index (e.g., CPI) or rate would be determined using readily available forward rates. If forward rates are not readily available, the contingent rents would be estimated based on the current rate.

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Right-to-use asset is amortised straight-line over the lease term along with declining interest expense based on the obligation to pay rentals liability. Right-of-use asset is evaluated for impairment under existing standards for intangible assets. No grandfathering of existing leases i.e., all leases would need to be reflected on the balance sheet upon adoption.

4. Application of the accounting standard (in a management accounting context) using practical examples ‘Rent’ would disappear from the income statement.

Net Operating Income (NOI) would decrease in early years after effective lease date Earnings before interest, taxes, depreciation and amortisation (EBITDA) would increase as rent is replaced by interest and amortisation.

Financial ratios are affected due to newly inflated balance sheets with potential changes to debt/equity ratios, interest coverage ratios and loan covenants may lead to potential renegotiation of existing loan agreements especially for firms with capital adequacy concerns.

Business unit charge backs for departmental space :usage expense would be greater in the early part of the lease potentially impacting HR issues surrounding executive performance metrics Although lessees may consider shorter term leases in order to reduce the balance sheet effects, this consideration would need to be balanced against the following effects of a shorter lease term: -Increased rent due to market uncertainty and reduced landlord concessions for tenant improvements due to shorter recovery periods -Potential increased reconsideration of ‘buy’ versus ––‘lease’ decisions for real estate, driven by desire for more tenant control of space when balance sheet impact is no longer a distinguishing factor.

5. Major impact on corporate business units The following business / service units would have a greater impact from the standard.

Corporate Real Estate Lease Administration Finance/Accounting Tax Information/Technology Human Resources

6. Industry case studies Classification issues Industry case example one Company A (Lessee) entered into a four year lease contract with company B (Lessor). Monthly payments are Rs. 40,000. At the end of four years, the machine will be returned to company B unless company A pays Rs. 30,000, in which case ownership will transfer to company A. At the beginning of the contract it is estimated that the useful life of the machinery is eight years.

The existence of a purchase option that is expected, based on facts and circumstances at inception of the lease, to be exercised means that title to the asset is expected to transfer. Since the purchase option is substantially lower compared to the monthly payment (Rs.40,000> Rs.30,000) it can be assumed that company A will obtain the ownership of the asset.

Therefore lease will be classified as Finance lease.

Industry case example two Company A rents a vehicle from company B for seven years. At the end of the lease period, the vehicle will be returned to company B. The expected useful life of the photocopier is eight years.

The lease term is for the major part of the economic life of the leased asset (7/8=87.5% of the economic life), hence the agreement will be classified as a finance lease.

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Industry case example three Company A rents two new cars from company B for four years (economic life of the cars will be eight years), after which time the cars will be returned to company B. Present value of the total rental payments amount to about 55% of the new price of the cars.

The lease is an operating lease. i. The arrangement is not for major part of the economic life (4/8=50%) ii. The present value of the minimum lease is 55% (55% is not equals substantially all of the fair value.)

Industry case example four Leases of land The classification of a lease of land is assessed based on the general classification guidance. In determining the lease classification an important consideration is that land normally has an indefinite economic life. However, the fact that the lease term normally is shorter than the economic life of the land does not necessarily mean that a lease of land always is an operating lease: For instance: - If the selling price and the present value of the lease is economically the same and lessee has the option of extend the lease agreement at the end of the lease period then the lease will be classified as finance lease.

Industry case example five Company A enters into an agreement with supplier B relating to processing of a specific type of material for a five year period. The contract specifies the following: the manufacturing plant is explicitly identified in the arrangement

• • • •

the plant is only used to processing of raw materials for company A and it would neither be economically feasible or practicable for supplier B to use other assets each month company A pays a fixed processing price amounting to Rs.1000000 (payment is not made for the units produced) company A has the option to change the supplier without losing the control over the processing plant and hence, it is also able to prevent others from getting physical access to plant.

The following points are noted: processing plant is identified as a specific asset in processing raw materials. other conditions are: - the plant is only used for processing RM of company A and shall not be used for other activities by company B since it is not practicable -the payment is fixed. Rs.1000000 for a month regardless of the units processed.

Company A controls the physical access to the plant. the arrangement conveys right to use the asset to Company, therefore accounted under LKAS 17

Disclaimer This document is compiled with the objective of presenting a basic overview of the respective Sri Lanka accounting standard, and does not construe professional advice in the application of the standard. For specific application and understanding of all facets of the standard, the relevant Sri Lanka Accounting Standard issued by The Institute of Chartered Accountants of Sri Lanka should be referred.

References and useful web-links pertaining to accounting standards http://www.cimaglobal.com/Thought-leadership/Research-topics/Financial-reporting/CIMA-Sri-Lanka-accounting- standardstudy-group/ http://www.iasplus.com/standard/ias17.htm http://www.icasrilanka.com/Technical/Accounting%20Standards.html?bcsi_scan_ECD903E68216D30C=0&bcsi_scan_filena me=Accounting%20Standards.html http://www.pwc.co.uk/eng/publications/practical_guide_to_ifrs.html 5 | Accounting standard study group, CIMA Sri Lanka Division: Study of LKAS 18

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Compiled by the ‘team one’ members of the accounting standard study group Manil Jayesinghe, Partner, Ernst and Young (Chairman of the accounting standard study group) Jithendra Gunatilleke, Deputy General Manager, Financial Operations, Lanka Orix Leasing Company PLC M. Imraz Iqbal, Finance Manager – Lanka Orix Leasing Company PLC Danushka Mallawarachchi, Assistant Manager – Finance corporate, Lanka Orix Leasing company PLC Dileepa Prasad Assarapperuma, Assistant Accountant -People's Merchant Bank PLC Shabeeb Nauman, Accounts Assistant, CIMA Sri Lanka Division.

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