KPMG's Niall Naughton explores the impact of new lease standards IFRS 16 and US GAAP and their relevance to Irish lessors and airlines.
After nearly 10 years of discussions, the international accounting standard setters (IASB) published IFRS 16 Leases in January 2016 with the new standard requiring companies to bring all significant leases on-balance sheet from 2019. The US standard setters (FASB) issued the new US GAAP standard on leases shortly afterwards in February 2016. Key aspects of the new standards are converged, but there are some important differences which will result in different practice under the two frameworks, although it is predominantly the IASB standard that is relevant to Irish lessors and airlines.
A key long standing objective of the IASB has been to bring leases on-balance sheet forlessees. All companies that lease major assets for use in their business will see an increase in reported assets and liabilities. This will affect a wide variety of sectors, from airlines that lease aircraft to retailers that lease stores and the larger the lease portfolio, the greater the input.
Currently operating leases are off-balance sheet for lessees. Companies are currentlyrequired to disclose details of their off-balance sheet leases and many analysts already use this information to adjust published financial statements. The key change will be the increase in transparency and comparability. For the first time, analysts will be able to see a company’s own assessment of its lease liabilities, calculated using a prescribed methodology that all companies reporting under IFRS will be required to follow.
The impact of the new standard is not contained to the balance sheet. There are also changes in accounting over the life of the lease. In particular, companies will now recognise a front-loaded pattern of expense for most leases, even when they pay constant annual rentals.
The new standard takes effect in January 2019. Before that, companies will need to gather significant additional data about their leases, and make new estimates and calculations. The new requirements are less complex and less costly to apply than the IASB’s initial proposals.
However, there will still be a compliance cost. For some companies, a key challenge will be gathering the required data. For certain sectors, more judgemental issues will dominate, e.g. identifying which transactions contain leases in the first instance or assessing whether a contract falls into the category of a lease contract or a service contract.
Helpfully the IASB have permitted some exemptions to make the standard easier to apply. The objective of this is to ease the pressure on application of the lease definition and reduce the compliance costs for IFRS preparers – notably in relation to leases of low value items and short-term leases.
The low-value item exemption is intended to capture leases that are high in volume but low in value, e.g. leases of small IT equipment (laptops, mobile phones, basic printers) or office furniture. The exemption can be applied even if the effect is material in aggregate. IFRS 16 does not define ‘low-value’ though the IASB has indicated that it had in mind assets with a value of US$5,000 or less when new. This election can be made on a lease-by lease basis.
The short-term lease exemption applies to leases with a term of 12 months or less. If elected, the exemption is applied to all leases within that class of underlying asset.
The exemptions permit a lessee to account for qualifying leases in the same manner as existing operating leases and to disclose only the income statement expense relating to these leases, rather than provide detailed disclosures under IAS 17.
The lobby for the lessor community was successful in achieving a result of very limited change in lessor accounting. The lobbying approach was very much one of “why try and fix something that’s not broken”, which the IASB ultimately listened to.
Lessor accounting remains similar to current practice, i.e. lessors continue to classify leases as finance and operating leases. Leases that transfer substantially all the risks and rewards incidental to ownership of the underlying asset are finance leases; all other leases are operating leases. The lease classification test is based on the criteria in the current lease accounting standard, IAS 17 Leases.
This accounting model is inconsistent with the accounting model to be applied by lessees – lessees follow a new single accounting model, whereas lessors retain a dual model. For example, in the case of an operating lease, the lessee will recognise a financial liability for its obligation to make fixed lease payments, but the lessor will not recognise a financial asset for its right to receive those lease payments.
At the simplest level, the accounting treatment of leases by lessees will change fundamentally. IFRS 16 eliminates the current dual accounting model for lessees, which distinguishes between on-balance-sheet finance leases and off-balance-sheet operating leases. Instead, there is a single, on-balance-sheet accounting model that is similar to current finance lease accounting.
Bringing operating leases on-balance sheet also changes the profit-and-loss account of lessees. Currently, operating lease expenses are charged to the P&L on a straight-line basis over the life of a lease.
From 2019, leases will be accounted for as if a company had borrowed funds to purchase an interest in the leased asset. This typically results in higher interest expense in the early years than in the later years, similar to any amortising debt. In turn, this means that total lease expense in the profit and loss account will be higher in the early years of a lease – even if a lease has fixed regular cash rental payments.
For airlines that lease aircraft this will have a significant impact on their balance sheets with the limited recognition exemptions likely to be of limited benefit given the value and duration of typical aircraft leases. An additional consideration will be the foreign exchange aspect which may introduce increased profit and loss volatility where the lease liability is in a currency (normally US dollars) other than the functional currency of the airline.
Key financial metrics will be affected by the recognition of new assets and liabilities, and differences in the timing and classification of lease income/expense. This could impact debt covenants, tax balances and a company’s ability to pay dividends. The additional assets and liabilities recognised and the change in presentation will affect key performance ratios, e.g. asset ratios and debt/equity ratios, and consequently could impair the ability to satisfy any debt covenants that are not applied on a ‘frozen GAAP’ basis.
The IFRS and FASB progressed a joint project in this area for a number of years before ultimately deciding to issue two separate standards. There were a number of areas where agreement could not be reached with the most important relating to:
The biggest difference relates to the lessee dual accounting model. While IFRS 16 contains a single lessee accounting model, US GAAP will feature a dual model for lessee accounting, i.e. finance vs. operating leases. Under US GAAP, finance leases will be accounted for in the same way as under the IASB’s model. Operating leases will also be presented on the balance sheet with a right-of-use asset and a lease liability.
However, for operating leases, lease expense will typically be recognised on a straight-line basis, i.e. not front-loaded, and presented as a single amount within operating expenses. In order to achieve this profile of lease expense, the lessee will measure the right-of-use asset as a balancing figure, i.e. a plug. In addition, lease payments for operating leases will be presented within operating activities in the statement of cash flows.
First time application of the new standard is likely to be challenging for many reporting entities and hence a lead in time of almost three years. Now that the debate of almost 10 years is over and the new rules finalised, companies will need to move quickly to commence implementation which in many cases will need to be executed in parallel with other significant financial reporting change projects related to IFRS 9 on financial instruments and IFRS 15 revenue recognition. The transition options within the standard are complex and early engagement to determine the most appropriate option for an entity’s circumstances is critical.
For the aviation industry, it is likely to be broadly business as usual for lessors with some considerations around sale-and-leaseback transactions and intermediate leases to be factored into transition plans. For airlines with large lease portfolios, the transition will be significant with the balance sheet changing fundamentally, a different profile of lease expense in the profit-and-loss account as well as potential foreign exchange volatility from dollar-denominated leases.