The consequence of leasing

With the application of PFRS 16 beginning 1 January 2019, companies would have culminated the accounting transition to recognize a right-to-use asset and a lease liability in their financial statements.

By now, those charged with governance are well aware of the sweeping changes brought by the new lease standard. Adjustments made beyond accounting include lease management process, lease-vs.-buy decisions, systems and processes to manage data, and investor communications. In PwC’s 2018 Q4 accounting change survey, an overwhelming majority (87 percent) of respondents said the combined difficulty of adopting recent accounting changes was somewhat or very difficult.

As the immediate impact of this new lease model has taken on a familiar financial reporting to management, another consequential impact of PFRS 16 will shift towards other financial reporting matters, including deferred income tax, consolidation, business combination, and impairment.

Accounting changes will not necessarily align with tax rules. In the previous lease standard, leases accounted for as operating leases resulted in a temporary difference due to straight-lining of leases since the amount of lease claimed as expenses was different from accounting lease expense recognized in the financial statements. With the elimination of the operating lease model, deferred income taxes arising from operating lease model is derecognized and new deferred income taxes is recognized arising from new accounting bases in the financial statements in the form of right-to-use asset and lease liability. The tax base for leases will not change.

Usually, in a conglomerate scenario, a property company (propco) leases out its properties to operating companies (opcos). In the past, consolidation would simply be eliminating the lease income at the propco’s financial statements and the lease expense in the opco’s financial statements, and the related intercompany receivable and payable.

Beginning 1 January 2019, the elimination is not as straightforward since the lease expense at the opco level has morphed into an amortization expense and a finance charge, including the elimination of the right-to-use asset and accumulated amortization, and lease liability, in the opco’s balance sheet. This adds a few more entries to be considered in preparing the consolidation worksheet for companies. For companies with sophisticated consolidation systems, automated entries must be configured appropriately.

In implementing PFRS 16, a consequential amendment was made to PFRS 3, Business combinations. Initial measurement of the right-to-use asset and lease liability is required from the date of acquisition, and not from the start date of the lease. As the new lease standard allows companies to adopt the new rules either fully and retrospectively, or modified retrospectively – complication will arise when the subsidiary adopts a full retrospective approach to PFRS 16. The parent company at consolidation level should make adjustments to consider the reckoning point of recognizing the right-of-use asset and lease liability. While it may be less likely for companies to take a full retrospective approach to implement the new lease standard, companies with investments in controlled entities or subsidiaries should confirm the transition method adopted by each subsidiary for proper accounting.

The impact of PFRS 16 on impairments touches on different elements where the value-in-use model is utilized. First, the carrying amount of the cash-generating unit will increase due to the recognition of an asset and liability – this is because the subsequent measurement of the asset and liability is different. Next, the discounted cash flow model will need to be updated due to the expenses arising from PFRS 16 model. Lastly, another important element likely to be updated is the discount rate or the weighted average cost of capital (WACC), mainly because the company’s gearing has changed. Discount rate previously did not consider lease liability in the debt piece of the WACC calculation. Now that a lease liability is part of the company’s debt component, discount rate would possibly be reduced. Changes in these elements require a closer review of impairment testing as the headroom may change after taking up these updates.

Depending on your company’s approach to reporting, the new standard creates expanded qualitative and quantitative disclosures, with the goal of increasing transparency around revenues and expenses recognized, and expected to be recognized, from existing contracts. These disclosures require significant judgment by management, and companies will want to plan how they will gather the necessary information and communicate with relevant stakeholders.