Time to bring all 'Leases' on the balance sheet

The economic growth requires resources and leasing provides an option to obtain those resources. We all know that leasing is an important and widely used financing solution. Through leasing a particular item can be obtained and used by paying installments. In this way leasing also provides flexibility in using cash for other economic activities. The issue of obsolescence and residual value risk is also generally addressed through the leasing arrangements. Further, there could be situations where the availability of asset is only through the leasing arrangement.
Leases are popular and widely used by individuals, organizations and governments. Those that lease assets are termed as 'lessees' and those that provide those assets to lessee are termed as 'lessors'. We have also studied and seen that there are two types of leases, operating and finance. Currently, there is distinction in the accounting treatment of these leases. The accounting of operating lease is to treat it like a rental expenditure. These leases do not appear as liabilities and are often described as 'off-balance sheet' financing. Whereas the finance lease is treated similar to a standard loan, and recorded on the balance sheet as a liability.
Importantly, the above distinction of operating and finance leases is short-lived as a significant change in lease accounting is on the horizon. This change will bring all leases on the balance sheet of the lessee.
The change in lease accounting would be prompted by the applicability of the International Financial Reporting Standard 16 - 'Leases' from 1 January 2019. IFRS 16 will be the new leasing standard replacing IAS 17 and all other leasing pronouncements.
The new leasing IFRS requires that operating leases should also be accounted for in the balance sheet of lessee companies, therefore eliminating for lessees the lease classification of operating and finance. The new concept is based on the premise that the lease conveys the right to control the use of an asset in exchange for a payment obligation. This right to use the asset and related liability shall be recognised in the balance sheet irrespective of the nature lease , i.e., operating or financing lease arrangement. The previous accounting model for leases required lessees to classify their leases as either finance leases or operating leases and account for those two types of leases differently. That model was criticized for failing to meet the needs of users of financial statements because it did not always provide a faithful representation of leasing transactions. In particular, as stated above it did not require lessees to recognise assets and liabilities arising from operating leases.
The IFRS 16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases. The two exceptions to recognizing on the balance sheet relate to the leasing contract being for a term less than 12 months or the underlying asset is of low value. The IFRS provides detailed guidance on practical application of these exception approaches.
The lease classification for the lessors is the same under new leasing standard. This implies that in case of an operating lease the asset would be appearing in the balance sheet of the lessor, while the lessee would also be recording a 'right to use' of the same asset in its balance sheet.
The IASB has outlined and changed the lease accounting only in the IFRS and there is no change in the lease models and accounting specified in other financial reporting frameworks, including IFRS for SMEs.
One of the practical challenges with regard to the application of new lease standard will be in connection with the determination of term period of leases, as to how the non-cancelable period of lease is to be determined. In general, many leases for property are for a period of 11 months but with a renewal right for lessee. There may be situations where though lessee has the right to renew beyond 12 months but the lessor also has the right to cancel such lease after 12 months. The companies have to consider specific facts and circumstances of such leases to determine the accounting treatment of renewable leases.
In Pakistan, there is a business practice to pay pagree for acquiring rented properties. There could be questions around treatment of such costs. The pagree is an initial direct cost of obtaining a lease. Therefore, it forms part of the cost of right of use of the asset and should be recognized accordingly.
The long-term lease for land is also a common leasing arrangement in Pakistan. Such arrangements involve yearly payments by lessee. Queries may arise about the accounting of the long-term leases for land, especially from the lessee's perspective. Under the IFRS 16 specified right of use leasing model, the lessee should account for a long-term lease of land on the balance sheet and depreciate the same.
Further, there may be also questions around whether the leased property, plant and equipment should be revalued where the same class of owned assets follows revaluation model of accounting. It may be noted that IFRS 16 allows such an option but not mandatorily requires the revaluation of leased assets. Therefore, now we might see varied approaches and accounting policies for the revaluation of owned and leased assets.
Almost all the industry sectors will be affected by the new requirements of the leasing standard; some of the most affected sectors in Pakistan could include: the transport and logistics sector as they would be brining all leased aircrafts, ships, trucks etc. on the balance sheet; banking sector would be recognizing the lease properties where the branches are housed; distribution or retail companies with rented stores and warehouse facilities across many cities, would be bringing these warehouses and rented stores on the balance sheet; and telecommunication companies balance sheet may now also include leased network equipment, cell towers and fibre optics etc.
The new requirements will gross up balance sheets and change income statement and cash flow presentation. Rent expense will be replaced by depreciation and interest expense in the income statement (similar to finance leases today). This results in a front-loaded lease expense, which for some might decrease earnings and equity immediately after entering into a lease compared to an operating lease today.
The most commonly used financial ratios and performance metrics may be impacted, such as gearing, current ratio, asset turnover, interest cover, EBIT, operating profit, net income, EPS etc. The new lease accounting model can have significant implications for lessees that are statutorily or contractually obligated to maintain certain ratios, thresholds and capital requirements. For example, the grossing up of the balance sheet through recognition of all leases in the balance sheet will potentially impact the capital adequacy ratio computation for banks.
In Pakistan context, two specific matters that require fresh examination include the provision of exemption to power sector companies from lease accounting and accounting of Islamic mode ijarah transactions. We know that previously it had been concluded that the power purchase agreements of IPPs falls under the lease standard and related interpretation. However, SECP had provided exemption from the application of lease accounting of IFRIC 4. With the applicability of IFRS 16 the power purchase arrangements of IPPs would require analysis for their accounting under lease model and continuity of related exemption.
The other matter of accounting of Islamic mode lease transactions, i.e., Ijarah transactions also requires reconsideration. Presently, a separate Ijarah accounting standard issued by the Institute of Chartered Accountants of Pakistan outlines that an Ijarah transaction is similar to a rental transaction with no recording of the right of use asset in the lessee's balance sheet. This accounting of Ijarah transactions will reflect different accounting treatments of similar nature transactions under the IFRS 16 and Ijarah Standard, therefore requiring further analyses and deliberations for convergence.
Lastly, for all the stakeholders and especially for the companies the question is about their readiness to the new requirements of IFRS 16. Unless the companies have already instituted the analysis of existing lease contracts it is high time that proper assessment of these contracts are carried out to ensure the accounting is done in accordance with the Standard.
(The writer is the Chairman of Accounting Standards Board of the Institute of Chartered Accountants of Pakistan)