Video transcript: Financial reporting update: For-profit entities
Brett Story, Associate Director Technical
Hello, I’m Brett Story, Associate Director Technical at Audit New Zealand. Welcome to this 2020 financial reporting update video. Today I will be talking about two standard changes that come into effect this year for for-profit entities.
The main focus of the presentation today is providing an overview of the new lease standard NZ IFRS 16. There are a lot details and considerations under this new standard and I am not going to get into all those today in this short recording. However, I will cover some common areas to be aware of.
I will also highlight the considerations you must now make when faced with uncertainties over tax treatments, which is now addressed by the interpretation, NZ IFRIC 23.
NZ IFRS 16 has been along time coming and for some of you if will be the most significant accounting change to your financial statements since adoption to NZ IFRS.
The new standard requires lessees to recognise most leases on their balance sheets, which will typically result in the recognition of a present valued lease liability and a right of use asset that is subsequently depreciated. That accounting is similar to the finance lease accounting model under NZ IAS 17.
For lessees with significant operating leases, there are likely to be significant implications to your financial statements, which I’ll highlight in a moment.
For lessors, you continue to apply the finance and operating lease model. This means the lease accounting models for lessors and lessees are no longer symmetrical.
Today I will only be covering lessee accounting. I won’t be covering lessor accounting as that is largely unchanged under NZ IFRS 16.
So what are the consequences of the new standard for the financial statements for lessees with significant operating leases?
There are likely to be significant implications for the balance sheet with the recognition of new right of use assets and lease liabilities. This is likely to impact on balance sheet ratios and possibly borrowing covenant calculations.
EBITDA will increase as operating lease expenses will be replaced by interest on the finance lease liability and depreciation on the right of use asset.
It’s important to highlight that the total expense recognised over the lease term does not change.
However, the expense will be higher in the earlier years of the lease due to the higher finance charge on the lease liability.
Operating cash outflows will decrease as the lability principal portion of the lease payments will now be a financing cash outflow.
There are two optional recognition exemptions available for lessees to make the standard easier to apply.
The first is for short term leases, which are those leases with a lease term that is less than 12 months.
The second is for leases of low valued assets. So what is a low valued asset? The basis for conclusion of IFRS 16 refers to USD 5,000 and below as a guide. The standard also provides examples that low value items could includes tablets, PCs, small items of office furniture and phones.
The assessment of low value is based on the value of the asset when new regardless of the actual age of the asset. For example, a lease of 2nd hand car would not qualify as a new car would not be low value. The assessment of low value is also made for an individual item when it is not highly dependent or interrelated with other assets. For example, if you lease 100 smart phones with a value of $1,500 each you would assess the value on a per phone basis rather than as a single group with a combined new value of $150,000.
Whether an item is low value will sometimes be an area that requires judgement. When these elections are applied, the lease expense is recognised over the lease term on a straight line/or other systematic basis, consistent with operating lease accounting.
I will now cover the 3 key building blocks when valuing the lease lability, these being lease term, cash flows, and discount rate.
The first of these is the lease term. The lease term is an important input into the valuation as it determines the duration of cash flows you will need to discount and therefore is a key driver over the size of the liability. The lease term is the non-cancellable period of the lease plus:
- periods covered by an option to extend if the lessee is reasonably certain to exercise that option; and
- periods covered by an option to terminate if the lessee is reasonably certain not to exercise that option.
Accommodation leases commonly provide lessees with renewal rights to extend the lease. For example, an accommodation lease may be for an initial 5 year term, and the lessee has the right to renew the lease for a further term of five years. In this example, is the lease term 5 years or 10 years?
In making judgements on the lease term with options, you need to consider all relevant facts and circumstances that create an economic incentive to exercise or not exercise the option. Examples of factors to consider include:
- Have significant leasehold improvements been undertaken by the lessee?
- Are there significant costs relating to termination or non-renewing, such as relocation costs, termination payments?
- How important is asset to an entity’s operations?
An entity’s past practice regarding the period over which it has typically used particular types of assets may also provide information that is helpful in making lease term assessments.
Determining lease terms will sometimes be a subjective area that will require significant judgement. Particularly, for long term property leases that may include multiple renewal periods. It is important that these significant judgements are well documented to support the lease term decided by management and this is likely to be area scrutinised by your auditor.
The second matter is how to determine the lease payments that are included in the lease liability. This is straight-forward if the lease agreement has fixed lease payments that do not change over the lease term. However, lease payments typically will vary over the lease term, such as for property leases.
If lease payments are based on sales or usage in using the leased asset, then those lease payments are not part of the lease liability. Instead, those payments are recognised as an expense when the underlying event occurs . However, if there is a minimum payment amount that is payable regardless of sales or usage, then that cash flow is part of the lease liability.
It is common for accommodation related lease payments to initially set and then be reviewed periodically and adjusted prospectively based on changes in market rental rates or CPI, or a mix of both. For such leases, you do not forecast these changes at initial recognition. Instead, the initial lease liability is based on rate/index at the date the lease commences.
For example if, you have a 10 year lease where the lease payments are reviewed and reset to market every 2 years and the initial lease payment is $100k per annum. In this case, the undiscounted cash flows of the lease liability is $100k per year* 10 years equalling $1m.
However, the lease liability will need to be re-measured in future when rent reviews occur, which will result in an adjustment to the lease liability and an adjustment made against the right of use of asset.
The re-measurement of the lease liability and resulting adjustment to the ROU in future periods for CPI and rent reviews complicates the accounting and will require careful tracking and monitoring by finance teams to ensure the lease accounting is up to date.
The final matter to consider after determining your lease cash flows is determining an appropriate discount rate to present value those cash flows.
The standard has a discount rate hierarchy of first using the interest rate implicit in the lease if that is readily determinable. Otherwise, an entity uses its incremental borrowing rate.
The interest rate implicit in the lease is essentially the lessor’s internal rate of return on the lease. This means lessees typically are unable to determine this rate as they often don’t have the necessary information to readily calculate it. In practice, lessees will typically be discounting the lease cash flows using its incremental borrowing rate.
The incremental borrowing rate is a defined term and its sets out the key features that need to be followed in estimating that rate. It reflects the interest rate that an entity would have to pay if it borrowed funds:
- over a similar term to the lease term;
- with similar security,
- to obtain an asset of a similar value.
This means the incremental borrowing rate is specific to the lessee and the asset being leased.
Determining an appropriate discount rate that is consistent with the incremental borrowing rate definition will be one of most challenging judgements under the new standard. The level of precision you need to apply in determining a discount rate for a lease will depend on the materiality of the undiscounted lease cash flows in the context of the financial statements.
We are aware of questions arising on whether WACC and property yields can be used for a discount rate. The short answer is such rates are not consistent with the incremental borrowing rate definition and adjustments would be required to align with the IBR definition. Such adjustments are likely to be difficult to do in practice.
Approaches to consider in estimating the IBR could include:
- Referring to existing borrowing rates – however these may require adjustment if they are out of date or do not reflect a borrowing term or security consistent with the lease
- We have seen some entities take a building block approach by taking a relevant benchmark interest rate, and then add a credit spread and other adjustments.
- If you are finding it difficult to determine a robust rate when one is needed, you should consider engaging external expertise to help with this.
Now to an amendment to IFRS 16 hot off the press. The International Accounting Standards Board released on 28 May an amendment to IFRS 16 for COVID related rent concessions.
The amendment provides lessees with a practical expedient that relieves them from assessing whether a COVID-19-related rent concession is a lease modification. This should result in easier accounting if a lessee elects to apply the practical expedient when it meets the three criteria. These criteria are:
- the change in lease payments results in revised consideration for the lease that is substantially the same as, or less than, the consideration for the lease immediately preceding the change;
- any reduction in lease payments affects only payments originally due on or before 30 June 2021; and
- there is no substantive change to other terms and conditions of the lease.
At the time of this recording on 4 June [2020], this amendment is not yet available for application in NZ as it first needs to go through the NZ Accounting Standards Board approval process. The NZASB is meeting today to approve the amendment and also have it available for application as soon as possible.
How do you transition to NZ IFRS 16?
NZ IFRS 16 includes specific transitional provisions to minimise the impact of transition. There are two approaches to choose from for transition. There is the full retrospective restatement approach under NZ IAS 8. This may be difficult to do in practice as you would need to account for leases retrospectively as though you had always applied the standard.
If you are wanting to apply a simpler approach, then you can elect to use the cumulative catch-up approach as at the date of initial application (which is the first day of the year you transition). This means you don’t restate the comparative year financial statements and the cumulative difference between the right of use asset and lease liability is recognised in the opening retained earnings balance of current year. There are also several concessions under this approach. For example, determining the discount rate using the incremental borrowing rate at the date of transition rather than at lease inception.
There are some consolidation considerations for those for-profits with subsidiaries, or those who are part of public benefit entity group.
If you are a for-profit group, you will need to ensure that for group consolidation purposes that all your significant subsidiaries are providing consolidating information using consistent transition options and recognition exemptions. You should be clear in your group instructions on what approaches you are taking for the group.
A number of for-profit entities in the public sector are consolidated into a PBE group. PBEs are still applying a lease standard based on NZ IAS 17. This will mean when you provide consolidated information via your reporting packs to your PBE parent you will need to be applying the operating and finance lease accounting model. Essentially you need to unwind your NZ IFRS 16 transition adjustments for operating leases.
The International Public Sector Accounting Standards Board is continuing to work on a new lease standard based on IFRS 16; however it is unclear when a revised PBE leases standard will be available for PBEs to adopt.
As mentioned earlier, I was not covering all aspects of the standard today. Some of the areas I have not covered include:
- the lease definition, which some entities will need to carefully consider for some arrangements, particularly for leases that may be embedded in a contract for services;
- subleases – there are specific requirements on how a sub-lease is assessed by the lessor as either an operating or financing lease
- other lease modifications;
- non-lease components, such as those components where the lessor transfers a good or service to the lessee (for example, maintenance and cleaning services for an accommodation lease); and
- disclosures – as with any new standard, there is more disclosure than its predecessor. Entities will need to carefully consider the new lease related disclosures.
Now, on to a new topic.
The International Accounting Standards Board’s interpretations committee released IFRIC 23 in 2017 to address how to reflect uncertainty in accounting for income taxes. The Interpretation provides a helpful clarification on how the requirements of NZ IAS 12 Income Taxes shall be applied when there is uncertainty over income tax treatments. The Interpretation is effective for annual reporting periods beginning on or after 1 January 2019.
In assessing how to account for an uncertain tax treatment, you are required to assume that the IRD will examine amounts it has a right to examine and have full knowledge of all related information when making those examinations. That is, you don’t assess the likelihood of IRD examining your treatment.
If you consider it probable that IRD will accept an uncertain tax treatment that you have filed or plan to file, you determine the tax accounting consistently with that. However, if you consider it probable that IRD will not accept an uncertain tax treatment that you have filed or plan to file, you reflect the uncertainty in determining taxable profit/loss following the method you expect to better predict the resolution of the uncertainty. This is made based on the most likely amount or expected valued method.
That concludes this short financial reporting update video. I hope you have found this useful in providing an overview of the new leases standard and income tax uncertainties interpretation. If you have any particular audit-related questions that arise from application of these changes, then contact your auditor to discuss further in the normal manner.
Thank-you and stay safe.
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