Leases have become extremely important as instruments of financing entrepreneurial activities all over the world. By its nature, leasing as a financing option gives rise to important taxation, income, expenditure, asset and liability reporting considerations. Accounting bodies have the responsibility for pronouncements on important accounting issues. Lease accounting standards have been widely debated in recent years.
Financial reporting in the last few years, has changed with the introduction of the International Financial Reporting Standards (IFRS). In Nigeria, IFRS have been adopted in phases over a period of three years, which commenced in 2012 with the significant Public Interest Entities (SPIEs), followed by the Other Public Interest Entities (OPIES) in 2013 and lastly the Small and Medium – Sized Entities (SMEs) in 2014. Consequently, the Statements of Accounting Standards are no longer applicable in the preparation of financial statements. Therefore, the relevant IFRS are to be applied in lease accounting and preparation of financial statement. The main Standard in this regard, is the International Accounting Standards on leases (IAS 17) which prescribes the accounting policies and disclosures applicable to leases, both for lessors and lessees.
International Accounting Standards on Leases (IAS 17)
The objective of IAS 17 is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosures to apply in relation to finance and operating leases.
Scope: IAS 17 applies to all leases other than lease agreements for minerals, oil, natural gas, and similar regenerative resources and licensing agreements for films, videos, plays, manuscripts, patents, copyrights, and similar items.
Accounting by Lessees
The following principles should be applied in the financial statements of lessees:
At commencement of the lease term, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity’s incremental borrowing rate)
Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability)
The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease – the asset should be depreciated over the shorter of the lease term or the life of the asset
For operating lease, the lease payments should be recognised as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user’s benefit.
Incentives for the agreement of a new or renewed operating lease should be recognised by the lessee as a reduction of the rental expense over the lease term, irrespective of the incentive’s nature or form, or the timing of payments.
Accounting by Lessors
The following principles should be applied in the financial statements of lessors:
At commencement of the lease term, the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the net investment in the lease
The lessor should recognise finance income based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment outstanding in respect of the finance lease
Assets held for operating leases should be presented in the balance sheet of the lessor according to the nature of the asset. Lease income should be recognised over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern in which use benefit is derived from the leased asset is diminished.
Incentives for the agreement of a new or renewed operating lease should be recognised by the lessor as a reduction of the rental income over the lease term, irrespective of the incentive’s nature or form, or the timing of payments.
Manufacturers or dealer lessors should include selling profit or loss in the same period as they would for an outright sale. If artificially low rates of interest are charged, selling profit should be restricted to that which would apply if a commercial rate of interest were charged.
Under the 2003 revisions to IAS 17, initial direct and incremental costs incurred by lessors in negotiating leases must be recognised over the lease term. They may no longer be charged to expense when incurred. This treatment does not apply to manufacturer or dealer lessors where such cost recognition is as an expense when the selling profit is recognised.
THE NEW IFRS 16 LEASE STANDARD AND ITS IMPLICATIONS
The International Financial Reporting Standards (IFRS) recently announced a new standard on leases, IFRS 16 intended to improve the financial reporting of leasing activities. The Financial Reporting Council of Nigeria (FRCN) is expected to adopt it.
Basically, the IFRS 16 will replace IAS 17 leases, and is expected to come into effect by January 1, 2019. The changes mainly affect the accounting for operating leases by the lessee focusing on the elimination of off balance sheet financing. The following are the salient provisions of the standard:
The lessee will no longer classify leases as either finance or operating
The lessee recognises all lease assets and liability on the balance sheet
The lessee recognises depreciation of lease assets and interest on liabilities in income statement over lease term
The lessee separate the total amount of cash paid into a principal portion and interest in the cashflow statement
In summary, a lessee will account for all leases similarly to the accounting for finance leases under IAS 17.
However, a lessee may choose not to recognise assets and liabilities for leases of 12months or less (short term leases) and leases of low value assets such as furniture, laptops (Value not exceeding $5million).
Implications of the New IFRS 16 to the lessee;
Majorly, the new IFRS 16 leases standard will lead to an increase in lease assets and financial liabilities. Accordingly, there will be a change to key financial ratios derived from a lessee’s assets and liabilities e.g. leverage and performance ratios.
Higher asset base which will affect return on assets (ROA)
Higher financial liabilities and leverage ratio
Recognition of depreciation and interest expense instead of operating lease expense leads to higher operating results (interest expense is typically excluded from operating expense)
Earnings Before Interest and Taxes (EBIT) and Earnings Before Interest, Taxes, Depreciation and Ammortisation (EBITDA) will be higher
It may affect lessors’ business models and offerings, as lease needs and behaviours of lessees change.
It may accelerate existing market developments in leasing such as an increased focus on services rather than physical assets.
To the lessor;
The accounting requirements for lessors remain largely unchanged.