A closer look at the new leases standard – An analysis of lessee’s financial statements
A closer look at the new leases standard
– An analysis of lessee’s financial statements
International Accounting Standard (IAS) 17 Leases first became effective in 1984 and went on to become adopted by most jurisdictions. In January 2016, the International Accounting Standards Board (IASB) issued its replacement, International Financial Reporting Standard (IFRS) 16 Leases, which superseded IAS 17 and related interpretations.
The Hong Kong Institute of CPAs issued the local version of the standard, HKFRS 16 Leases, in May 2016 to maintain the convergence of Hong Kong Financial Reporting Standards (HKFR) with IFRS. All listed companies in Hong Kong are statutorily required to apply IFRS/HKFRS 16 from 1 January 2019.
Under the new standard, the accounting treatment of leases by lessee changes fundamentally, but lessor accounting remains substantially the same as the prior practice of IAS 17.
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Lessees are required to adopt a new “right-of-use” model. A right-of-use asset and a lease liability must be recognized. All leases are now included on the lessee’s statement of financial position (with a few exemptions).
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Lessor continues to apply the “risks and rewards” model and classify the leases into “operating” and “financing”.
IFRS 16 – a mixed blessings?
IFRS 16 is deemed as significantly enhancing the transparency of financial statements. The new standard abandons the prior dual accounting model for lessees, which required them to classify their leases as on-balance-sheet finance leases or off-balance-sheet operating leases. As such, by applying a more uniform way to account for leases, the new single on-balance-sheet accounting model improves the comparability of lessees’ financial statements. Moreover, users of financial statements no longer need to study the sophisticated disclosures about operating lease commitments in order to assess a company’s true “debt” level, as all lease liabilities are now clearly shown on the statement of financial position.
As a corollary, industries that are heavily dependent on leases in their business operations (such as retailers and airlines) are anticipated to be most adversely affected by the new standard – owing to the higher gearing level when lease liabilities are included.
In the following discussion, we are going to examine the new standard in more detail by analyzing its impacts on lessee’s financial statements through an illustrative example.
Illustrative Example [1]
Airways Limited (Airways) is a key player in the airline industry of Hong Kong. Upon its mandatory adoption of HKFRS 16 on 1 January 2019, it has disclosed the following information in its 2019 annual report regarding the impact of the new standard on its financial statements.
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Estimated increase on selected items in consolidated statement of financial position:
Property, plant and equipment (a) Long-term liabilities (a) · Current portion of lease liability* · Non-current portion of lease liability**
* repayable within 12 months ** repayable after 12 months |
HK$ billion
39.9
(8.1) (31.7) |
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Estimated (increase)/decrease in selected items on consolidated statement of profit or loss and other comprehensive income:
Operating lease rentals* (b) Depreciation of property, plant and equipment (c) Finance charges (d)
* Nil operating lease rentals recognised in 2019 |
HK$ billion
9 (7.7) (1.5) |
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Estimated increase in selected items on consolidated statement of cash flows:
Cash generated from operations (under operating activities) (e) Interest paid (under operating activities) (e) Loan and lease repayments (under financing activities) (e) |
HK$ billion
8.9 (1.5) (7.4) |
The disclosure items of Airways are analyzed below. Accompanied with each analysis, a technical review on HKFRS 16 (regarding the accounting treatments for lessees) is provided for easy reference.
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Analysis of disclosure items |
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Technical review on HKFRS 16
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(a) Property, Plant and Equipment and Long-Term Liabilities
Airways has more than half of its aircraft leases being classified as operating leases under the old accounting standard.
Since HKFRS 16 requires all leases to be recognized on the lessee’s statement of financial position, Airways’ operating leases prior to 2019 now become “capitalized”.
Airways has to measure and recognize the right-of-use assets and lease liabilities of such leases.
This results in an enormous increase in Airways’ property, plant and equipment and long-term liabilities by nearly HK$40 billion.
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Initial Recognition and Measurement of Right-Of-Use Asset and Lease Liability (HKFRS 16.22 – 28)
At commencement of the lease, the following entry is recorded in lessee’s books:
Dr. Right-of-use asset Cr. Lease liability
The lease liability is initially measured at the present value of the following payments:
The capitalized amount of right-of-use asset comprises the following:
Variable lease payments that do not depend on an index or a rate (e.g. variable lease payments based on sales) are not included in the measurement of the lease liability and are expensed when incurred.
Lease payments are discounted using the interest rate implicit in the lease. If that rate cannot be determined, the lessee’s incremental borrowing rate is used.
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(b) Operating Lease Rentals
Under HKFRS 16, a lessee shall apply a single recognition and measurement approach to all of its leases – that is to account for them “as if” they are finance leases only.
HKFRS 16 indeed provides flexibility (but to a limited extent) to leases of short- term (12 months or less) or low-value assets (US$5,000 or less). These leases can be exempted from capitalization and the lease payments will be expensed as incurred.
Since Airways mainly engages in lease contracts for its aircrafts which are of high value and long leasing period, exemption from capitalization is rather unlikely.
Upon adoption of HKFRS 16, Airways’ prior operating leases are all capitalized and this leads to an immense reduction in Airways’ operating lease rentals by HK$9 billion.
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Recognition Exemptions (HKFRS 16.5 – 8)
Lessees can opt for not to recognize right-of-use assets and lease liabilities for:
Lessees shall recognize lease payments on either a straight-line basis over the lease term or another systematic basis if that basis is more representative of the pattern of the lessee’s benefit. |
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(c) Depreciation of Property, Plant and Equipment
Airways applies a cost model for its right-of-use assets (mainly the aircrafts in its property, plant and equipment). The company shall measure and depreciate these assets in subsequent years.
Airways has incurred HK$7.7 billion more depreciation expense in the year of 2019 upon adoption of HKFRS 16.
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Subsequent Measurement of Right-Of-Use Asset (HKFRS 16.29 – 35)
After the commencement date, a lessee shall measure the right-of-use asset applying a cost model, unless it applies a fair value model in HKAS 40 Investment Property or elects for revaluation model in HKAS 16 Property, Plant and Equipment.
In applying a cost model, right-of-use assets are subsequently stated at cost less accumulated depreciation (and impairment losses, if any).
Under the following circumstances, the lessee shall depreciate the right-of-use asset from the commencement date to the end of the useful life of the underlying asset:
Otherwise, the depreciation period of a right-of-use asset is the shorter of the asset useful life and the lease term.
Right-of-use asset is typically depreciated on a straight-line basis, or another systematic basis that is more representative of the pattern in which the entity expects to consume the right-of-use asset.
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(d) Finance Charges
Lease liability is typically measured at amortized cost in subsequent years.
Airways calculates interests on its lease liabilities using the typical effective interest method. Finance charges of HK$1.5 billion were incurred upon amortization of the newly recognized lease liabilities in the year of 2019.
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Subsequent Measurement of Lease Liability (HKFRS 16.36 – 43)
After initial recognition, the lease liability is measured at amortized cost and interest charges are calculated using the effective interest method.
When a lease payment is made, the lessee will record the following entry (the deduction in lease liability represents the repayment of the principal):
Dr. Lease liability Dr. Interest expense Cr. Cash
A lessee shall remeasure the lease liability in the following scenarios:
A lessee shall recognize the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset.
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(e) Operating and Financing Cash Flows
Airways reported its lease payments in the statement of cash flows.
The lease payments made by Airways are no longer operating lease rentals but are interest charges and lease (principal) repayments.
Operating lease rentals under HKAS 17 were considered as cash paid in the computation of cash generated from operations. Upon removal of these rental payments after adoption of HKFRS 16, Airways’ cash generated from operations increased by HK$8.9 billion.
This amount was offset by the HK$1.5 billion increase in interest paid under operating activities and the massive rise of HK$7.4 billion in lease repayments under financing activities.
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Lease Payments in the Statement of Cash Flows (HKFRS 16.50)
In the statement of cash flows, a lessee shall classify:
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[1] This is a hypothetical example which is constructed with reference to the HKFRS 16 disclosures in real annual reports.
Overall, Airways appears to be more asset-rich, but also more heavily indebted upon adoption of HKFRS 16. Profit or loss is worsened in the initial year of adoption with the increase in depreciation expense and finance charges outweighing the decrease in operating lease rentals by nearly HK$200 million. There’s no significant effect on net cash flows but the reclassification of payments has made Airways more appealing in terms of operating cash flows.
Apart from the impact of HKFRS 16 on individual financial statement items, Airways has also disclosed the following key changes on its important financial metrics, using the hypothetical adoption of HKAS 17 for the financial year of 2019 as a comparison.
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As at December 31, 2019 Gearing (i)
For the year ended December 31, 2019 EBITDA (ii) EPS (iii) Return on capital employed (iv) |
Actual implementation of HKFRS 16
1.23
HK$20b 43.0¢ 3.5% |
Hypothetical adoption of HKAS 17
0.90
HK$15b 43.7¢ 3.6% |
Increase/ (decrease)
36.7%
33.3% (1.6%) (2.8%) |
Here comes an analysis of these key changes:
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Gearing, measured as net debt divided by net assets, rises sharply by 36.7%.
After adoption of HKFRS 16, a lessee shall have its assets (right-of-use asset) and liabilities (lease liability) increased by approximately the same extent, so net assets remain rather similar.
The sharp increase in gearing is mainly due to the numerator effect. Airways’ net debt increases significantly by HK$39.8 billion after capitalizing the operating leases prior to 2019.
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EBITDA (earnings before interest, ax, depreciation and amortization) increases by 33.3%.
Recall that operating lease expense is included in the calculation of EBITDA while depreciation expense and interest expense are excluded from the calculation of EBITDA.
Therefore, after the adoption of HKFRS 16, Airways’ EBITDA increases as its HK$9 billion operating lease expense under HKAS 17 is “replaced” by HK$7.7 billion depreciation expense and HK$1.5 billion interest expense.
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EPS (earnings per share) drops by 1.6%.
EPS is measured as net profit or loss attributable to ordinary shareholders divided by the weighted average number of ordinary shares.
Under HKFRS 16, right-of-use assets are typically depreciated on a straight-line basis while lease liabilities are amortized using effective interest method with higher interest charges in early years. The combined effects will lead to the front-loading of the total lease expense, resulting in lower EPS figures in earlier years of the lease, even if the lessee actually pays the same amount of lease rentals every period.
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ROCE (return on capital employed) decreases by 2.8%.
ROCE is measured as EBIT (earnings before interest and tax) divided by the capital employed (i.e. shareholders’ equity plus long-term liabilities).
Similar to EBITDA, EBIT increases after adoption of HKFRS 16. Therefore, the drop in ROCE is mainly due to the denominator effect where Airways’ long-term liabilities increase significantly by HK$39.8 billion after capitalizing the operating leases prior to 2019.
Overall, Airways becomes more leveraged and experiences a lower ROCE upon a surge in lease liabilities. The change in the “accounting nature” of lease payments (from operating lease to finance lease) has made Airways more appealing in its EBITDA. Owing to the front-loaded finance charges, EPS seems worsened in the initial year of HKFRS 16 adoption.
Behind the scene
Restructuring of lease terms
We shall be aware that one of the possible changes in how some enterprises (lessees) operate is their tendency to restructure leases to get away with the negative impact of the new standard.
For lessees who are inclined to avoid recognition of right-of-use assets and lease liabilities on their statement of financial position, they may try searching and negotiating for leases within 12 months’ period or with a value below US$5,000, though these are not possible strategies for airlines to handle their aircrafts.
Companies may also be tempted to pursue lease terms that allow a greater portion, if not the whole portion, of lease payments to be variable in nature and independent of any index or rate. For airlines, it could be flying hours. In this way, the variable payments will be expensed as incurred and will not be capitalized at the inception of the lease.
Credit risk exposure
We should also be wary of whether the lessee has the bargaining power to renegotiate more lenient restrictions, particularly gearing ratios (such as net debt to equity ratio and interest cover ratio), in avoidance of potential breaches of debt covenants for instance. It could be imperative to reassess the risk of breaches, in light of the financial statements’ information prepared under the new standard.
Conclusion
HKFRS 16 introduces a single lessee accounting model and it no longer requires lessees’ judgement on assessing whether the leases are operating or financing. Lessees are required to report all leases on their statements of financial position except those of short-term and low-value.
This clear-cut classification of leases enhances transparency of lessees, particularly those who are in substance heavily indebted by their commitments in the previously-reported operating leases. However, some argue that it further blurs the line between leasing an asset and actually buying it because “real” operating leases are not uncommon in many sectors (e.g. rental contracts in retail sector are normally more than US$5,000 and with lease term more than 12 months).
In addition, opponents of HKFRS 16 think that the new standard has shifted lessees’ focus from managing their core businesses to managing asset values (as finance lease model imposes significant residual value risks to lessees).
Nevertheless, more research is needed to investigate the actual impacts of IFRS 16 on lessees’ and lessors’ financial reporting as well as the influence of the new standard on their firm behaviours.
About the author
Dr. Winnie S.C. LEUNG – PhD, CPA (HK), FCCA, FCMA, Assistant Dean (UG), Principal Lecturer, Faculty of Business and Economics, The University of Hong Kong
