A switch to International Financial Reporting Standards (hereinafter IFRS), accounting and financial reporting in compliance with IFRS has always been a challenging task for companies, as it involves the need to consider numerous details, not to forget about any finer points, assess and check hundreds of requirements to presentation and disclosure of information.
But after the release of IFRS 16 Leases the world has faced a new challenge that forced companies to spend a lot of resources for implementation and adjustment of internal business processes to comply with all requirements and guidelines of this small but revolutionary standard.
IFRS 16 has become revolutionary due to radical change in requirements with regard to lease accounting by the lessee; therefore the present article is devoted solely to disputable issues and particulars of lease accounting by the lessee, which we have managed to accumulate lately.
Despite the fact that on a global scale IFRS 16 has become mandatory for all companies that report in compliance with IFRS for annual reporting periods beginning on or after January 1, 2019, for a large number of Ukrainian companies reporting in compliance with IFRS for the first time this requirement came into force on January 1, 2018, as required by the Law of Ukraine “On accounting and financial reporting in Ukraine”. Thus, Ukrainian experience of implementation already includes certain acquired knowledge and practical skills.
At initial recognition of lease, assets and liabilities arising from a lease are recognized, where liabilities equal to current value of lease payments due as of the date of initial recognition of lease payments, while the initial lease asset equals the lease liability and a few clearly defined expenses and payments.
Rather than dealing with basic requirements of the standard that are understandable to everyone, this article is dealing with interesting particulars which we consider worth noting.
The first point to be considered is the problem of currency choice for lease contract administration. It is a secret to no one that operations in foreign currency between Ukrainian residents are prohibited in Ukraine, except the expressly-defined list of exceptions. This has led to various statements in contracts, where the calculation base is either the exchange rate between hryvnia and foreign currency or hryvnia equivalent in accordance with the exchange rate as of the date of invoice, payment, signing the work completion statement etc. This has led to the situation when, despite actual settlements in hryvnias, operations are covered by the definition of “operations in foreign currency” according to IAS 21 “The Effects of Changes in Foreign Exchange Rates”:
A foreign currency transaction is a transaction that is determined (or requires calculations) in foreign currency, including operations that arise when a business entity:
a) buys or sells goods or services with their price being set in foreign currency;
b) borrows or lends funds if the amounts payable or receivable are set in foreign currency; or
c) otherwise purchases or disposes of assets, or takes liabilities set in foreign currency, or repays such liabilities.
Thus, key in the choice of currency for accounting lease is the method applied to determine the amount of payment and not just the actual payment. Special attention should be given to choosing the currency of the agreement, as this choice will further affect the amount of discounting rate and whether or not foreign exchange difference will apply; this can be one of important factors in determining the company’s profits and losses, especially considering significant volatility of hryvnia exchange rate to other currencies.
A high-profile issue is the choice of discounting rate, as this is one of the most significant judgements that affects calculation of lease liabilities. According to the standard, a lessee shall measure the lease liability at the present value of the lease payments; the lease payments shall be discounted using the interest rate implicit in the lease, but if that rate cannot be readily determined, the lessee’s incremental borrowing rate shall be used.
Normally lease agreements do not provide for application of interest rates, therefore companies shall decide which discounting rate they are going to use.
Here special attention should be paid to the contractual currency, lease term applicable for calculations, business environment as well as the company’s financial sustainability. The reference point for determining the rate can be statistical data of the National Bank of Ukraine published on a monthly basis and containing interest rates on loans provided to Ukrainian companies, arranged by currency, term, region and business size. Methods of calculation, specific sources of incoming information and all judgements that have been used when defining the discounting rate are also worth documenting.
According to IFRS 16, the cost of the right-of-use asset shall comprise any lease payments made at or before the commencement date, less any lease incentives received. While lease incentives are infrequent in Ukraine, advance and indemnity payments are common practice. Here two points should be noted.
First, indemnity payments that shall be returned by the lessor after the lease term should be excluded from the calculation, since they do not belong to lease payments and only serve as collateral value of possible damages; however the calculation should include payments allocated to payment of lease at the end of the lease term.
Second, when the lease liability is being reassessed to reflect increase in the lease payment, one should remember to include to the cash flows additional payment for increase of advance or indemnity payment that will be taken into account as payment for the last month. This is one of the most common mistakes.
Lease of state- or community-owned land
Another issue that gave rise to disputes among consultants, accountants and all stakeholders is the one on whether or not lease of state- or community-owned land complies with the definition of lease according to IFRS 16. The main argument against it is that the lessee pays tax, not rent, and this implies the need to apply IFRIC 21 Levies and not IFRS 16. However, in IFRIC there is the point setting its application rules in any cases that involve provision of tangible assets or services: A payment made by an entity for the acquisition of an asset, or for the rendering of services under a contractual agreement with a government, does not meet the definition of a levy.
Besides, the core of state- or community-owned land lease fully complies with the criteria to recognize lease according to IFRS 16: A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset (plot of land) for a period of time (lease term) in exchange for consideration (land use fees).
We can dwell much longer on numerous particulars and details that should be noted at first implementation and further administration of lease contracts according to IFRS 16. This standard requires considerable efforts on the part of financial department team, both in terms of arranging business processes to obtain information and thoroughly study contractual terms, and implementation of all rules and practices of the standard.
World experience and practice shows that specialized software is absolutely necessary where there is a need to administer a large number of lease contracts, with very limited time frame for closing period and preparing financial statements. There is no room for doubt when one has to choose between a specialized software and MS Excel; the only remaining question is, whether to use out-of-the-box solutions or to develop a custom software to cover unique needs of a certain business.
Everyone is aware of pros and contras of each of the options: the first is quick to implement and cheaper than a custom product, but may be deficient in covering specific needs; the second requires more resources in terms of both money and time, but is sure to tick all the boxes.
In our opinion, if a company is switching to accounting in compliance with IFRS and needs a quick solution right away, the answer is obvious.