Getting Ready For FRS 116 (Leases)
Getting Ready forFRS 116 (Leases)August 2016
Contents1Executive Summary3Introduction5Method6Companies’ Awareness of FRS 1167Companies’ Readiness and Challengesin Adopting/Implementing FRS 1169Companies Perceived Benefit of Adopting FRS 11610Expected Financial Implications of FRS 11612Expected Changes in Business Practices Arising From FRS 11613Determination of Low Value Leases14Conclusion
Getting Ready for FRS 116 (Leases)1Executive SummaryThe International Accounting Standards Board (IASB)issued IFRS 16 Leases in January 2016 which will beeffective from January 2019. IFRS 16 introduces majorchanges in lessee accounting while lessor accountingremains largely unchanged. In the current leases standardIAS 17, lessees account for leases according to the termsof the lease contracts as either operating leases or financeleases. In IFRS 16, lessees are generally not allowed to usethe operating lease approach unless exempted as shortleases or low value leases. IFRS 16 would bring majority ofleases onto the balance sheet resulting in new assets andliabilities being recognised.On 30 June 2016, the Accounting Standards Council (ASC)issued FRS 116 Leases as the Singapore equivalent of IFRS16. The new Singapore leases standard will be effectivein January 2019 and companies need to get ready forthe adoption and implementation of FRS 116. Underthe new FRS 116, financial statements of lessees will bemore transparent with the recognition of lease assets andlease liabilities on the balance sheet, the recognition ofdepreciation on right-of-use assets and interest expensefor lease liabilities on the income statement, and thereduction in operating cash outflows and increase infinancing cash outflows in the cash flow statement. Keyfinancial statement implications are the bringing of moredebts onto the balance sheet and the front loading oftotal lease expenses.Adopting and implementing FRS 116 would not be a bedof roses for businesses with significant number of leasecontracts. Some of the challenges that these businessesmay encounter include creating a centralized databaseof all the lease contracts and transactions they have, andupdating or modifying the accounting information systemto cope with the requirements of FRS 116, amongstothers.We surveyed companies that lease assets for their use(lessees) to gain an understanding of their readiness toimplement FRS 116. An online survey was carried out inMay and June 2016 and a total of 68 valid responses werecollected.We have captured the following key insights drawn fromthe survey results:1. Good Level of Awareness of FRS 116: Majority ofthe companies appeared to possess a good level ofawareness of the key changes to leases accountingunder FRS 116.2. Companies Should Start Preparations forAdoption/Implementation of FRS 116: Half of thecompanies have not started making preparations toadopt/implement FRS 116. When asked to describewhat help they needed to adopt/implement FRS116, a large number of the companies indicated thatthey needed training in FRS 116 and updating theiraccounting information system to capture the datanecessary to comply with the new requirements of FRS116.3. Adoption/Implementation of FRS 116 Consideredto be a Major/Moderate Challenge and a CostlyExercise: Half of the companies considered thechallenge in adopting/implementing FRS 116 to bemajor/moderate. Companies reported that the twotop challenges were educating investors and internalstakeholders, and ensuring proper lease accountingtreatment and adequate documentation. While morethan half of the companies agreed that FRS 116 wouldresult in more relevant, faithful, transparent andcomparable financial statements, a large percentageof companies indicated that FRS 116 will requiresignificant implementation costs. Hence, only half ofthe companies were convinced that FRS 116 would bebeneficial to users and the market and almost a third ofthe companies were uncertain.
2Getting Ready for FRS 116 (Leases)4. Companies’ Borrowing Costs Expected to Increase:Given that companies’ financial ratios such as gearingratio and current ratio would deteriorate under FRS116, a large percentage of companies indicated thatthey expected interest rates for new debts to increase.Almost a third of the companies were uncertain aboutthe impact of FRS 116 on existing debts. It is importantfor companies to critically evaluate the financial impactof FRS 116 on existing loans and renegotiate the loanagreements, if necessary.5. Expected Changes in Business Practices: Theexpected change in business practices arising fromFRS 116 includes reduction in “sale and lease back”transactions, increase in “borrow and buy” overleasing of assets, increase in the number of short –term leases (that is, lease period less than 12 months)and preference for service contracts instead of leases ofassets. Majority of companies also indicated that moreaudit work is expected under FRS 116 as new assetsand liabilities are recognised on the balance sheet.6. No Preferred Method to Determine Low ValueLeases: Companies did not show any strong preferenceon the method to use in determining a low value lease.38% of companies indicated they would apply themateriality concept, 35% would apply a threshold and26% have not decided on the method.
Getting Ready for FRS 116 (Leases)3IntroductionIn January 2016, the IASB issued the new leases accountingstandard IFRS 16 which would require companies thatlease assets for use in their business to record the leases intheir balance sheets unless exempted by provisions in thestandard. IFRS 16 will replace the current lease accountingstandard IAS 17 with effect from January 2019. On 30June 2016, the ASC issued the Singapore equivalentleases standard FRS 116 which is also effective beginningJanuary 2019. This will replace the existing FRS 17 Leases.financial statements of airlines that lease aircrafts asoperating lease and /or borrow-and-buy aircrafts are notcomparable unless adjustments are made. Analysts oftenmake such adjustments (i.e., constructive capitalization ofoperating leases) but face substantial difficulties becausethe disclosure of operating leases contracts in the notesof the financial statements is often inadequate and on anaggregated basis.FRS116 - Lessor AccountingUnder FRS 17, a lease is to be accounted for as eithera finance lease (also known as a capital lease) or anoperating lease subject to meeting certain conditions. Fora finance lease, the lessee recognizes a leased asset anda lease liability on the balance sheet; the lease payment isdisaggregated into an interest expense and a repaymentof the lease liability; and the leased asset is depreciated.For an operating lease, a lessee simply recognizes thelease payment as an operating cost and does not recordany leased asset or lease liability on the balance sheet.The key change in FRS 116 is that lessees will use a singlelessee model based on the finance lease method. Therationale for the change in lease accounting for lesseesis to better reflect the economic substance of the leasetransaction. Sir David Tweedie’s example of aircraft leasingis a classic explanation1. Airlines that lease aircrafts oftenaccount for them as operating leases with no trace of theaircrafts, or their financing, in the balance sheets. Yet, theairlines clearly control the aircrafts and reap economicbenefits arising from the aircrafts (this is defined asasset). Moreover, the lease payments are unavoidableand of known amounts (this is defined as liability). Leasedassets and lease liabilities should therefore be recognizedas a matter of economic substance. Under FRS 17, the1Under FRS 116, lessor accounting is basically unchanged.Lessor accounting continues to classify leases as eitheroperating leases or finance leases, and account for thosetwo types of leases differently with additional disclosureabout how the lessor manages risks related to its residualinterest in assets subject to leases.FRS 116 - Lessee AccountingThe key change in FRS 116 is that lessees are not allowedto account for leases using the operating lease methodunless the lease is less than 12 months or of low value. Forleases previously accounted as operating lease under FRS17, FRS 116 requires the company to recognize lease assetsand liabilities on the balance sheet initially measured atthe present value of unavoidable future lease payments;recognize depreciation of lease assets and interest onlease liabilities in the income statement over the leaseterm; and separate the total amount of cash paid intoa principal portion (presented within financing activities)and interest (typically presented within either operating orfinancing activities) in the cash flow statement.Tweedie, D. (2007) “Can Global Standards be Principle Based?” Journal of Applied Research in Accounting and Finance, Vol. 2(1): 3-8.
4Getting Ready for FRS 116 (Leases)FRS 116 does not change substantially the accountingfor finance leases in FRS 17. The main difference relatesto the treatment of residual value guarantees providedby a lessee to a lessor. This is because FRS 116 requiresthat the company recognise only amounts expected to bepayable under residual value guarantees, rather than themaximum amount guaranteed as required by FRS 17.Expected Impact on Lessees with SignificantOperating Leases under FRS 17Assuming that a company currently carries a significantamount of leases off its balance sheet as operating leases,the effects of the FRS 116 are predictable from comparingthe different accounting treatments for finance andoperating leases as discussed in the following table.Table 1MetricWhat it MeasuresCalculationFRS 116 effectExplanationIncrease because financialliabilities increase (and equityis expected to decrease).Leverage (gearing)Long term solvencyLiability/ EquityIncreaseCurrent RatioLiquidityCurrent Asset/Current LiabilityDecreaseDecrease because currentlease liabilities increase whilecurrent assets do not.Asset turnoverProfitabilitySales/Total AssetDecreaseDecrease because leaseassets will be recognised aspart of total assetEBIT (Earnings beforeProfitabilityinterest and tax)VariousIncreaseIncrease because thedepreciation charge addedis lower than the expensefor off balance sheet leasesexcluded.EBITDA (Earningsbefore interest, taxand depreciation)VariousIncreaseIncrease because expensesfor off balance sheet leasesare excluded.Various MethodsIncreaseIncrease because at least partof the lease payments (thosepayments relating to theprincipal) will be moved tothe financing section of thecash flow statement.Difference betweencash inflows andcash outflowsNo changeNo change because cash willnot be affected.ProfitabilityOperating cash flow ProfitabilityNet cash flowProfitability andliquiditySource: Extracted from IASB’s IFRS 16 Effect Analysis
Getting Ready for FRS 116 (Leases)Adopting FRS 116 is expected to have financialimplications for lessees. It can be seen that the leverageratio and current ratio, which are commonly used in debtcovenants, will deteriorate with the proposed accountingchange. This change may trigger a breach of covenantsfor existing debts and increase the cost of raising newdebts. A 2013 study2 showed that Singapore companiescould see an increase in the book value of debts by 30%and debt/equity ratio by 33% if operating leases werecapitalised.5The study was approved by the Institution of Review Board(IRB) of Nanyang Technological University, Singapore (NTU).Profile62% of the companies are not listed. Of the listedcompanies, 10% of the companies have marketcapitalisation above S 1billion, 7% with S 300 million toS 1 billion and 21% below S 300 million.Figure 1: Size - Market CapitalizationAdopting FRS 116 is also expected to have behaviouralimplications for lessees. For example, applying FRS 116can affect companies’ decisions to lease or buy an asset.There are clear advantages for lessees in leasing insteadof buying an asset such as avoidance of ownership riskslike obsolescence, repair and maintenance costs, flexibilityto change asset, and avoiding financing and liquidityconstraints. However, FRS 116 eliminates the opportunityfor off balance sheet financing3 by lessees and, all elsebeing equal, may favour buying over leasing an asset.Research QuestionsCompanies were surveyed on the following six areas usingthe questionnaire in Appendix A: Companies’ awareness of FRS 116Companies’ readiness and challenges faced inadoption/implementing FRS 116Companies perceived benefit of adopting FRS 116Expected financial implications of FRS 116Expected changes in business practices arising fromFRS 116Determination of low value leasesAlmost half of the companies recorded S 10 millionto S 100 million annual revenue and one third of thecompanies recorded S 100 million to S 1 billion annualrevenue.Figure 2: Size - Annual RevenueMETHODWe collected survey data from 68 companies using anonline survey issued from May to June 2016 to ISCAmembers holding senior positions (for example, ChiefFinance Officer, Financial Controller, Vice President ofFinance or the equivalent) in companies.2Koh, W.C. and Tan, P. (2013) “Impact of the Leases Exposure Draft on Lessees Leverage Ratios” IS Chartered Accountant, September issue 2013: 50-53.3This point is made explicitly on p.39 of a KPMG report available at /leases-first-impressions-2016.pdf
6Getting Ready for FRS 116 (Leases)COMPANIES’ AWARENESS OF FRS 116We assessed the respondents’ level of awareness ofthe key aspects of FRS 116 by asking them to indicatewhether the statements in Table 2 are “True” or “False”under FRS 116. All but one statement had at least 80%of respondents who answered correctly. The questionthat recorded the lowest percentage of correct response(only 18%) was “FRS 116 requires lessor to account forall leases essentially as finance leases (except for certainexempted leases)”.We found that the surveyed companies were generallyaware of FRS 116 with 72% of respondents havinganswered at least four out of five questions correctly.The distribution of the number of correct answers byrespondents is captured in Table 3 below.Table 2QuestionCorrect Answer% of respondentswho answeredcorrectlyFRS 116 significantly limits the use of operating leases as a mechanism foroff-balance sheet financing.True96%FRS 116 requires lessor to account for all leases essentially as financeleases (except for certain exempted leases).False18%The decision-making rights differentiate a lease from a contract forpurchasing supplies or services.True90%FRS 116 eliminates the classification of leases as either operating leases orfinance leases for a lessee.True79%For lessees, FRS 116 will bring more off-balance sheet operating leasesonto the balance sheets and show higher gearing ratios and asset bases.True94%Table 3Number of correct answers% of respondents00%11%27%319%457%515%*Note: Percentages may not add to 100% due to rounding
Getting Ready for FRS 116 (Leases)COMPANIES’ READINESS AND CHALLENGESIN ADOPTING/IMPLEMENTING FRS 116The survey seeks to understand how ready companiesare for FRS 116 and what are the implementationchallenges they face in implementing the new leases7accounting standard. To assess the level of readinessof companies, we surveyed them on the six aspects ofimplementation readiness modified from Deloitte’s 2014report entitled “Lease Accounting Survey: Preparing forImplementation”4. The results are tabulated in Table 4.Table 4ReadinessNot started Unsatisfactory SatisfactoryVeryNot CertainSatisfactoryPreparation and approval of an implementationroad map for FRS 11657%12%25%3%3%Identification of organisation’s transactions orcontracts that are, or contain, leases under FRS 11646%13%29%10%1%Gathering and validation of the necessary data foran organisation’s lease database44%18%28%9%1%Training of accounting staff on FRS 11649%21%21%9%1%Analysis of FRS 116 tax considerations andimplications60%15%18%6%1%Upgrade and modification of organisation’saccounting information system for FRS 11662%18%13%4%3%*Note: Percentages may not add to 100% due to roundingOn average, about half of the companies (53%) indicatedthat they have not started preparations for adoption/implementation of FRS 116 (see Table 4 above). Inparticular, the top three areas which companies have notmade any preparations are:(i) Upgrade and modification of the organisation’saccounting information system for FRS 116 (62%),(ii) Analysis of FRS 116 tax considerations and implications(60%); and(iii) Preparation and approval of an implementation roadmap for FRS 116 (57%).Figure 3 shows the profile of the companies that havenot started preparations to adopt/implement FRS 116. Wenoted that more than half of the companies that have notstarted are not listed.Figure 3: Profile of Companies thathave not started preparations to adopt/implement FRS 116For companies that have started making preparations forFRS 116, at least half have started to identify leases inaccordance with FRS 116 (54%), compile a lease database(56%) and provide training to the accounting staff (51%).*Note: Percentages may not add to 100% due to report.pdf,on page 10 and 12.
8Getting Ready for FRS 116 (Leases)Beyond accounting and financial reporting, FRS 116 willhave an impact on IT systems and processes, internalcontrols, training, procurement, taxes, budgeting, andoperational functions of a business. According to KPMG5,lease data today are often managed through disparatemanual spreadsheets and databases in various locations.This alone makes the lease data gathering step a significantundertaking. As leases are regularly being undertaken,renewed, modified or cancelled, the data gatheringprocess is further prolonged, which makes it a tediousone. Lease contracts (or contracts containing leases) canbe complex depending on the terms and conditions.This would require judgement to be exercised on theaccounting treatment based on the principles set out inFRS 116. Additionally, the current accounting informationsystem may require upgrading or modifications to be ableto store new or updated data, calculate the new journalentries, and generate the analysis and disclosure reportingrequired by FRS 116. This may also require changes tointernal control processes. Having well trained staff is thekey to ensuring the success of such organisational widechanges. There is a lot preparatory work to be done andit would be wise, in particular, for those companies withnumerous leases, to plan ahead and prepare the companyfor changes expected on the horizon.In the survey, we have also asked the respondentsto describe the type of help their companies need inimplementing FRS 116. A large number of the responsesindicated training. Other respondents indicated that helpwas needed for adapting the accounting informationsystem while a small group indicated no help was needed.Having an understanding of the challenges in adoption/implementing new accounting standards can helpcompanies to allocate the necessary resources toensure adequate preparations are made to ensuresmooth transition to the new standard. We surveyedthe respondents on how they would rate the degree ofchallenge that their companies faced in preparing for FRS116. Table 5 shows that half of the companies consideredthe challenges in adopting/implementing FRS 116 to bemajor/moderate.Table allengeNotCertainAdequacy of the organisation’s accountinginformation system to comply with FRS 11612%41%34%10%3%Ensuring proper lease accounting treatment andadequate documentation under FRS 11610%46%32%9%3%Creating a database of all the lease contracts andtransactions of the organisation12%40%29%18%1%Educating investors and internal stakeholders19%37%25%16%3%Area of Preparation*Note: Percentages may not add to 100% due to rounding5https://advisory.kpmg.us/deal-advisory/
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