New (FRS 16 and ASC 842) Operating Leases Accounting Policies

Dear Friends and Clients:

Situation

In short, the new operating lease accounting standards under International Financial Reporting Standards (“IFRS”) and U.S. General Accepted Accounting Policies (“GAAP”) will come into force at the latest in 2019 and cause certain operating leases to be reported on the balance sheet (i.e., increasing debt and assets) and reclassify lease expenses related to rental of equipment as depreciation and interest under IFRS (i.e., increasing EBITDA), but not under U.S. GAAP where the costs of operating leases are still captured in a single expense item (and not separately coded as depreciation and interest) in operating costs (i.e., no impact on EBITDA).

These potential changes to reported debt and EBITDA could ultimately impact the price of a transaction (if based on a multiple of EBITDA), earn-outs and the ability to borrow monies (as debt make-up and capacity may be impacted). In addition, not everyone is aware of these impacts and there may be further confusion on the definition of EBITDA on international transactions due to differences in accounting policies in overseas countries.  Accordingly, it will imperative to properly document the implications (e.g., method and discount rates to calculate right of use fixed assets and debt and definition of EBITDA) within Letter of Intents, Sale and Purchase Agreements and borrowing agreements and to review existing documents to ensure you will not be negatively impacted.

Accounting Standards Codification Topic 842, Lease Accounting (“ASC 842”)  

Effective Dates

ASC 842 came into force for public companies for financial years beginning after December 15, 2018, and for most private companies for financial years beginning after December 15, 2019 but can be adopted earlier.

What’s New?

ASC Topic 842 primarily changes the accounting for lessees (not lessors), requiring lessees to record assets and liabilities on the balance sheet for almost every lease. This significantly differs from legacy accounting for operating leases, under which they were viewed as executory contracts not recognized for accounting purposes; in other words, they were off balance sheet.

Which Operating Leases and Expenses Will Be Reclassified?

In simple terms the following operating leases will be reclassified as on-balance sheet:

• Lessee has (i) the right to control the use; and (ii) obtain substantially all of the economic benefits of the use of the identified asset through-out the period of the lease.
  • One would not normally include leases where the supplier has the practical ability to substitute the identified asset and the supplier has the benefit from exercising this right of substitution.
  • There are no scope exceptions for small-ticket items (e.g., cars, computers or photocopiers).
• Lease term is greater than one year.

Lease costs include the costs of renting (including insurance and taxes) the asset but exclude certain ancillary services (e.g., maintenance), these services will be accounted for as separate expense.

Present Value of Lease Payments

In calculating the right of use (“ROU”) asset and lease liability, future lease payments should be discounted at the percentage rate implicit in the lease, if known.  While this rate is sometimes disclosed in the lease documentation, it is often not disclosed.

• The rate implicit in the lease can be calculated if the fair value of the leased asset, the periodic payments due under the lease, and the lessor’s expected residual value for the leased asset are all known to the lessee at lease commencement.
• If the rate implicit in the lease is not known or not calculable, the lessee should use its incremental borrowing rate at lease commencement. ASC Topic 842 defines the incremental borrowing rate as, “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar [lease] term an amount equal to the lease payments in a similar economic environment.” Companies should support their judgmental estimates of incremental borrowing rates by using all available evidence, including but not limited to:
  • Rates charged to the lessee by third-party creditors in recent borrowings.
  • Observable risk-free interest rates and credit spreads for similar-tenor commercial debt.
  • Quotes from third-party lending institutions of the borrowing rate that would be charged if the lessee elected to purchase the asset on installment over the same term as the lease.

What I suspect may happen for simplicity reasons in M&A deals is that both parties will agree on a pre-agreed discount rate and use this for calculating the present value of the lease costs for renting an asset.

Differences Between FRS 16 and ASC 842

ASC Topic 842 is the culmination of a decade-long, joint project with the FASB’s international counterpart, the International Accounting Standards Board (“IASB”). The IASB released its standard on lease accounting, IFRS 16, Leases, on January 12, 2016.

International Financial Reporting Standard 16 Leases (“IFRS 16”) comes into force for financial years beginning on or after January 1, 2019, while ASC 842 comes into force for public companies for financial years beginning after December 15, 2018, and for most private companies for financial years beginning after December 15, 2019. While ACS 842 can formally be adopted earlier, it might be beneficial to prepare pro forma financial statements as if ASC 842 was already adopted for the last (two) years so that the reader of the financial statements understands the implications of the change in accounting policies.

The IASB and FASB agreed on many aspects of lease accounting but reached different decisions in one fundamental area, the lessee accounting model. IFRS 16 applies a single lessee accounting model, which requires all operating leases to be accounted for in a manner similar to a finance lease with (i) the “right-to-use asset” and the financial liability being recognized on the balance sheet representing the net present value of the future lease payments; and (ii) the costs of renting assets of all leases being reflected as (a) depreciation of the leased assets, and (b) interest expense. As mentioned earlier, ASC 842 treats leases in a similar way, except that the costs of operating leases are captured in a single expense item in operating costs rather than through depreciation and interest expenses. While it is to be seen, some (minority of) prepares of the financial statements may informally report the operating lease costs separately as interest and depreciation.

IFRS 16 also provides an exemption for leases of low-value assets with a value of $5,000 or less at lease commencement.  IFRS 16 and ASC 842 also differ in terms of the treatment of subleases, sale-leaseback transactions, and variable lease payments. Last, IFRS 16 contains different disclosure and transition provisions.

Conclusion

I would always recommend being proactive, transparent and fair and not using this change in accounting policy to disadvantage (e.g., by impacting valuation, earn-outs or ability to borrow) the other party.  This will involve having informative, early conversations with the other party so this change can be fully accounted for within the necessary legal documentation and financial statements.