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Improving balance sheet transparency

A new accounting standard seeks to put an end to off-balance sheet leases.

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"With the new standard, financial statements would provide a more faithful representation of a company's financial position and greater transparency about the company's financial leverage and capital employed," says Lee Fook Chiew, chief executive officer, Institute of Singapore Chartered Accountants.
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"The standard marks the end of the last widely-criticised form of off-balance sheet accounting. It is no secret that analysts and financiers have long been adjusting reported financials of lessees for operating lease commitments - at least until now," says Cheung Pui Yuen, member, Singapore Accounting Standards Council.
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"It (the new accounting standard) will definitely go a long way towards meeting investor's needs and strengthen market confidence," says Ho Tuck Chuen, group chief financial officer of JTC Corporation.

COMPANIES that lease big-ticket items such as airlines, telcos and those in the energy sector need to prepare for changes in the way that such leases will be treated on the balance sheet when new accounting standards come into force in 2019.

Issued by the Accounting Standards Council (ASC), the new standard, FRS116, brings leases onto the balance sheet, improving transparency about leasing activities and comparability of lessees.

"With the new standard, financial statements would provide a more faithful representation of a company's financial position and greater transparency about the company's financial leverage and capital employed," explained Lee Fook Chiew, chief executive officer, Institute of Singapore Chartered Accountants (ISCA).

He added: "Investors would see such leases reported on the lessees' balance sheets and have a more complete picture of the assets controlled and used in operations, as well as unavoidable lease payments. This helps investors better assess and compare the financial leverage and operating flexibility of companies."

Under the existing accounting standard for leases, information about a company's undiscounted commitments for off-balance sheet leases is provided in the notes to the financial statements. While more sophisticated investors could use this information to estimate assets and liabilities arising from such leases, many investors, especially retail investors, are not in a position to make such an analysis.

The new standard would therefore lead to a more level playing field for all investors and companies, resulting in the strengthening of market confidence, industry experts said.

"The standard marks the end of the last widely-criticised form of off-balance sheet accounting," said Cheung Pui Yuen, member, Singapore Accounting Standards Council. "It is no secret that analysts and financiers have long been adjusting reported financials of lessees for operating lease commitments - at least until now.

"Reporting leases on balance sheet changes neither the economic position of lessees nor the economic benefits of leases. The ensuing impact on financial metrics, such as gearing, liquidity, return on capital, is all but a sheer reflection of economic reality."

More importantly, industry players said that the curbing of operating leases as a mechanism for off-balance sheet financial will help increase transparency and boost investors' confidence in the market.

"It will definitely go a long way towards meeting investor's needs and strengthen market confidence," said Ho Tuck Chuen, group chief financial officer of JTC Corporation.

Preparing for change

According to a recent PwC study on the impact of the new lease standard on tenants across all industries and sectors, 53 per cent of the entities surveyed would see an increase in their debt of over 25 per cent. And given the significant use of rented premises for their stores, it was found in the same survey that the median increase in debt for retail companies would be 98 per cent.

Kok Moi Lre, partner, PwC Singapore, said: "Most of such leases are in the form of medium term leases, whether in premium locations such as flagship stores, shopping centres or ordinary outlets. Such leases typically offer renewal options, and often involve variable rentals."

Apart from retailers, companies in the airline, travel, transportation, telecommunications and energy sectors will be more affected than others, as businesses in these industries tend to lease big-ticket items. Affected businesses with loan agreements will need to reassess compliance with debt covenants due to changes in the debt-equity ratio. They may also need to re-evaluate key performance indicators such as Ebitda and return on assets.

To prepare for the change, companies will first need to identify arrangements that are lease contracts or contain a lease in accordance with a "right to control the use of an asset" framework.

"This is the most challenging aspect of FRS116," Mr Lee said, "and requires the exercise of substantial judgment because the line between a lease contract and a service contract can be blurred at times."

He advises companies to perform an initial review of all arrangements that may contain a lease. The next step would be to examine the terms of the arrangements for the existence of stipulated rights to determine if the arrangement is a lease. One tool to help with this task is ISCA's Leases Roadmap, which provides guidance for companies to perform a step-by-step assessment.

Designing systems, processes and controls to capture, store and validate lease data is another important preparation step. IT and accounting systems will need to be equipped to perform lease calculations and to generate the information to satisfy the requirements of the new leases standard.

"Taking the necessary steps to identify existing system gaps would aid companies in deciding whether to upgrade their existing systems or to invest in new software solutions or IT systems," said Mr Lee.

Mr Cheung highlighted the importance of early implementation and effective stakeholder communication, as the new major standards on revenue, financial instruments and leases are coming into effect over the next 11/2-21/2 years. Furthermore, Singapore-incorporated companies listed on Singapore Exchange have to apply additional requirements on transition to the new IFRS-identical financial reporting framework in 2018.

"Change is the only certainty and change creates opportunity. Entities are strongly encouraged to start working with their professional advisers to avoid roadblocks that could derail implementation," he said.