Operating Leases, IFRS 16 and Tax: What You Need to Know
Understanding Operating Leases
An operating lease is a type of lease where the financier owns the asset and leases it to the customer for a fixed monthly fee. The customer (lessee) uses the asset without owning it, and the lease payments don’t necessarily cover the full cost of the asset.
Key Points:
The financier (lessor) owns the asset.
The lessee pays a monthly rent to use the asset.
No residual value is stipulated in the rental agreement.
Tax Implications of Operating Leases
For the Lessor (Owner of the Asset):
Income Tax: The lessor can claim capital allowances on the asset, though Section 23A might limit these deductions.
Gross Income: Monthly lease income must be included in the lessor’s gross income.
VAT: VAT is charged on the monthly rental payments, and the lessor can claim VAT on the asset's purchase.
For the Lessee (User of the Asset):
Income Tax: The lessee can generally claim the monthly lease payments as a tax deduction. If payments are prepaid, deductions are limited by Section 23H.
VAT: The lessee can claim VAT on the monthly rental if the asset is used for taxable supplies.
IFRS 16: Bringing Leases On-Balance Sheet
IFRS 16, effective from January 1, 2019, changes how leases are accounted for in financial statements. Under this standard, many leases that were previously off-balance sheet must now be included on the balance sheet as a "Right-of-Use" (ROU) asset and a corresponding lease liability.
Key Changes:
Capitalization of Leases: Future operating lease payments are recorded as an ROU asset and a lease liability.
Depreciation and Interest: The ROU asset is depreciated, and interest is recognized on the lease liability over the lease term.
Profit Impact: Initially, the combination of lease liability interest expense and ROU asset depreciation is higher than the lease rental expense, reducing net profit. This effect reverses over time as the lease liability is repaid.
Example of IFRS 16 Accounting
Consider Company A, which enters a 5-year lease for a building at R30,000 per month with a 6% annual increase. The present value of these payments, discounted at 8%, is R1,500,000.
Initial Journal Entry:
Debit: ROU Asset R1,500,000
Credit: Lease Liability R1,500,000
Yearly Adjustments:
Exemptions and Software Needs
Exemptions:
Short-term leases (less than 12 months) and low-value leases (e.g., items under USD $5,000) are exempt from capitalization.
Software Needs:
Calculating lease liabilities and ROU assets requires specialized software, especially for handling rent variations like CPI increases.
Handling CPI and Other Variable Payments
CPI Changes: Recalculate discounted cash flows for lease liabilities when rentals change due to CPI adjustments.
Other Variable Payments: For leases with variable payments (e.g., a percentage of sales), only fixed payments are included in the ROU asset and liability calculations.
Special Cases and Practical Considerations
Novated Leases: Typically, these leases revert to the employee if they leave the company, and may not be controlled by the employer.
Peppercorn Leases: Not-for-profits must recognize leases as though they pay market rent, even if they pay a nominal amount.
Revaluations: The ROU asset can be revalued like other property, plant, and equipment.
Conclusion
Adopting IFRS 16 significantly changes how leases are accounted for, bringing more transparency to financial statements. Understanding these changes helps businesses manage their finances and comply with new accounting standards.
Addendum: The Role of Accounting Policies in Reflecting Lease Contracts
When selecting an accounting policy, it is essential to consider the users of the financial statements and the objectives of the reporting framework. Different accounting standards, such as IFRS 16, IFRS for SMEs, and the Modified Cash Basis, offer varying degrees of accuracy and expediency in reflecting the reality of lease contracts. Here's an in-depth look at how these considerations impact accounting policies and their eventual scrutiny.
Choosing an Accounting Policy
1. IFRS 16:
User Focus: Aimed at providing detailed and transparent information to sophisticated users, such as investors and regulators.
Accuracy: Emphasizes a true and fair representation of the financial position by bringing lease liabilities and right-of-use (ROU) assets onto the balance sheet.
Reflection of Reality: Strives to closely align accounting entries with the real nature of lease transactions, ensuring that financial statements accurately reflect the economic substance of lease agreements.
2. IFRS for SMEs:
User Focus: Designed for smaller entities with less complex reporting needs, often focusing on owners, lenders, and other stakeholders who require straightforward financial information.
Economic Expediency: Prioritizes simplicity and cost-effectiveness over exhaustive accuracy. While it provides a reasonable reflection of financial position, it may not capture all nuances of lease agreements.
Potential Conflicts: In situations of dispute, especially with creditors, the actual nature of the transactions may be subject to interpretation and legal scrutiny.
3. Modified Cash Basis:
User Focus: Suited for very small entities or specific jurisdictions where simplicity and cash flow tracking are paramount.
Simplicity Over Accuracy: Focuses on recording transactions based on cash movements rather than accruals, which can simplify accounting processes but may not fully reflect the economic reality.
Legal Interpretations: The simplicity of this basis means that in the event of conflicts, particularly with creditors, the true nature of transactions may need to be determined by courts.
Reflecting the Reality of Lease Contracts
IFRS 16 vs. Other Standards:
True Reflection: IFRS 16 aims to bridge the gap between the accounting entries and the real nature of lease contracts, providing users with a clear and accurate picture of lease obligations.
Economic Expediency: In contrast, IFRS for SMEs and Modified Cash Basis prioritize economic expediency and ease of use over detailed accuracy. These frameworks are designed to meet the needs of their users without the complexity of full IFRS.
Tax Implications:
Consistency with Tax Laws: Regardless of the accounting standard chosen, companies must ensure that their accounting policies align with tax regulations to accurately report taxable income and allowable deductions.
Adjustments for Accuracy: Companies using IFRS 16 may need to make more adjustments to align their financial reporting with tax laws, whereas those using simpler standards may find the process more straightforward but less precise.
Conflict Resolution and Legal Considerations
Potential for Disputes:
IFRS for SMEs and Modified Cash Basis: These standards, while easier to apply, may lead to disputes over the true nature of transactions. In such cases, courts may need to interpret the underlying contracts to resolve conflicts, particularly with creditors.
Legal Interpretations: Courts will examine the substance of the transactions to determine their true economic impact, which might differ from the simplified accounting treatments.
Conclusion
The choice of accounting policy depends on the intended users and the objectives of the financial reporting. While IFRS 16 seeks to provide an accurate reflection of lease contracts, IFRS for SMEs and Modified Cash Basis offer more practical, albeit less precise, approaches. Understanding these differences is crucial for entities to ensure compliance, manage stakeholder expectations, and be prepared for any potential legal interpretations of their financial transactions.