New lease accounting standard: the road to adoption

The new lease standard under Philippine Financial Reporting Standard (PFRS) 16 has been effective for annual periods beginning on or after January 1, 2019.

One of the significant changes brought about by PFRS 16 is in lessee accounting, as it requires most leases to be recognized on the lessee’s balance sheet by recording a right-of-use asset and a corresponding lease liability.

For many entities, the effects are not limited to the accounting implications but also encompass areas such as lease procurement and negotiation, contract administration, financial statement processes and controls.

Entities have embarked on activities to assess the impact of PFRS 16 on their businesses and implement the requisite changes. We share below what many of the financial statement preparers have gone through in their PFRS 16 voyage.

ESTABLISHING PROJECT STEERING COMMITTEES AND WORKING GROUPS
As part of the governance and implementation processes, entities have established project steering committees and working groups. The steering committee generally provides overall direction and guidance, resolves issues, and monitors the status of the project and approves project deliverables. The working group on the other hand performs overall project management and coordinates with working teams, business units, advisors and other project stakeholders.

UNDERSTANDING THE LEASE ACCOUNTING CHANGES AND CURRENT STATE
As one of the critical initial steps, entities have acquired an understanding of PFRS 16 either through formal training, discussions with advisors, or knowledge transfer sessions. Aided by this knowledge, entities then conduct current state assessments vis-à-vis the changes brought about by PFRS 16 around identification of leasing activities, distinguishing lease arrangements (including relevant contract terms) and understanding lease administration tasks. The current state assessment allows entities to determine the degree of impact on the areas affected by the lease arrangements.

REVIEWING LEASE ARRANGEMENTS
The project working groups review the agreements based on the requirements of PFRS 16 and considered any required changes. Many entities have depended on spreadsheets, particularly for the following:

Lease arrangement database — Entities develop spreadsheets which document, at a minimum, the counterparty, lease term (considering the impact of lease renewal options and termination clauses where present), lease amount (considering variable lease payments that are in substance fixed where applicable) and other relevant data that were needed for the lease computation.

Computation of lease income expense — Entities develop macro enabled spreadsheets to compute for the requirement of the new lease standard especially the impact for lessee accounting.

While spreadsheets might be helpful to some, there are also electronic or automated solutions that are more responsive to processing voluminous contracts, such as for those with many leased branches like quick service restaurants, banks and those in retail. As this process is manual in nature, administratively burdensome and prone to errors, it exposes the entities’ operational process and financial reporting risks. To address these, some entities have turned to better solutions using web-based tools, computer programs or artificial intelligence (AI).

One example of a tool that uses AI to support entities lease accounting approach is the EY Lease Reviewer. The EY Lease Reviewer uses AI or machine learning, which can help improve the assessment of a large number of lease arrangements. It helps entities to identify and extract relevant contract clauses in adopting PFRS 16 such as the lease amounts, and terms including renewal options and termination options.

In finding the right tool in reviewing the contracts, entities check whether the tools supported adequate internal controls and processes applicable to their businesses.

IDENTIFYING GAPS AND QUANTIFICATION OF IMPACT
Entities identify the gaps between PFRS 16 and PAS 17 which was the legacy standard. They then prepare a gap report that show the results of their implementation. This report summarizes their assessments of the impact and the key items that the entities have to change on their processes and policies. The gap report also serve as the basis of the entities’ results of their quantification.

UPDATING PROCESSES AND INTERNAL CONTROLS
Some entities took the adoption of PFRS 16 as an opportunity for them to modify their current processes and controls. One example is the centralization of the lease arrangements into one repository. Since most of the lease liabilities under PAS 17 were recognized off books by the lessee and thus, might not be centrally monitored, lease arrangements might often be stored in different locations and handled by different persons or departments. The transition to PFRS 16 is not only beneficial to the accounting and finance functions. Other departments such as procurement, general administration or treasury might also benefit from the centralization — since the critical information would have become readily available (e.g., renewal terms, critical payment dates, etc.).

Furthermore, entities would have updated the documentation of the related processes and internal controls that were affected by PFRS 16 to aid in its business as usual.

LESSONS LEARNED
Success in adopting an accounting change depends on the entity’s state of readiness. Entities must proactively consider their current state, the steps needed for compliance and the processes by which they need to transition to any new accounting standard. This demonstrates the importance of not being resistant to change; but instead, embracing and learning from it.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Anna Maria Rubi B. Diaz is a Financial Accounting Advisory Services Senior Director of SGV & Co.