What implications will there be for community housing providers (CHPs) with the Australian Accounting Standards Board’s new Standard 1058 Income of Not-for-Profit Entities and how will it impact their forward budgets?
CHPs are struggling to come to grips with the concept of valuing peppercorn leases and other leases with significantly below-market terms and conditions. On 23 November 2018, the AASB released an exposure draft which proposes to provide temporary relief to CHPs from fair valuing Right-of-Use Assets as required by AASB 16 and AASB 1058.
The proposed changes are a result of feedback received by the AASB on the difficulties associated with valuations of CHP’s assets.
AASB 16 and AASB 1058 will be mandatory for CHP’s for reporting periods beginning on or after 1 January 2019. Under the existing version of these standards, CHP’s that have a peppercorn lease (or a lease that is significantly less than fair value), are required to measure the right of use asset at fair value on commencement of the lease. This results in Day One income, recognised in profit or loss. The requirement to "fair value" the Right of Use Asset may provide significant challenges to an NFP and would likely incur significant cost as an external valuer will be required in most instances.
The changes will impact income recognition in the CHP sector in that:
some types of income will not be immediately recognised in the income statement, particularly where there is a performance obligation or other liability, and
donations of assets to CHP entities at a discount to their fair value will need to be recognised at current fair market value.
Examples of the above include the income recognition in relation to peppercorn leases, capital grant funding and volunteer services.
Currently, leases with significantly below market terms or values are accounted for by measuring both the lease asset and liability at the present value of the minimum lease payments, which is negligible in a peppercorn lease. This understates the lease asset and fails to recognise the donation component.
The new standard will address this by amending AASB 16 Leases to require CHPs to measure assets under a peppercorn lease at fair value on the balance sheet, with the lease liability measured at the present value of the minimum lease payments. The difference between the current fair market value of the asset and the present value of the minimum lease payments will be recorded as income, as it is effectively a donation to the CHP.
This accounting treatment will impact the CHP’s results both initially, due to the non-cash income component elevating its net surplus, and on an ongoing basis due to depreciation on the asset being recognised in the income statement. Also, asset and liability data and the related ratios (such as Return on Assets, Gearing, Debt serviceability, Interest cover, etc.) will be impacted.
Income recognition of capital grant funding
Under the new standard the revenue is recognised when the performance obligation in an agreement is recognised. As such, at the time a capital agreement is entered into, the income received by the CHP will be accounted for as an asset in its balance sheet, with a corresponding liability (the obligation). As the obligation is fulfilled over time and the percentage reflected in the agreement (donation) applied, the liability will diminish. This reduction will be recognised as income (a donation) in the income statement.
Again, the net surplus of the CHP will be impacted in that the capital grant income is spread over the life of the agreement, as opposed to the total funding being recognised as income at the inception of the agreement. Furthermore, asset and liability data and ratios will be affected, thus potentially affecting borrowing capacity.
In short, the new lease accounting treatment will lead to:
An increase in net debt,
A higher EBITDA. EBIT will also increase, however less substantial, as the majority of formal rental expenses will be reflected in depreciation, and
A higher invested capital for the lessee, which generally lowers ROIC.
Data Collection and Ongoing Data Management
In order to determine what changes are necessary to apply the new standard, much of the preliminary work will involve assessing the state of a company’s current lease contract data management (i.e., its systems, policies, processes and controls), including the data required for financial reporting purposes.
Companies that already have well-organised lease administration and accounting functions may simply need to evaluate whether their existing systems, policies, processes and controls require adjustments to accommodate the changes in the new standard. However, while existing systems (e.g., spreadsheets and software) may include some lease information, they may not have all of the information required to make the calculations, judgements (including on-going assessments) and information for disclosures necessary to comply with the new standard. As such, significant effort could be required to manually gather missing lease information.
Other companies (e.g., those with lease procurement, lease administration and lease accounting functions that are decentralised depending on the business unit, geographic location, or type of leased asset) could have a challenging journey ahead. For such companies, determining the completeness of the lease portfolio, as well as the accuracy and completeness of the lease data, may require considerable effort.
IT systems, Processes and Controls
Today’s lease-related IT systems are often designed primarily to assist with lease administration, and many are focused on real estate leasing or a lessor’s investment in leased assets. However, lessees commonly use spreadsheets to supplement requirements for current lease accounting and reporting because today’s lease-related IT systems often lack the capabilities to perform the calculations required for accounting.
To satisfy the new financial statement presentation and disclosure requirements, companies will need to evaluate whether to update their existing systems or to implement a new system. Selecting or updating a lease IT system will probably require input, not only from accounting, but also from the lease administration and IT functions, depending on the company’s enterprise resource planning (ERP) environment. When implementing any IT system, it is important to define system requirements and the expectations of relevant stakeholders prior to selecting a vendor.
If a company chooses to apply the new standard on a full retrospective basis, upon initial application, it will be required to restate comparative reporting periods. Furthermore, companies may need to keep separate books for external reporting, local statutory requirements and tax purposes. This will increase the IT system requirements, and may also further complicate processes and controls. Identifying, developing and implementing changes to IT systems are not easy exercises, and the amount of time necessary would depend on the legacy systems in place.
Companies that are presently designing or upgrading IT financial reporting systems would be well advised to consider the new standard as part of their current IT development efforts. This could reduce the risk of costly re-work and redesign at a later date. Companies also should be mindful that although IT programs can help accumulate data and perform calculations required by the new standard, they are not the complete solution; no program can make the critical estimates or judgements required by the new standard.
For additional information on Lease Accounting, its applicability to Community Housing and Lease Accounting technology, please contact
at +61 403 842 480 or email us
Sources: Deloittes, Breather Insights, BeyondFM, IFRS
Visit www.beyond-fm.com for further information