May-June-issue

Financial Reporting and Assurance
the obligation with respect to the lease
contract or commitment. The lease
liability reduces as periodic payments
are made by the lessee. The impact on
the balance sheet can be demonstrated
by the diagrams below:
The company’s profit or loss reduces with time as shown below:
Why is this important?
The new standard brings enhanced
transparency in financial reporting by
ensuring material lease obligations are
on-balance sheet. It was previously
difficult for the general public, as a
user of financial statements to track
the level of risk to the company from
its lease commitments which were offbalance
sheet. IFRS 16 also requires a
lessor to disclose information about
how it manages the risks related to
its residual interest in assets subject
to leases. It is perhaps an opportunity
for companies to start assessing the
value of the lease contracts they enter
into on the basis of the right-of-use
asset recognised in the books. This is
because going forward, it is possible
that the right-of-use asset may be
impaired since future benefits are less
than costs of the lease.
The impact of IFRS 16 is
that a substantial amount
of off-balance sheet leases
will now be recognised
in the balance sheet of
the lessee. The asset will
be depreciated over the
lease period and interest
expense charged over the
lease term, which reduces
as the liability reduces
due to periodic payments
made. The asset is subject
to impairment assessment
as well.
Tax implications
The tax impact will depend upon the requirements
of the current tax regulations on leases and/or any
possible changes in tax regulations in so far as
leases are concerned. Given that IFRS 16 does not
change the definition of both terms, it may be easy
to conclude that nothing much will change from
a tax perspective. However, it is not so clear cut.
Where a lease under the terms of the transaction
qualifies as an operating lease, the lessor will
continue to claim capital allowance on the asset
throughout the duration of the lease. However,
under the IFRS, the lessee would have capitalized
the same asset, recognised a depreciation expense
and an interest expense. Based on current tax
regulations, the depreciation expense would be
disallowed. Also, given that the lease remains
an operating lease despite the new basis for
recognition and accounting, it can be argued
that the lessee should not be able to claim capital
allowances on the value of the asset recognised (If
this were to be the case then the same asset would
have received allowance twice due to claim by the
two entities in the contract). This treatment would
therefore serve as double jeopardy for the lessee
since they will have a depreciation expense and
one would argue that it would only be fair for the
lessee to be allowed to claim capital allowances.
To put this in proper perspective, a company
which takes out a lease on a property would
have to capitalize the value of the payments due
and take benefit for it over the lease term. There
will likely be a mismatch in the annual payment
made on the operating lease and the tax benefit
obtained in the same year. Though, this will more
or less even out with the recognition of a deferred
tax asset or liability, there may still be significant
impact on cash flow.
There is also the issue of recognition. Given
that the assets would be capitalized, tax managers
and advisers may need to query all additions to the
fixed asset to determine their nature and ensure
that the proper tax treatment is accorded them.
This is even more so where the company has not
included relevant notes in the financial statements.
Notwithstanding, there is clearly a need to
keep additional accounting information which
shows the relationship between the periodic
rental payments and the depreciation and interest
expense recognised in the books for review by
tax managers, advisers and authorities in order to
ensure that the proper treatment is accorded the
relevant items. It is not clear whether the interest
expense will be allowable for tax purposes.
The new Standard is mandatory for annual
periods beginning on or after 1 January 2019
and companies are allowed to apply the standard
earlier if certain conditions are met.
sobock@kpmg.co.ke
MAY - JUNE 2018 9