TECHNICAL EXCELLENCE

FRS 17 VS FRS 116

DON’S COLUMN: FRS 17 VERSUS FRS 116

KOH WEI CHERN AND TONG YEN HEE

IMPLICATIONS OF RESIDUAL VALUE GUARANTEE ON LEASE ACCOUNTING:

In January 2016, the International Accounting Standards Board issued an effects analysis paper on International Financial Reporting Standard (IFRS) 16: Leases, which is the equivalent of Financial Reporting Standard (FRS) 116 in Singapore. The paper stated that IFRS 16 “does not change substantially the accounting for finance leases in International Accounting Standard (IAS) 17. The main difference relates to the treatment of residual value guarantees provided by a lessee to a lessor”. This article serves to highlight how the accounting for residual value guarantee under a lease arrangement will change when FRS 116 becomes effective for annual periods beginning on or after 1 January 2019.

CURRENT TREATMENT UNDER FRS 17

Under FRS 17 paragraph 20, a lessee shall recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments. FRS 17 paragraph 4 defines minimum lease payments as payments over the lease term that the lessee is or can be required to make, which include any guaranteed residual value. Paragraph 4 further defines guaranteed residual value for a lessee as “that part of the residual value that is guaranteed by the lessee or by a party related to the lessee”, and is “the amount of the guarantee being the maximum amount that could, in any event, become payable”.

Let us use a numerical example to illustrate the accounting for a lease arrangement with residual value guarantee by a lessee under FRS 17. On 1 January 20×1, Lessee Ltd leases a machine for four years. The annual lease payment of $20,000 is payable on 31 December each year, which is also Lessee Ltd’s financial year-end. Lessee Ltd guarantees to the lessor that the residual value of the machine at the end of the lease term would be $10,000. In an extreme scenario where the machine becomes worthless at the end of the lease term, the maximum amount that could become payable is $10,000, and this would be the amount used to compute the lease liability at initial recognition.

Assuming an implicit interest rate of 5%, the present value of the minimum lease payments, which is also the lease liability, is $79,146. Correspondingly, the leased asset would also be $79,146.

Using the effective interest method, the interest expense for the year 20×1 would be recorded at $3,957. Assuming that depreciation is based on the straight-line method, the depreciation expense per year is $17,287, calculated as the leased asset amount of $79,146 less $10,000 (that is, the guaranteed residual value at the end of the lease term), and divided by four. The total lease expense recognised on the income statement is therefore $21,244. The carrying amount of the leased asset and lease liability on 31 December 20×1 would be $61,859 and $63,103 respectively, and the net effect on the statement of financial position is a net credit of $1,244.

At the end of the lease term, if the residual value of the machine is greater than the guaranteed value, Lessee Ltd simply returns the machine to the lessor. If the residual value of the machine is less than the guaranteed residual value, then Lessee Ltd returns the machine, pays the difference in cash to the lessor, and recognises the difference as a loss on lease.

TREATMENT UNDER FRS 116

How would the accounting for residual value guarantees for a lessee be changed under FRS 116?

Under FRS 116 paragraph 26, a lessee shall measure the lease liability at the present value of the lease payments. Paragraph 27 goes on to define lease payments to include the amounts expected to be payable by the lessee under residual value guarantees. This results in two significant differences in the computation of lease liability when compared to FRS 17. First, a lessee no longer considers the maximum amount that could become payable, but just the amount expected to be payable under residual value guarantees. The lessee is also required to re-measure the lease liability if there are changes in amounts expected to be payable under the residual value guarantees. Second, while residual value guarantees by a party related to the lessee is included in the computation of lease liability under FRS 17, only residual value guarantees by the lessee is included under FRS 116.

Going back to the Lessee Ltd’s example, at initial recognition, Lessee Ltd would have to estimate the amount expected to be payable under the residual value guarantee. If the residual value of the machine is expected to be greater than the guaranteed value at the end of the lease term, the amount expected to be payable is zero. In this case, the lease liability will be computed as $70,919 based on 5% implicit rate. If the residual value of the machine is expected to be $8,000, then Lessee Ltd expects $2,000 to be payable at the end of the lease term. In this case, the lease liability is computed to be $72,564. Note that all else being the same, under FRS 116, the amount recognised as lease liability under this lease arrangement will not be more than that recognised under FRS 17. Correspondingly, the amount recognised as the right-of-use asset under FRS 116 would also be smaller than that of the leased asset recognised under FRS 17.

Suppose the lease liability is recognised at $70,919 based on zero expected amount payable under the residual value guarantee. Using the effective interest method, the interest expense for 20×1 is recorded at $3,546. As the right-of-use asset under FRS 116 would be fully consumed by the end of the lease term, straight-line depreciation per year is $17,730 (computed as $70,919 divided by four). Thus, the total lease expense recognised on the income statement is $21,276. The carrying amount of the right-of-use asset and lease liability on 31 December 20×1 would be $53,189 and $54,465 respectively, and the net effect on the statement of financial position is a net credit of $1,276.

At the end of the lease term, if the residual value of the machine is greater than the guaranteed value, then there is no amount payable by Lessee Ltd. However, if the residual value of the machine is less than the guaranteed value, Lessee Ltd pays the difference in cash to the lessor, and recognises the difference as a loss on lease.

As a further illustration, suppose that at the end of 20×2, Lessee Ltd expects the residual value at the end of the lease term to be $8,000. Thus, the amount expected to be payable under the residual value guarantee at the end of the lease term is now $2,000. The lease liability will have to be re-measured from $37,188 to $39,002, and a corresponding adjustment is made to the right-of-use asset. At the end of the lease term, if the residual value of the machine is $8,000, Lessee Ltd would simply debit lease payable of $2,000 and credit cash of the same amount under FRS 116.

Note that unlike FRS 116, FRS 17 does not require the re-measurement of the lease liability at the end of 20×2 because the maximum amount payable under the residual guarantee (that is, $10,000) is already incorporated into the liability amount at initial recognition and amortised accordingly. With the increase in lease liability and increase in right-of-use asset as a result of this re-measurement, the interest and depreciation expenses in 20×3 and 20×4 are higher under FRS 116 when compared to those under FRS 17. However, if the residual value of the machine is $8,000 at the end of the lease term, Lessee Ltd would have to recognise a loss on lease of $2,000 under FRS 17 but need not do so under FRS 116 because of the re-measurement at the end of 20×2.

SUMMARY AND CONCLUSIONS

Based on the above examples, it is clear that the definition of lease payments by the lessee is different between FRS 17 and FRS 116. This results in the differential treatment of residual value guarantees and the computation of lease liability and asset. However, it seems that any differential impact on the income statement and the statement of financial position over the lease term is likely to be minimal. Under FRS 116, any re-measurement of lease liability and right-of-use asset because of changes to the expected amount payable under residual value guarantees will result in subsequent recognition of total lease expenses that are higher than those under FRS 17 (which does not require re-measurement) for each of the affected financial year. Such re-measurement allows for more relevant financial information because it mitigates the delayed recognition of lease expenses, which is only recognised as a loss on lease at the end of the lease term under FRS 17.


Koh Wei Chern is Associate Professor, Accountancy Programme, School of Business, Singapore University of Social Sciences, and Tong Yen Hee is Associate Professor of Accounting, Nanyang Business School, Nanyang Technological University.