Public sector adoption of IFRS 16 Leases

This blog discusses the public sector adoption of IASB’s leasing standard – IFRS 16. We take a look at what the International Public Sector Accounting Standards Board (IPSASB) and HM Treasury (HMT) propose.

Previous Leasing Standard
Under the previous international leasing standard, IAS 17, leases were classified either as finance leases or operating leases. Finance leases are those leases that transfer substantially all the risks and rewards of ownership to the lessee and thus give rise to an asset and liability for the lessee and a receivable for the lessor. Operating leases are those that don’t transfer the risks and rewards of ownership and therefore only result in expense recognition by the lessee with the asset remaining recognised by the lessor.

IFRS 16 Leases was issued in January 2016 to ‘fix’ the lessee accounting model. After much debate, IFRS 16 retains the finance and operating lease distinction for lessors but lessees are now required to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. This will have a significant impact on financial statements, especially if the entity has a large amount of operating leases.

IPSASB proposal
Back in January 2018, the IPSASB issued a consultation on the adoption of IFRS 16 Leases. They proposed to adopt the new IFRS 16 lessee model but not the lessor model, which retains the finance and operating lease distinction/classification of IAS 17.

IPSASB does not support the current ‘risks and rewards’ based model for lessor accounting for several reasons:

  • It is not based on control and so is not compatible with its conceptual framework and other standards;
  • It doesn’t provide enough information on how lessors manage the resources entrusted to it since they either omit the underlying asset (finance lease) or the lease receivable (operating lease);
  • A dual model approach gives rise to inconsistent accounting by the two parties to a lease which could give rise to a number of practical issues in the public sector such as on consolidation.

IPSASB alternative lessor model
IPSASB recommended using a right-of-use model for lessor accounting where the lessor would:

  • Continue to recognise the underlying asset in full;
  • Recognise a lease receivable; and
  • Recognise a credit entry – unearned revenue as a balance sheet liability.

Many respondents to the consultation noted that assets appear to be double counted - the underlying asset as well as the lease receivable. In ICAEW’s response, we also noted that the assets would most likely face impairment since the single cash flow from the lessee cannot, in our view, support both assets.

UK’s public sector response
Finally, I would like to make you aware of the UK government’s recent consultation on leases for central government which was carried out by the Ministry of Finance, called HM Treasury (HMT).

Although HMT does not propose changing the IFRS 16 model, they have proposed setting an internal rate of borrowing centrally when entities can’t obtain the rate implicit in the lease. That’s right - all central government entities would use the same discount factor to measure their leases! HMT argue that since most government entities don’t borrow on the open market and are not charged interest on internal funding, it makes it extremely challenging to work out their internal rate of borrowing. Effort to do so would be duplicated in many organisations and hence a central rate is proposed.

Views will no doubt be split over this proposal. Some will argue that entities will end up applying the wrong discount rate, potentially leading to materially misstated financial statements. For example, if a hospital could only borrow at say 8% yet is applying a 3% central discount rate, this may distort the accounts sufficiently to the extent that they are no longer true and fair.

The future
The two different approaches are revealing. IPSASB are keen to move away from the risks and rewards based model entirely whilst HMT have taken a more pragmatic approach – accepting the IFRS standard as it is yet looking to standardise the internal rate of borrowing. The outcome will see diverging treatment of leases in the public sector. Only time will tell which approach provides the most useful information whilst putting the least burden on preparers.