A Practical Guide to FRS 116
For years, one of the most common criticisms of financial reporting was that it allowed a fundamental piece of a company's financial obligations to remain hidden. A business could have significant, unavoidable rental commitments for offices, ships, or machinery, and yet a user of its financial statements might never see these liabilities on its balance sheet. This all changed with the introduction of FRS 116 Leases.
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What is FRS 116?
FRS 116 Property, Plant and Equipment are defined as tangible items that are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and are expected to be used during more than one accounting period.
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The Core Principle: One Model for Lessees
The most significant change brought by FRS 116 is the removal of the operating lease classification for lessees. Under the old standard, a lessee had to distinguish between a finance lease (where the risks and rewards of ownership were transferred) and an operating lease (essentially treated as a rental agreement).
FRS 116 replaces this dual model with a single, on-balance sheet model, similar to the previous finance lease accounting. Here’s how it works:
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Right-of-Use Asset: The lessee recognises an asset representing its right to use the underlying asset over the lease term.
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Lease Liability: The lessee also recognises a liability for its obligation to make lease payments.
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This means that for almost all leases, the balance sheet will now reflect both an asset (the right to use the property, plant, or equipment) and a corresponding liability (the future rental payments).
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What About Lessors?
The accounting for lessors remains largely unchanged from previous standards. A lessor continues to classify its leases as either operating or finance leases and will account for them accordingly. The focus of FRS 116 was squarely on increasing transparency for the users of lessees' financial statements.
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Exemptions: The Two Exceptions
While the model is described as applying to "most" leases, FRS 116 does provide two practical expedients, allowing companies to continue treating certain leases much like operating leases:
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Short-term leases: Leases with a term of 12 months or less.
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Low-value assets: Leases for which the underlying asset is of low value (e.g., personal computers, small office furniture). The standard suggests a value of S$5,000 or less when new, as a guideline.
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For these two categories, a lessee can choose not to recognise a right-of-use asset and lease liability and instead simply recognise the lease payments as an expense over the lease term.
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Examples
(a)
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Style Pte. Ltd. enters a 5-year lease for a new store, with annual payments of S$50,000.
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Under old rules: Style Pte. Ltd., would simply record rent expense of S$50,000 each year. Its balance sheet would show no asset or liability for this lease.
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Under FRS 116: At the start of the lease, Style Pte. Ltd. must calculate the present value of the 5 years of payments (say, approximately S$227,000). It then records a "Right-of-Use Asset" and a "Lease Liability" of S$227,000 on its balance sheet. Over the 5 years, it will recognise a depreciation expense on the asset and an interest expense on the liability, rather than a single rent expense.
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(b)
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Adventures Pte. Ltd. needs extra space to host a three-day client workshop. They rent a conference room in a hotel for two months at S$1,500 per month. The total contract is only S$3,000.
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Under FRS 116: Because the lease term is less than 12 months, it qualifies as a short-term lease. Adventures Pte. Ltd. does not need to put a "Right-of-Use Asset" or a "Lease Liability" on its balance sheet for this room. Instead, they will simply recognize the S$1,500 as a rental expense in month one and month two. It is business as usual.
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(c)
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To improve office efficiency, Studio Pte. Ltd. leases an office photocopier. The monthly payments are S$50, and the lease runs for three years. However, the cash price of that photocopier if purchased new today is only S$2,000.
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Under FRS 116: While this lease is long-term (3 years), the underlying asset is of "low value" (significantly below the suggested S$5,000 threshold). Therefore, Studio Pte. Ltd. can apply the low-value asset exemption. Again, they do not have to capitalize the lease. They will simply record the S$50 monthly payment as a rent expense.
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Why Was This Change Necessary?
The move to FRS 116 was driven by the need for greater transparency. Under the old rules, investors and analysts often had to make their own adjustments to a company's balance sheet to estimate its off-balance-sheet lease obligations. This was known as "liabilisation."
FRS 116 brings these obligations onto the balance sheet, providing a clearer and more comparable view of a company's financial health. For users of financial statements, this means:
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Better Comparability: You can now more accurately compare a company that buys its assets with debt to a company that leases its assets. Both will show the asset and the associated liability on their balance sheet.
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Improved Key Metrics: Ratios such as Return on Capital Employed (ROCE), Gearing, and Debt/Equity ratios become more meaningful and comparable across companies.
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A More Complete Picture: Financial statements now provide a more holistic view of a company's financial commitments and the assets it uses to generate revenue.
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Conclusion
FRS 116 represents a fundamental shift in lease accounting, bringing long-overdue transparency to corporate balance sheets. While the transition requires careful planning and effort, the end result is a set of financial statements that more faithfully represent a company's economic reality. For businesses, understanding the nuances of this standard is no longer optional—it is an essential part of accurate financial reporting and maintaining clear communication with stakeholders.
KNOWLEDGE
