Implementing RKR R5: 5 Steps for Successful Lease Accounting in Municipalities

2024-12-04

Tiego has conducted a webinar on experiences from the implementation of RKR R5, organized by the Swedish Association of Municipal Economists (KEF). The Swedish Local Government Accounting Council (RKR) has for many years provided recommendations for leasing accounting, culminating in the publication of recommendation R5 in May 2023, followed by the idea paper “Leasing and Rental Agreement Accounting” in November 2023. Tiego has long provided solutions for the needs of businesses in group reporting and leasing accounting. Applying RKR is similar but has some distinct differences, which is why Tiego conducted this training. The goal was to give more municipalities and regions the opportunity to benefit from experiences and possibly consider using Tiego's systems and consulting services to comply with the regulations.

A survey was sent out before the training, with 14 municipalities/regions responding. Some of the questions and answers are summarized below. Responses were given with a number: 1: Not at all, 2: Partially, 3: Okay, 4: Good, 5: Very good.

Below is an excerpt from the respective sections of the webinar:

Part 1: Background and Regulations

Question A: How well did the 2023 annual report meet the updated RKR R5?

Answer A: Average score 2.1, with six respondents answering “1: Not at all.”

"The purpose of RKR R5 is to create neutral and comparable accounting, regardless of how municipalities and regions choose to finance their resource acquisitions. Case studies and other follow-ups have shown that practices vary regarding the accounting of leasing and rental agreements. According to K3, lessees must recognize all financial leasing agreements in the group balance sheet, which in practice has meant that only leasing of machines and cars has been included.

When RKR included what we refer to as the '80%-rule' together with otherwise relatively clear rules, this has led to more municipalities and regions beginning to apply or at least start projects to apply RKR R5."

80%-Rule: "If the present value of the minimum lease payments at the beginning of the lease period essentially equals the fair value of the asset, the lease agreement must always be classified as a financial lease. Essentially means 80% of the asset's fair value at the beginning of the lease period."

In addition to the 80%-rule, R5 states that a rental agreement should also be considered financial if:

1. There is a purchase option

2. The lease term covers the entire asset's life

3. The asset has a special design or is of strategic importance

4. Other situations/conditions exist that cause the lease agreement to be classified as financial.

"The consequence of the regulation is the need for municipalities and regions to assess the value of properties and estimate future events. The alternative to classifying a rental agreement as financial is to calculate the present value of all future payments using the municipality's/region's marginal borrowing rate."

Question B: How good is your data for solving the challenge of calculating the implicit interest rate (market value and market value at the end of the contract)?

Answer B: Average score 1.9, with seven answering "Not at all" and only three answering "Okay," "Good," or "Very good."

Comments from survey responses: “We do not use implicit interest rates but instead use Kommuninvest's interest rates + an internal markup for the municipal companies."

Part 2: The Five Steps for Implementing RKR R5

1. Gather the Basic Contract Information
"The following information needs to be collected, regardless of whether it is a rental agreement for a property, a machine, or a car, etc.: Company, Contract ID, Description, Categorization (usually one category per expense account), Start period, End period, Period length, Prepaid or postpaid payment, Interest calculation method (Implicit / Marginal borrowing rate), Monthly cost."

2. Follow a process for evaluation with categorization of contracts and decisions on whether the contracts are financial or operational
"To analyze whether the present value of future payments is greater than 80% of the market value, it is required to estimate the market value. If the lessor is within the municipal group, the book value should be used, but if the counterparty is external, a different method is required. It is up to each municipality/region to find its own method for valuation, and Tiego recommends documenting which method has been chosen."

"Proposed 'Market Value Types':
a) Value from a valuation company
b) Value based on square meter price x area
c) Book value
d) Value from sale and leaseback transaction
e) Value based on own assessment."

"To evaluate the 80%-rule, it is also necessary to assess the non-guaranteed value at the end of the contract. Tiego’s view is that the value should be assumed to be lower than the market value at the start of the agreement, i.e., no value appreciation should be assumed."

"Proposed 'End Value Types':
a) Future value from a valuation company
b) Future value based on square meter price x area
c) Future value based on depreciation of current value
d) Future book value
e) Future value according to purchase option
f) Future value own assessment."

Comments from survey responses: Municipality 2: To get the true value, we use the square meter price according to our investment calculations and then increase these annually with construction indices.

"Regarding the level of special customization, Tiego recommends documenting this and defining what different levels of customization mean for your municipality/region.
Proposed 'Types of Special Customization':

1. No customization

2. Some customization

3. Medium customization

4. Extensive customization."

"Also document other factors that may affect decisions on reasonable certainty for extensions with strategic importance. Finally, an estimated end period should be included per contract based on the evaluation and any comments."

3. Iteratively calculate the implicit interest rate with Excel or mathematical formulas
"Even if the municipality/region buys a system like the one Tiego offers, it is valuable to understand the mathematical formula for present value calculation and to be familiar with the Excel formula for this calculation."

Implicit Interest Rate:
Interest Rate = RATE(Number of payment periods; Negative Payment; Market Value; Negative Non-guaranteed Residual Value; Prepaid ‘1’/Postpaid ‘0’)
The implicit period interest rate is calculated as: (1 + Implicit Interest Rate)^(Payment Interval/12) - 1
Present value with implicit interest rate is calculated as: =PV(Interest Rate; Number of periods; Payment; Prepaid/Postpaid)

"If you create your own Excel file, it is unfortunately common to make mistakes regarding period interest rate. Note that the period interest rate is NOT obtained by dividing the implicit interest rate by 12 but is calculated using the above formula for the implicit period interest rate."

4. Choose a strategy when the implicit interest rate cannot be used
"RKR R5 advocates for using market value and non-guaranteed residual value to calculate the implicit interest rate, but if the inputs are misleading, Tiego's experience is that this can lead to interest rates that are far from market-based, causing odd effects in the income statement and balance sheet. If that is the case, there is a simpler method to use the municipality's/region's alternative borrowing rate to calculate the present value without being able to verify the 80% of market value. For these cases, other factors than the 80% rule need to be evaluated to determine if the contract should be classified as a financial contract."

"Tiego recommends evaluating contracts both with inputs for implicit interest rates and present values based on the marginal borrowing rate side by side in an Excel template."

5. Analyze the accounting consequences and create accounting documentation
"If the municipality/region invests in a leasing calculation system, there will likely be documentation per contract and for all contracts reported from the system, but we recommend analyzing the accounting consequences already during the contract inventory. By working this way, you can evaluate the contract based on implicit interest rate and alternative borrowing rate, which has been an appreciated method for several customers."

Example assumptions: Contract length 20 years, Monthly cost 250,000, Postpaid.
Value with implicit interest rate: Market value 50,000,000, Market value at end of contract = 30,000,000 (i.e., 2% depreciation), Implicit interest rate calculated as 4.76%, Present value 38,161,971.
Accounting entry: Asset & Liability: Debit / Credit 38,161,971, Depreciation Debit 1,908,099, Rental cost Credit 3,000,000, Interest Debit 1,816,197, i.e., an income effect Debit 724,296 (loss).
Value with marginal borrowing rate: Marginal borrowing rate 2.5%, Present value 46,767,487
Asset & Liability: Debit / Credit 46,767,487, Depreciation Debit 2,338,374, Rental cost Credit 3,000,000, Interest Debit 1,169,187, i.e., an income effect Debit 507,562 (loss).

Part 3: Do It Yourself or Use a System Solution

"Many municipalities/regions are faced with the choice of doing the work of accounting according to RKR R5 themselves or collaborating with a system provider. Tiego's suggestion is to carry out steps 1 to 5 yourself (possibly together with an accounting expert), and then collaborate with Tiego for steps 6-12."

Do it yourself (or possibly together with an accounting expert):

1. Inventory all basic information

2. Follow the steps for evaluation

3. Decide per contract if the information is sufficient for the implicit interest rate

4. Choose a base for the marginal borrowing rate

5. Create an understanding of accounting handling

Collaborate with Tiego and an accounting expert:
6. Send the inventory
7. Determine contract categories and accounts
8. Prepare for importing accounting entries
9. Prepare for group elimination of internal lease agreements
10. Practice and understand how the system handles new contracts, changes, and complexities
11. Analysis and creation of documentation
12. Presentation in the annual report

"Tiego is happy to conduct a workshop based on contracts sent to Tiego in the Excel format presented in this webinar (or other readable formats). Contact Tiego via the website’s 'Book a demo' to get access to the Excel file."

"The starting fee is based on the customer’s net revenue (for municipalities and regions including tax revenues) and the number of units. Tiego provides a quote within 24 hours, where the pricing model includes a starting fee based on the municipality's/region's size and a monthly fee depending on the number of contracts and users. Consulting fees are invoiced on an hourly basis."