«TABLE OF CONTENTS Introduction 3 Existing guidance and the rationale for change 4 The IASB/FASB project to date 5 The main proposals 6 Definition of ...»
NEED TO KNOW
Leases — A Project Update
2 LEASES - A PROJECT UPDATE
TABLE OF CONTENTS
Existing guidance and the rationale for change 4
The IASB/FASB project to date 5
The main proposals 6
Definition of a lease 6 When would a contract contain a lease? 6 What would be the lease term? 6 What would be a ‘significant economic incentive’? 7 Scope 8 Contracts that contain lease and non-lease components 8 Lessee accounting 9 Initial recognition and measurement 9 Subsequent accounting 10 Accounting for the lease 11 Presentation 15 Lessor accounting 16 Recognition and measurement 16 ‘Operating lease’ approach 19 Presentation 19 Amounts included in lease payments 20 Variable lease payments 20 Purchase options 21 Residual value guarantees 21 Term option penalties 21 Reassessment of the discount rate 22 Short term leases 22 Sale and leaseback transactions 22 Disclosure 23 Consequential amendments – business combinations 24 Transition 25 Lessees 25 Lessor 25
LEASES - A PROJECT UPDATE 3
finalised on the basis of decisions taken to date, a wide range of entities will be affected. In summary:
Lessees – Lessees would record assets and liabilities for a wide range of leases that are currently not recognised on balance sheet – For leases of items that are currently accounted for as operating leases, except for leases of real estate, the single amount currently included within operating results in the income statement will be split into operating and finance components – For leases of real estate, although assets and liabilities willbe recognised on balance sheet, the lease expense recognised in profit or loss will continue to be on the same basis as under IAS 17 Leases, in most cases resulting in a constant expense over the lease term.
Lessors – For many leases except most leases of real estate, lessors would adopt a ‘receivable and residual’ approach, with the leased asset being partially derecognised and a separate lease receivable being recognised – For leases of real estate, in many cases an approach similar to operating lease accounting in accordance with IAS 17 would be retained.
For some entities, the effect on their financial statements will be very significant, with this extending to include not only the statement of financial position (or balance sheet) but also their comprehensive income and cash flow statements. Although a finalised accounting standard is not expected to be effective on a mandatory basis before 2015, we now know enough about the IASB’s tentative decisions to have a fairly clear picture of the revised proposals. Given the extent of outreach and discussion with constituents, it appears likely that the revised exposure draft will contain many proposals that will be taken forward.
Consequently, entities should start to assess the effect of the proposals on their financial statements, and in particular the
consequent effect on related arrangements including:
– Lending agreements, including key ratios and covenants – Employee remuneration arrangements, including bonus schemes linked to reported profits and share-based payments; and – Investor communications.
The revised exposure draft is expected to be issued before the end of 2012, with a comment period of 120 days.
4 LEASES - A PROJECT UPDATE
EXISTING GUIDANCE AND
THE RATIONALE FOR CHANGEThe existing accounting models under both IFRS and US GAAP require lessees to classify their lease contracts as either finance (capital) leases or operating leases. Under a finance lease, a lessee recognises the leased asset on balance sheet together with a corresponding lease liability which is subsequently accounted for as a financing transaction. Under an operating lease, leased assets and related gross liabilities are not recognised, with only a lease expense being recognised in profit or loss (usually on a straight line basis over the lease term). Under IFRS, the distinction between a finance and an operating lease is based on whether the lease transfers substantially all of the risks and rewards associated with the leased asset to the lessee. Under US GAAP, although specified criteria are used to determine the classification, the result is typically the same as under IFRS although the US GAAP ‘bright line’ thresholds can result in differences for some transactions.
These models have been criticised for failing to meet the needs of users of financial statements, because, unless a lease is classified as a finance lease, rights and obligations that meet the definitions of assets and liabilities in the IASB and FASB conceptual frameworks are omitted from balance sheets. Transactions are frequently structured specifically to result in operating lease classification, and hence to avoid recording associated assets and liabilities. This leads to a lack of comparability and, because of the structuring of transactions to achieve a particular accounting result, to complexity. As a result, many users of financial statements adjust amounts presented in financial statements to reflect assets and liabilities arising from arrangements classified as operating leases.
LEASES - A PROJECT UPDATE 5
THE IASB/FASB PROJECT TO DATEIn order to address the criticisms set out above, the IASB and the FASB (the Boards) initiated a joint project to develop a new approach to lease accounting that would result in most, if not all, assets and liabilities arising from lease contracts being recognised in an entity’s statement of financial position. While the main focus was on lessee accounting, proposals were also developed for changes to lessor accounting. An exposure draft (the ED) was issued in August 2010 which set out an accounting approach based on the premise that lease contracts result in lessees obtaining the right to use an asset for a specified period (the ‘right of use’ model). The proposals were controversial, and the Boards received almost 800 comment letters.
In addition to publishing the ED for comment, the Boards:
– Initiated over 200 outreach meetings, including 7 round tables and 15 preparer workshops – Prepared questionnaires that were completed by over 250 lessors and over 400 lessees – Carried out targeted outreach during redeliberations with over 70 organisations.
There was general support for the proposed ‘right of use’ model. However, the feedback received also included many comments that the detailed approach proposed in the ED was too complex, inconsistent with the economics underlying certain transactions and, for many companies, excessively costly to implement. In particular, there were concerns about complexity of measurement, costs associated with required reassessments during lease terms, accounting for multi element contracts (contracts which contain lease and non-lease components) and the proposed lessor accounting model. During their redeliberations, the Boards have made significant changes to the proposals set out in the ED. Consequently, as noted above, the proposals will be re-exposed in order to provide interested parties with an opportunity to comment on revisions that the Boards have proposed.
BDO comment The Boards have addressed many of the concerns raised by constituents in response to the original proposals, and this has resulted in simplifications being made to the proposed model which would assist in making them more straightforward to implement. We welcome these developments. However, the proposals that we expect to be re-exposed for comment also include what some might regard as a compromise for leases of real estate. While we believe that the proposals would continue to bring a significant improvement to the quality of financial reporting, the extent of this improvement in accounting for leases of real estate would be more limited. The revised proposals for lessor accounting are also complex, and we anticipate that there may be calls for further simplification of the model in responses to the revised exposure draft.
6 LEASES - A PROJECT UPDATE
THE MAIN PROPOSALSThe main objective of the project has been maintained, which is that for most leases with a term of one year or more lessees will record assets and liabilities. There will be two approaches to be followed to determine the amounts to be recorded in profit or loss; one will result in a higher overall charge in the early periods of a lease due to the effect of finance charges on the lease liability which will decline as the obligation declines over the lease term, while the other will normally result in an overall constant charge to profit or loss over the lease term. The model to be followed will depend on the extent of consumption of the leased asset over the lease term.
For lessors, there will also be two approaches which will be based on the same classification criteria used by lessees. One approach will result in the recording of the sale of part or all of the leased asset, while the other will result in accounting that is similar to current guidance for operating leases.
BDO comment We believe that clear application guidance will need to be included in the revised proposals, in particular in respect of the new concept of the ‘extent of consumption of the leased asset’, as the accounting result under each of the two approaches may be significantly different.
DEFINITION OF A LEASEWhen would a contract contain a lease?
An entity would determine whether a contract contains a lease on the basis of the substance of the contract, by assessing whether the fulfilment of the contract depends on the use of a specified asset (an asset that is explicitly or implicitly identifiable) and whether the contract conveys the right to control the use of that specified asset for a period of time. A right to control the use of an asset is conveyed if the lessee has the ability to direct the use, and receive the benefit from that use throughout the lease term.
The requirement for the arrangement to cover a specified asset is an important distinction, as it means that it would be necessary to be able specifically to identify the asset (for example, an item of plant and machinery or a building). A physically distinct portion of a larger asset could also be a specified asset (for example, the first floor of a building, floors 10 to 15 of a 20 storey building or an indentified 100 square metre area of a 1,000 square metre commercial space). However, if a portion of an asset cannot be specifically identified (for example, a specified proportion of the capacity of a pipeline or of a fibre optic cable network) that portion is not a specified asset.
What would be a ‘significant economic incentive’?
In assessing whether there is a significant economic incentive to exercise an extension or termination option, a lessee and a lessor would consider contract-based terms (terms that are included in the lease contract), asset-based factors (for example significant leasehold improvements made by the lessee that might have material value when a lease extension option is due to be exercised and would be lost if the lessee exercised the termination option) and entity-based factors (for example management intent). All these factors would be considered together and the existence of only one factor would not necessarily, by itself, signify a significant economic incentive to exercise an option.
The lease term would be reassessed only when there is a significant change in relevant factors, meaning that the lessee would either now have, or no longer have, a significant economic incentive to exercise an option.
The thresholds for evaluating a lessee’s economic incentive to exercise options to extend or terminate a lease and options to purchase the underlying asset would be the same for both initial and subsequent assessment. However, changes in market rental rates after lease commencement would not be included in the analysis.
BDO comment The Boards’ decision to exclude future changes in market rental rates from the analysis when reassessing whether there is a significant economic incentive to exercise options to extend or terminate a lease might initially seem odd. However, this was in response to comments received by the Boards that, if changes in market rental rates were included in the analysis, this could result in excessive complexity in financial reporting. This is because the effect could be excessive volatility in the carrying amounts of assets and liabilities, as part or all of the arrangements subsequently fell within or moved outside the recognition threshold.
What is not yet entirely clear from the Boards’ discussion is the linkage between market rental rates and management intent, as the latter would be taken into account. The IASB Staff included the following example to support the decision to exclude
changes in market rental rates (IASB Board paper, May 2011):
Lessee A has a 10-year lease for its corporate headquarters in a large metropolitan area with annual payments of CU150,000.
The lease has a 5-year renewal option at the same annual payment of CU150,000. During the 10 years, the following occurs to
annual market rates for the lease of comparative real estate:
(a) At the end of year 3, there is an increase in demand. The annual market rate increases to CU300,000.
(b) At the end of year 6, a local recession drives the annual market rate to CU50,000 per year.
(c) At the end of year 8, because of tax incentives instituted by the local jurisdiction to stimulate the economy, an increase in demand results in the market rate increasing to CU320,000 per year.