New on the Horizon: Leases

Transcription

1 IFRS New on the Horizon: Leases May 2013 kpmg.com/ifrs

2 Contents Leases on-balance sheet but at what cost? 1 1. The proposals at a glance Key facts Key impacts 3 2. Overview and effective date 4 3. When to apply the proposals Identification of a lease Scope Multiple component arrangements 9 4. Lease classification Classification tests Applying the classification tests Multiple underlying assets in a single lease component Combined leases of land and buildings Accounting models for lessees Overview Initial measurement of the lease liability Initial measurement of the ROU asset Subsequent measurement of the liability Subsequent measurement of the ROU asset Presentation Accounting models for lessors Overview Lessor accounting for Type A leases Lessor accounting for Type B leases Other lease accounting issues Sale and leaseback transactions Sub-leases Investment property Lease modifications Disclosures General disclosure objective Additional disclosures for lessees Additional disclosures for lessors Transition Lessee approach to transition Lessor approach to transition Practical expedients 54 About this publication 55 Content 55 Acknowledgements 55 Keeping you informed 55

3 New on the Horizon: Leases 1 Leases on-balance sheet but at what cost? In their revised exposure draft (ED) on Leases, the IASB and FASB (the Boards) propose fundamental changes to lease accounting which would bring most leases on-balance sheet for lessees. Bringing leases on-balance sheet is a cherished goal of the standard setters. These proposals would achieve that goal. Many lessee companies would see an increase in reported assets and liabilities, and the proposals would have significant impacts on many different lease transactions ranging from leases of big-ticket items such as manufacturing facilities and aircraft, to leases of office space and smaller items such as company cars and computers. In addition to bringing most leases on-balance sheet for lessees, the proposals would also introduce new lease classification tests resulting in a dual model for both lessees and lessors. This would preserve straight-line expense recognition for most leases of property i.e. land and/or buildings similar to operating leases today. However, there would be interest and amortisation expense recognition for most other leases, similar to finance leases today i.e. lease expense would not be recognised on a straight-line basis. The dual model for leases is inconsistent with the Boards initial objective of introducing a single lease accounting model. This is a major compromise by the Boards, designed to make the proposals more palatable when applied to leases of property. The transition to the new proposals would require all existing leases and potential lease contracts to be re-analysed. There would also be an ongoing need for increased monitoring of leases to comply with the reassessment requirements. For some particularly lessors and lessees with large existing leasing portfolios the system changes required are likely to be significant. Implementing these proposals would be a real challenge for many organisations, as they would need to identify all their leases, extract key data, make new estimates and judgements, and perform new calculations. Companies will also need to consider how these proposals would affect their organisation and business practices. The proposals would impact a company s ability to accurately predict and forecast assets and liabilities, due to the requirement to reassess certain key estimates and judgements at the end of each reporting period. Such volatility could have a significant impact on a company s compliance with debt covenants, its tax balances and its ability to pay dividends. Lessor accounting proposals involve considerable complexity, particularly for most leases of assets other than property. The Boards have made a strong case that it is time to improve lease accounting. Some will see the proposed changes as a step forward. Others will see cost, complexity and conceptual compromise. Indeed, members of both the IASB and the FASB have dissented from the proposals. Ultimately, it is not clear whether these specific proposals will satisfy financial statement users or whether this is the best way to take forward this important project. We hope that this publication will assist you in gaining a greater understanding of the revised proposals. We encourage you to join in the debate and to provide the Boards with your comments by the deadline of 13 September Wolfgang Laubach Kris Peach Ramon Jubels Brian O Donovan KPMG s global IFRS leases, investment property and service concessions leadership team KPMG International Standards Group

4 2 New on the Horizon: Leases 1. The proposals at a glance 1.1 Key facts The IASB and FASB published ED/2013/6 Leases (the ED or the proposals) on 16 May The ED proposes new dual accounting models for lessees and lessors, and new lease classification tests to determine which of the accounting models to apply. A key objective of the proposals is to ensure that lessees recognise the assets and liabilities arising from leases. Lease identification. A lease would be a contract that conveys the right to use an identifiable asset for a period of time in exchange for consideration. The criteria for identifying a lease would be based on rights to control the use of specified assets. Lease classification. Many property leases would be Type B leases with straight-line recognition of lease income/expense. Many leases of other assets would be Type A leases with front-loaded recognition of lease income/expense. Lessee accounting. Recognise a right-of-use (ROU) asset (representing the right to use the underlying asset) and a lease liability (representing the obligation to make lease payments). For Type B leases, measure the ROU asset as a balancing figure to achieve a straight-line expense profile. Lessor accounting Type A leases. Derecognise the underlying asset and recognise a lease receivable and residual asset. Lessor accounting Type B leases. Continue to recognise the underlying asset and recognise lease payments as income (similar to current operating lease accounting). Short-term leases. There would be an exemption for leases with a maximum term, including renewal options, of 12 months or less. Transition. The new standard could be applied retrospectively, or a modified retrospective approach could be followed. Effective date. The ED does not propose an effective date for the new standard. However, it seems unlikely that entities would be required to adopt the new lease requirements before the effective date of the Boards new standard on revenue recognition, which is 1 January The proposed new standard would replace IAS 17 Leases, IFRIC 4 Determining whether an Arrangement contains a Lease, SIC 15 Operating Leases Incentives and SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease. In addition, there would be significant consequential amendments to IAS 40 Investment Property. The comment deadline for the ED is 13 September The Boards plan to undertake further outreach and to hold public round-table meetings and plan an additional consultation on the effective date of this and other new standards.

5 New on the Horizon: Leases Key impacts Identifying all lease agreements and extracting lease data. All leases longer than 12 months, including all renewal options, would be recognised on-balance sheet. It may require substantial effort to identify all lease agreements and extract all relevant lease data necessary to apply the proposals. In order to apply the simplified model for short-term leases, a company would need to identify the lease and extract key lease terms. Changes in key financial metrics. Key financial metrics would be affected by the recognition of new assets and liabilities; and differences in the timing and classification of lease income/expense. This could impact debt covenants, tax balances and a company s ability to pay dividends. New estimates and judgements. The proposals introduce new estimates and judgemental thresholds that would affect the identification, classification and measurement of lease transactions. Senior staff would need to be involved in these decisions both at lease commencement and at reporting period ends as a result of the continuous reassessment requirements. Balance sheet volatility. The proposals would introduce volatility to assets and liabilities for lessees, and for lessors in Type A leases, due to the proposed requirements to reassess certain key estimates and judgements at each reporting date. This may impact a company s ability to accurately predict and forecast results. Changes in contract terms and business practices. In order to minimise the impact of the proposals, some companies may wish to reconsider certain contract terms and business practices e.g. changes in the structuring or pricing of a transaction, including lease length and renewal options. The proposals are therefore likely to affect departments beyond financial reporting including treasury, tax, legal, procurement, real estate, budgeting, sales, internal audit and IT. New systems and processes. Systems and process changes may be required to capture the data necessary to comply with the new requirements, including creating an inventory of all leases on transition. The complexity, judgement and continuous reassessment requirements may require additional resources and controls focused on monitoring lease activity throughout the life of leases. Communication with stakeholders will require careful consideration. Investors and other stakeholders will want to understand the impact of the proposals on the business. Areas of interest may include the effect of the proposals on financial results, the costs of implementation and any proposed changes to business practices.

6 4 New on the Horizon: Leases 2. Overview and effective date The following diagram illustrates how key elements of the proposals are explained throughout this publication. The corresponding section numbers are in brackets. Determine when to apply the proposals Identify the lease (3.1) Assess whether the lease is within scope (3.2) Separate the lease and non-lease component(s) and allocate consideration (3.3) Classify the lease as Type A or Type B Apply the lease classification tests (4.1 2) If the lease component covers multiple assets, determine the primary asset (4.3) Special considerations for leases of land and buildings (4.4) Apply the lease accounting models Lessee accounting Overview (5.1) Recognition and initial measurement (5.2 3) Subsequent measurement (5.4 5) Presentation (5.6) Lessor accounting Overview (6.1) Type A leases (6.2) Type B leases (6.3) Apply other guidance if relevant Sale and leaseback transactions (7.1) Sub-leases (7.2) Investment property (7.3) Lease modifications (7.4) Prepare the necessary disclosures (8) Prepare for transition (9) The ED does not propose an effective date for the new standard and does not specify whether early adoption would be permitted. However, it seems unlikely that entities would be required to adopt the new lease requirements before the effective date of the Boards new standard on revenue recognition. The Boards have decided tentatively that the new revenue standard would be effective for annual periods beginning on or after 1 January Early adoption of the revenue standard would be permitted under IFRS but not under US GAAP.

7 New on the Horizon: Leases 5 3. When to apply the proposals 3.1 Identification of a lease Basic definition ED 6 The proposals define a lease as, A contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Right to use underlying asset Lessor Underlying asset Lessee Right-of-use asset Consideration (lease rentals) ED 7 A lease would exist if both of the following conditions are met: fulfilment of the contract depends on the use of an identified asset; and the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration. Observations Lease identification is a key judgement Identifying whether an agreement is or contains a lease would be a key judgement when implementing the proposals, particularly for lessees. In effect, there is a new bright-line between leases (on-balance sheet for lessees) and service contracts (off-balance sheet for lessees). This would remain the case for as long as the basic accounting requirements for leases and executory contracts remain fundamentally different Lease definition A closer look ED 11 ED 12 Factors to consider when applying the lease definition include the following. l l Portions A portion of an asset could be an identified asset if it is physically distinct. For example, a floor of a building could be an identified asset. However, a portion of the capacity of a pipeline would not be an identified asset, because it is not physically distinct unless the capacity portion comprises substantially all of the output of the asset. Control A contract would convey the right to control the use of the identified asset if the customer has the ability to direct the use of the asset and derive the benefits from its use throughout the term of the contract.

8 6 New on the Horizon: Leases ED ED 19 ED 9, BC105(b) l l l Directing the use In order to have the ability to direct the use, a customer needs to be able to make decisions about the use of the asset that most significantly affect the economic benefits to be derived from the use of the asset e.g. determining for what purpose the asset is employed and how the asset is operated. Deriving the benefits A customer would not be able to derive the benefits from use of the asset if it can only obtain those benefits in conjunction with the use of other goods or services that are not sold separately by the supplier or any other supplier, and the asset is incidental to the delivery of services because it is designed to function only with those other goods or services. Substitution A contract would not contain a lease if a supplier has a substantive right to substitute the underlying asset at any time during the term of the contract. A supplier s right to substitute an asset is substantive if the supplier can substitute an alternative asset without requiring the customer s consent and there are no economic or other barriers that would prevent the supplier from substituting an alternative asset. Observations New definition may change which arrangements are identified as leases At first glance, the basic elements of the lease definition appear similar to current requirements in IFRIC 4. However, the clarifications and examples included in the ED may lead to different conclusions about whether a lease exists in some important cases. For example, some power purchase agreements that are identified as leases under IFRIC 4 may not be leases under these proposals. This is because the ED s approach to control has a greater focus on the purchaser s ability to direct the use of the underlying asset than IFRIC 4. So an agreement under which an entity agrees to purchase all of the electricity from a power plant but does not control the operations of the power plant might be a lease under IFRIC 4 but not under the ED. In other cases, assets that are incidental to services would not be in the scope of the proposals as the customer would only be able to derive the benefits from the use of the service, which is not sold separately. For example, a season ticket for a sports stadium may identify a specific seat but would not be a lease as use of the seat is an inseparable part of the overall service being provided. The ED includes an explicit statement that a supplier s right to substitute an asset is not substantive whenever customer consent is required. Often, some form of consent will be required whenever a supplier wishes to enter a customer s premises to service or replace an asset. If the Boards intend that such routine forms of consent would mean that a supplier s right of substitution is not substantive, then this could increase the number of arrangements that are identified as leases. Applying the revised definition would require entities to revisit all of their existing agreements to assess whether they are or contain leases. This exercise would require new judgements to be made in many cases. For the proposals to be implemented consistently, entities would need to reach similar conclusions on which agreements contain leases. Greater consistency of implementation may be achieved by slight clarifications to the generally well understood requirements of IFRIC 4.

9 New on the Horizon: Leases Scope Scope, exclusions and exemptions ED 4 5, The ED proposes a number of scope exclusions, and comments on agreements that would be in the scope. Some leases are excluded from the scope of the proposals; others are subject to specific exceptions. Contracts that meet the definition of a lease Within scope In scope with exceptions Outside scope Leases of assets Long leases of land Sale and leasebacks Sub-leases In-substance purchases/ sales Leases of inventory Leases of non-core assets Leases with service components Short-term leases (less than 12 months) Leases of intangibles (for lessees) Leases of: Intangibles for lessors Natural resources and exploration Biological assets Service concession arrangements ED B12 14 ED BC If a lessee incurs costs relating to the construction or design of an underlying asset before it is available for use, then the lessee would account for those costs in accordance with applicable IFRSs. In addition, the ED proposes that a lease that is assessed to be onerous between the dates of inception and commencement would be in the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Observations Scope similar to current practice with some important differences The scope of the proposals is broadly similar to current practice, with the following key differences. Short-term leases Lessees and lessors would be able to apply a simplified approach to short-term leases (see 3.2.2). Intangible assets other than ROU assets The IASB proposes that a lessee need not apply the lease models to leases of intangible assets. Leases of intangible assets would be outside the scope of the proposals for lessors as the new revenue standard will contain guidance on licensors. The ED proposes these exemptions because the Boards believe that the accounting issues associated with leases of intangible assets are too complex to address comprehensively. The rationale for exempting leases of biological assets is that the fair value model under IAS 41 Agriculture provides relevant information to financial statement users. The ED does not seek to address whether there is a general conceptual case for exempting from the proposals leases of assets measured at fair value through profit or loss. The Boards have rejected proposals to simplify implementation by excluding leases of non-core assets, noting that IFRS does not generally distinguish between core and non-core assets. This would increase the implementation burden for some.

10 8 New on the Horizon: Leases Short-term leases ED , App A The ED proposes that entities could elect not to apply the proposed new accounting models to shortterm leases. A short-term lease would be defined as a lease that: has a maximum possible term under the contract, including any options to extend, of 12 months or less; and does not contain an option permitting the lessee to purchase the underlying asset. Example Short-term leases Scenario Lessee A leases a car from Lessor B for 12 months. The lease does not contain a renewal or purchase option. Lessee A leases a car from Lessor B for 12 months. The lease contains a renewal option for a further 6 months which A does not expect to exercise. Lessee A leases a car from Lessor B for an indefinite period. A can return the car by giving one month s notice but expects to return the car after 12 months. Lessee A leases a car from Lessor B for 15 months, which represents A s operating cycle under IAS 1 Presentation of Financial Statements. Short-term? Yes maximum possible term of 12 months No maximum possible term of 18 months (the lessee s intention is not relevant to the analysis) No maximum possible term is indefinite No maximum possible term of 15 months ED BC ED A lease in which both the lessee and the lessor must agree to extend the lease beyond the noncancellable period would meet the definition of a short-term lease if the non-cancellable period, together with any notice period, is less than 12 months. However, if only one party has the right to terminate the lease, or if the lessee has the right to extend the lease without agreement of the lessor, then the parties would be required to include optional periods in the assessment of the lease term as there are enforceable rights and obligations beyond the initial non-cancellable period. The election not to apply the proposed accounting models to short-term leases would be available by class of underlying asset and would result in the following simplified accounting approach. No lease assets or lease liabilities recognised Lessee Recognise lease payments in profit or loss over lease term, generally on a straightline basis No lease receivables and residual assets recognised Lessor Continue to recognise the underlying asset Recognise lease payments in profit or loss over lease term, generally on a straightline basis

11 New on the Horizon: Leases 9 Observations A simplified approach but substantial efforts required to identify relevant leases Without the exemption for short-term leases, the proposals would require lessees to recognise onbalance sheet many small ticket items that previously may have been clearly classified as operating leases under IAS 17. Under the exemption an entity could elect to account for such leases using a model based on current operating lease accounting. In some cases, lessees may seek to negotiate the terms of new leases to qualify for the simplified approach. Taking advantage of this exemption would still require substantial effort by entities; an entity would need to identify the lease and the key lease terms including the details of any renewal and purchase options to confirm whether the lease meets the definition of a short-term lease. 3.3 Multiple component arrangements Identifying separate lease components ED If a contract contains a lease, then an entity would identify each separate lease component within the contract. A right to use an asset would be a separate lease component if both of the following criteria are met: the lessee can benefit from use of the leased asset either on its own or with readily available resources i.e. goods or services that are sold or leased separately or resources that the lessee has already obtained; and ED the leased asset is neither dependent on, nor highly inter-related with, other underlying assets in the contract. Combined leases of land and buildings are discussed in 4.4. A single contract may contain several lease components and may also contain non-lease components. After identifying the separate lease components, lessees and lessors evaluate whether to account for the lease components separately and, if so, how to allocate the consideration as follows. When the purchase price (PP) or selling price (SP) of each component is an observable standalone price 1 When the PP/SP of one or more, but not all, components are observable stand-alone prices When no observable stand-alone prices for any of the components in the arrangement are available Note Lessee Separate and allocate based on a relative stand-alone price basis Separate and allocate using the residual method All lease Lessor Always separate and allocate using guidance in the Boards forthcoming joint revenue recognition standard i.e. on a relative selling price basis 1 An observable stand-alone price is a price that the lessor or similar supplier charges for a similar lease, good, or service component on a stand-alone basis.

12 10 New on the Horizon: Leases Example Allocation of consideration between lease and non-lease components Lessor C leases a specialised machine for two years, and provides consulting services. The machine is not sold or leased separately by C and there are no similar machines for sale or lease from other suppliers. The contract is for fixed consideration of 180,000. Lessor Because C does not sell or lease the specialised machine, or provide substantially equivalent consulting services separately, C would separate the lease and non-lease components and allocate the consideration in the contract based on estimated selling prices. C determines that it will utilise an expected cost-plus-margin approach with respect to the machine because its specialised nature precludes the use of a market-based assessment approach i.e. there are no similar machines for sale or lease to assess. C will utilise a market-based assessment approach for the services based on similar services offered in the consulting marketplace. As a result, C allocates contract consideration as follows. Estimated stand-alone Allocated Component price consideration Machine lease 160, ,000 Consulting services 40,000 36, , ,000 Lessee Lessee D does not have an observable stand-alone price for the leased machine. However, similar consulting services are sold on a stand-alone basis by alternate service providers; therefore, D is able to obtain an observable stand-alone price for the services, which is 40,000 i.e. the same as C s estimated selling price as noted above. Therefore, D would allocate 40,000 to the consulting services i.e. the observable stand-alone price and 140,000 (180,000-40,000) to the machine lease as the residual amount. Observations Agreements containing lease and service components are common Many agreements contain service and lease components. Under current IFRS, the service components are typically treated as executory contracts. When an arrangement contains a lease and a service component, IFRIC 4 requires an entity to separate the payments between the two components on the basis of their relative fair values, which is the general approach proposed in IASB s proposed revenue standard, ED/2011/6 Revenue from Contracts with Customers, for allocating the transaction price to separate performance obligations. The proposals provide an incentive for lessees to clearly identify the pricing of the lease asset and the service, as the penalty for a lessee not being able to identify the stand-alone price of at least one element is that the whole arrangement would be treated as a lease i.e. both the lease and service would be on-balance sheet.

13 New on the Horizon: Leases Lease classification 4.1 Classification tests ED The ED proposes new lease classification tests to determine whether a lease is a Type A lease or a Type B lease. The accounting models for each type of lease are discussed in Sections 5 and 6. Both lessees and lessors would apply the same lease classification tests. To classify a lease, the entity first considers the nature of the underlying asset in the lease i.e. whether the underlying asset is property (land and/or a building) or non-property. In many cases, this will determine the lease classification. No Is the underlying asset property (land and/or a building)? Yes Type A lease Type B lease The presumption that a lease of a non-property asset is a Type A lease is rebutted if: the lease term is for an insignificant part of the total economic life of the underlying asset; or the present value of the lease payments is insignificant relative to the fair value of the underlying asset at the commencement date. The presumption that a lease of property is a Type B lease is rebutted if: the lease term is for the major part of the remaining economic life of the underlying asset; or the present value of the lease payments is substantially all of the fair value of the underlying asset at the commencement date. However, in all cases, if the lessee has a significant economic incentive to exercise an option within the lease to purchase the underlying asset, then the lease is classified as a Type A lease. To assess the above criteria, an entity would be required to make initial estimates of the lease term and the present value of the expected lease payments. See 5.2 for a discussion on determining the lease payments and for a discussion on the initial determination of the lease term. Observations Fundamental changes to current lease classification The proposed lease classification tests are fundamentally different from the current risks and rewards approach in IAS 17. They also perform a different role as, for lessees, the outcome of the classification tests would no longer determine whether a lease is recognised on-balance sheet but instead, would affect the profile of lease expense recognised over the lease term (see Section 5). The new tests would be based on the extent of the lessee s consumption of the underlying asset and the nature of the underlying asset. In many cases, the outcome of the lease classification tests would be clear, with the nature of the underlying asset being the dominant consideration: most leases of assets other than property i.e. not land or a building would be Type A leases; and most leases of property i.e. land and/or a building would be Type B leases.

14 12 New on the Horizon: Leases Lessees and lessors would apply these tests only at lease commencement and when accounting for a new lease following a lease modification. Therefore, no change in lease classification would occur upon the exercise of an option, which at lease commencement the lessee did not have a significant economic interest to exercise, or change in likelihood related to a contingent feature included in the lease as these are not modifications. This may motivate lessees and lessors to design lease contracts that limit the need for future modifications and avoid changes in the original lease classification. It will also place more weight on the initial judgements made by lessees and lessors at lease commencement. An entity does not have to apply the lease classification tests if the lease qualifies as a short-term lease and the entity elects as an accounting policy not to apply the recognition and measurement proposals (see 3.2.2). 4.2 Applying the classification tests Leases of assets other than property Application of the new lease classification tests to a lease of an underlying asset other than property i.e. not land and/or a building can be illustrated as follows. Example Non-property lease classification A lessee enters into a 2-year lease for an item of manufacturing equipment that has a total economic life of 12 years at the commencement date. The lease payments are 10,000 per year; their present value is 18,500, calculated using the rate that the lessor charges the lessee in the lease. The fair value of the property at the commencement date is 60,000. This would be a Type A lease because: the underlying asset is not property; the lease term is for more than an insignificant part of the total economic life of the equipment (2 / 12 = 16.7%); and the present value of the lease payments is more than insignificant relative to the fair value of the equipment at the commencement date (18,500 / 60,000 = 30.8%). Note that this would be a Type A lease if either the second or third criteria above were met; it is not necessary to meet both criteria. Observations Many current operating leases of equipment will be Type A The lease in the example would probably be classified as an operating lease under IAS 17 but as Type A under the proposals. This is likely to be the case for many current operating leases of assets other than property, from big ticket items such as aircraft to smaller items such as cars and photocopiers. The ED does not provide bright-line quantitative thresholds on what constitutes an insignificant part of the total economic life or an insignificant amount of the fair value of the underlying asset when performing the classification test for assets other than property. Illustrative Example 12 in the ED suggests that 16.6% and 27.8% of the economic life and present value, respectively, would not be deemed to be insignificant. However, it is not clear how much lower than these percentages the outcome needs to be to satisfy the insignificant criteria.

15 New on the Horizon: Leases Leases of property ED App A The ED defines property as land or a building, or part of a building, or both. Application of the new lease classification test to a lease of property can be illustrated as follows. Example Property lease classification A lessee enters into a 10-year lease of a retail space that has a remaining economic life of 30 years at the commencement date. The lease payments are 50,000 per year; their present value is 465,000, calculated using the rate that the lessor charges the lessee in the lease. The fair value of the property at the commencement date is 650,000. The lease does not contain a purchase option. This would be a Type B lease because: the lease does not contain an option for the lessee to purchase the underlying asset; the underlying asset is property; the lease term is not for a major part of the remaining economic life of the property (10/30 = 33.3%); and the present value of the lease payments does not account for substantially all of the fair value of the property (465,000/650,000 = 71.5%). Observations Many property leases will be Type B The lease classification tests have in large part been constructed so that most property leases would be Type B, preserving the straight-line pattern of lease income/expense that is familiar from current operating lease accounting for many property leases (see Sections 5 and 6) and a version of current operating lease accounting for property lessors (see 6.3). The ED s proposals for classification of property leases are at odds with the Boards principle that lease classification should reflect the extent of consumption of the underlying asset. Property is only considered Type A when the lease comprises a major part of the remaining useful life and/or substantially all of the fair value of the underlying asset, rather than when a more than insignificant amount of the underlying asset is used. The ED does not provide bright-line quantitative thresholds on what constitutes a major part of the remaining economic life or substantially all of the fair value of the underlying asset when performing the classification test for assets of property. Illustrative Example 13 in the ED does provide some guidance, suggesting that 37.5% and 75% of the economic life and fair value, respectively, would not be deemed to meet the major part and substantially all thresholds. It is not clear how much higher these percentages could be before meeting these criteria.

16 14 New on the Horizon: Leases Property vs non-property The following example illustrates the importance of the nature of the underlying asset to the outcome of the lease classification tests. Example Underlying asset lease classification A lessee enters into a 7-year lease of an underlying asset which has a total and remaining economic life of 30 years at the commencement date. The lease payments are 60,000 per year; their present value is 390,000, calculated using the rate the lessor charges the lessee. The fair value of the asset at commencement date is 560,000. The lease does not contain a purchase option. If the underlying asset is non-property e.g. a ship or aircraft it is determined that the lease is a Type A lease because of the following factors: the lease term is for more than an insignificant part of the total economic life of the asset (7 / 30 = 23.3%); and the present value of the lease payments is more than insignificant relative to the fair value of the asset at commencement date (390,000 / 560,000 =69.6%). However, if the underlying asset is property e.g. an office building then it would be a Type B lease because: the lease term is not for a major part of the total remaining economic life of the property (23.3%); and the present value of the lease payments does not account for substantially all of the fair value of the property (69.6%) at commencement date. Observations Economically similar leases may be classified differently As shown above, economically similar arrangements i.e. having similar lease terms and lease payments would be accounted for differently under the proposals depending on whether the underlying asset is property. The proposals do not define major part or insignificant part of the economic life or substantially all or insignificant relative to for the purposes of evaluating the lease classification tests. In some cases, these thresholds would be key to lease classification. The following is a summary of the terminology used in current IAS 17 compared with the new terminology from the ED proposals. Criterion IAS 17 Non-property Property Economic life Major part Insignificant part Major part PV of lease payments Substantially all Insignificant Substantially all Exercise of purchase options Reasonably certain Significant economic incentive Significant economic incentive It is not clear whether the Boards intend the new terms to have the same meaning as the functionally similar terms in IAS 17, including when the terminology is the same. Whilst major part and substantially all appear similar to the existing criteria in IAS 17, it is the abuse of these criteria and a bright-line approach that has generated much of the concern regarding the use of leases for off-balance sheet financing.

17 New on the Horizon: Leases Multiple underlying assets in a single lease component ED 32, BC If a separate lease component includes more than one underlying asset, then the entity should determine the primary asset within the lease component. The entity would then perform the lease classification tests based on the nature of the primary asset. This would include, for example, determining whether the primary asset was property or non-property and hence which lease classification test to apply. The primary asset would be determined as being the predominant asset for which the lessee has contracted for the right of use. The purpose of any other assets may simply be to help the lessee obtain the benefits associated with the use of the primary asset. Example Primary asset ED IE5-Ex.10 A lessee enters into a lease for a turbine plant, which contains a large turbine within a building, including the land which the building is located on. The turbine is used to generate electricity. In this case, the main purpose for the lessee entering into the lease is to obtain power generated by the turbine. The building enables the lessee to obtain the benefits from use of the turbine. As such, the primary asset in this case would be the turbine and not the building or land. Accordingly, the lessee would apply the classification test based on the underlying asset as non-property (being the turbine), and use the economic life of the turbine when applying the economic life test. Observations Identifying the primary asset requires judgement Determining which of the assets is the primary asset in a lease may be difficult in practice, and in some cases, will require a significant amount of judgement. For example, consider a lease of a port, which includes: land elements e.g. an on-site rail system, storage yard and water frontage; building elements e.g. an office and a warehouse; and equipment e.g. cranes, trucks and forklifts, and spare parts. In this case, it will first be necessary to identify the separate lease components. For example, it may be the case that the trucks, forklifts and spare parts would be deemed to be separate lease components, and therefore accounted for separately. However, it is likely there would remain a lease component that covered a broad range of port assets, including land, buildings and equipment. It is not immediately clear which asset is the primary asset i.e. the predominant asset for which the lessee has contracted for the right of use. The lessee s intent may be clear it has contracted for the right to use a port. Many elements are highly inter-related and the lessee benefits from the bundle. But is the primary asset property or non-property? This determination would require a significant amount of judgement at lease commencement and would have a significant impact on the subsequent accounting. Similar to lease classification, the assessment of the primary asset is made only at lease commencement and is not reassessed unless the contract is modified. Therefore, the primary asset would not change if the lessee makes a subsequent change to its business model or use of the underlying assets. This would place more weight on the initial judgements made by lessees and lessors at lease commencement.

18 16 New on the Horizon: Leases 4.4 Combined leases of land and buildings ED 33 If a lease component contains land and a building, then an entity would use the economic life of the building when assessing whether the lease term was for the major part of the economic life of the underlying asset for the purposes of lease classification. Observations No requirement to split combined leases of land and buildings In the case of a combined lease of land and building, under IAS 17 the land and building are considered separately to determine the lease classification, with certain exceptions. In determining the classification, the minimum lease payments at inception of the lease are allocated to land and buildings in proportion to their relative fair values. Generally this results in the land being assessed as an operating lease and the building as either an operating or finance lease depending on the terms and conditions. This split would not be a requirement under the current proposals. Instead, the requirement to use the life of the building as the life of the property means that many building leases currently classified as finance leases would also meet the Type A criteria and because land and building elements would no longer be separated both the land and building would be classified as Type A.

19 New on the Horizon: Leases Accounting models for lessees 5.1 Overview ED 37 The ED proposes that lessees account for Type A and Type B leases on-balance sheet; by recognising an ROU asset and a lease liability. The differences between the two accounting models relate primarily to the subsequent measurement of the ROU asset (see 5.5) and presentation of lease expense (see 5.6). Statement of financial position Statement of profit or loss Profile of total lease expense Type A leases (non-property) ROU asset Lease liability Amortisation of ROU asset (operating expense) Interest expense on lease liability (finance expense) Front-loaded Type B leases (property) ROU asset Lease liability Lease expense (operating expense) Straight-line Observations Wide-ranging consequences for lessees The ED s focus on the ROU model for lessees is consistent with previous proposals. Headlines to the effect that all leases will become finance leases or changes to lease accounting mean that debt will soar have been commonplace for some years. The ED represents a further step towards the onbalance sheet treatment of leases by lessees. Analysts routinely adjust lessees reported financial figures to reflect commitments under leases that are currently classified as operating leases, based on amounts disclosed in accordance with IAS 17 and IFRS 7 Financial Instruments: Disclosures. Following the ED s publication, many are likely to focus on the extent to which the lease balances that would be recognised under the ED s proposals would provide useful incremental information to users. The proposed requirement to recognise additional assets, liabilities and finance expense would be likely to affect key performance ratios e.g. tangible asset ratios and debt/equity ratios and consequently the ability to satisfy debt covenants. Entities currently renegotiating debt arrangements may wish to seek flexibility in determining appropriate debt covenants, to minimise the impact of the new leases standard when it becomes effective. Recognising additional assets and liabilities might also affect the results of impairment tests of the cash-generating units that include the leases.

20 18 New on the Horizon: Leases Tax considerations are often a major factor when an entity is assessing whether to lease or buy an asset, and when a lessor is pricing a lease contract. However, like IAS 17, the ED addresses lessee and lessor accounting on a pre-tax basis. The income tax accounting for lease contracts would remain in the scope of IAS 12 Income Taxes. At present, depending on the treatment allowed by the tax authorities, complexities can arise in accounting for income taxes by lessees on finance leases in particular. Complexities can include, for example, how to apply the initial recognition exemption and whether the finance lease asset and liability should be considered to be linked for the purposes of the income tax analysis. Lessees are likely to encounter similar issues under the proposals, because the lessee would recognise an asset and liability for all leases other than some short-term leases. In addition, depending on jurisdictional tax laws, an entity may be required to assess income tax balances based on IAS 17. This would require an entity to maintain two separate sets of accounting books i.e. one for IAS 17 balances and one for the new leasing standard. 5.2 Initial measurement of the lease liability A single liability ED 38 ED 39 The ED proposes that the lessee would initially measure its lease liability at the present value of the lease payments. The lessee would recognise the obligation to make lease payments as a single liability (the lease liability). Measurement of the liability would include expectations about various possible cash flows, as follows. PV of lease payments includes expectations about: Lease term (see 5.2.3) Variable lease payments that depend on an index or rate (see 5.2.4) Purchase options (see 5.2.6) RV guarantees (see 5.2.5) Term option penalties (see 5.2.5) Discount rate (see 5.2.2)

21 New on the Horizon: Leases 19 Observations Lease liability includes items that would be recognised separately under the financial instruments standards The lessee s lease liability is a financial liability. However, this liability would be measured in accordance with the requirements of the ED, and not the requirements of the financial instruments standards. As such, common features of lease agreements e.g. renewal and purchase options would not need to be accounted for separately or, potentially, measured at fair value. However, the ED contains extensive guidance on measurement. Therefore, in some cases, the measurement of a financial liability would be different depending on whether it arises from a lease. For example, an agreement to purchase an asset on deferred payment terms in which title passes when the final payment is made may be accounted for differently depending on whether the agreement is or is not a lease Determining the discount rate ED 38(a) ED App A The ED proposes that the lessee s lease liability be measured at the present value of the lease payments, discounted using the rate that the lessor charges the lessee. If that rate cannot be readily determined, then the lessee would use its incremental borrowing rate. The ED defines the lessee s incremental borrowing rate as the rate of interest that the lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the ROU asset in a similar economic environment. Observations Lessees may not be able to estimate the rate the lessor charges Measuring the lease liability at the interest rate that the lessor charges the lessee enables the specific circumstances of a lease including the structured financing of the arrangement or tax benefits inherent within the return agreed between the lessee and the lessor to be captured in the lease accounting. However, it may be difficult for a lessee to determine the rate that the lessor charges the lessee in particular, for leases in which the underlying asset has a significant residual value at the end of the lease term. This may often be the case for leases that are currently classified as operating leases and for which the lessee has not historically performed a quantitative investment appraisal to inform its lease vs buy decision Determining the lease term ED 39 ED 25 The potential lease payments that would be included in the lessee s lease liability are those that arise during the lease term. The ED proposes that the lease term be defined as the non-cancellable period of the lease, together with: the periods covered by an option to extend the lease if the lessee has a significant economic incentive to exercise that option; and ED 26, B5 6 the periods covered by an option to terminate the lease if the lessee has a significant economic incentive not to exercise that option. In determining the lease term, the ED proposes that an entity consider the following factors.

22 20 New on the Horizon: Leases Type of factor 1 Contract-based Examples Amount of lease payments in any secondary period Existence and amount of any contingent payments Existence and terms of renewal options Costs associated with an obligation to return the leased asset in a specified condition or to a specified location Asset-based Location of the asset Existence of significant leasehold improvements that would be lost if the lease were terminated or not extended Non-contractual relocation costs Costs associated with lost production Costs associated with sourcing an alternative item Entity-based Financial consequences of a decision to extend or terminate a lease Nature of the leased asset (specialised/non-specialised; the extent to which the asset is crucial to the lessee s operations) Tax consequences of terminating or not extending the lease Market-based Statutory law and local regulations Market rentals for a comparable asset Note 1 The ED does not map the examples against the type of factor. The only practical impact of the mapping is that an entity does not subsequently reassess the lease term solely for changes in market-based factors see Example Lease term Lessee N has entered into a non-cancellable lease contract with Lessor L to lease a building. The lease term is four years, and N has the option to extend the lease by another four years at the same rental. At inception of the lease, N s expectations are as follows: Market rentals for a comparable building in the same area are expected to increase by 10% over the 8-year period covered by the lease. N is intending to stay in business in the same area for at least 10 years. The location of the building is ideal for relationships with suppliers and customers. In this example, the factors support N having a significant economic incentive to extend the lease. Therefore, for the purpose of accounting for the lease, N uses a lease term of 8 years.

23 New on the Horizon: Leases 21 Observations Lease term is a critical estimate Under the proposals, assessment of the lease term would become a critical estimate and a key determinant of the amount of the lease liability. This is because the initial measurement of the lease payments would consist of the payments relating to the use of the underlying asset during the lease term as assessed. Under the proposals, a new threshold for including renewal periods and excluding termination periods would be introduced significant economic incentive. Under IAS 17, the lease term is the noncancellable contracted period plus any additional periods for which the lessee has the right to extend the lease and for which, at inception of the lease, it is reasonably certain that the lessee will exercise its option. It is not clear whether the differences in terminology will result in different outcomes. Consistent application of the new threshold will be crucial if meaningful comparisons are to be made between different entities. As noted in 6.2.1, a lessor would determine the lease term using the same guidance as a lessee. As such, lessees and lessors may make different assessments as to whether the lessee has a significant economic incentive to exercise a renewal or not to exercise a termination option, which may result in different conclusions about the lease term and potentially lease classification of the same underlying asset Variable lease payments ED 39(b) (c) The ED proposes that a lessee include the following types of variable lease payments when determining its lease liability: variable lease payments that depend on an index or a rate e.g. the Consumer Price Index (CPI) or a market interest rate initially measured using the index or rate as at the commencement date; and variable lease payments that are in-substance fixed payments. Example Variable lease payments Lessee X has entered into a 5-year lease contract with Lessor M for the lease of an office building, with an initial annual payment of 100,000. The contract includes an escalation clause specifying that the lease payments for each year excluding the first year of the lease will increase by the higher of the annual increase in the CPI for the preceding 12 months or 2%. At the commencement date, Lessee X measures the lease liability on the basis of the in-substance fixed lease payments. Lessee X includes an increase of 2% in the lease payments, because this will be the minimum amount due to Lessor M, regardless of the actual increase in the CPI. Based on the above fact pattern, the lessee calculates the lease payments as follows. Year 1 Year 2 Year 3 Year 4 Year 5 Lease payment 100, , , , ,243 (100,000 x 1.02) (102,000 x 1.02) (104,040 x 1.02) (106,121 x 1.02)

24 22 New on the Horizon: Leases Observations Initial measurement of variable payments similar to current practice At first glance, the ED s proposal for variable lease payments may appear different from current practice under IAS 17 for contingent rentals, under which lessees generally recognise contingent rentals as they are incurred. However the ED s proposals are closer to current practice than earlier versions of the proposals. For example: a lessee would not be required to estimate variable lease payments that depend on its own sales sometimes called turnover rents consistent with current practice; a lessee would not be required to estimate future increases in indices such as CPI when estimating future variable lease payments on lease commencement but would use the rate at that date consistent with current practice; and some examples of in-substance fixed lease payments would often be identified as minimum lease payments at present e.g. rent increases based on the greater of CPI or 2%. Arguably, the most significant difference to current practice arises on subsequent measurement (see 5.4) Residual value guarantees and term option penalties ED 39(d), (f) The ED proposes that amounts payable by the lessee under residual value guarantees and term option penalties would be included in the lease liability as follows: the lessee would include any amounts expected to be payable under residual value guarantees as lease payments; and the lessee would include any expected payments for penalties in terminating the lease i.e. if the lease term reflects the lessee exercising an option to terminate the lease. Example Residual value guarantee Lessee Z has entered into a lease contract with Lessor L to lease a car. The lease term is five years and the annual payments at the beginning of the year are 100. In addition, Z and L agree on a residual value guarantee; if the fair value of the car at the end of the lease term is below 400, then Z will pay to L an amount equal to the difference between 400 and the fair value of the car. Payments are due at the start of the year; Z s discount rate is 5.06%. At inception of the lease, Z expects that the amount payable at the end of the lease term in respect of the residual value guarantee will be 110 i.e. the fair value of the car at the end of the lease term is expected to be 290. The present value of Z s lease payments is 540, based on a discount rate of 5.06%, annual lease payments of 100 for 5 years, and an amount of 110 expected to be payable at the end of the lease term. Observations Initial measurement of residual value guarantees differs from current practice Amounts payable under residual value guarantees are currently included in a lessee s minimum lease payments under IAS 17. However, the amount to be included under IAS 17 is the maximum exposure under the guarantee, not the expected amount payable. Therefore, amounts relating to residual value guarantees included in lease payments under the ED would usually be lower than the corresponding amounts relating to residual value guarantees included in minimum lease payments under IAS 17.

25 New on the Horizon: Leases 23 The value of a residual value guarantee could be seen as being linked to the value of the underlying asset at the end of the lease term rather than the ROU asset. However, the Boards believe that residual value guarantees are often closely related to other lease conditions and so propose to include them within the lease liability. This is different to the approach proposed for lessors (see 6.2.1) Exercise price of a purchase option ED 39(e) The ED proposes that the exercise price of a purchase option be included in the lease payments in the initial measurement of the lease liability if the lessee has a significant economic incentive to exercise that option. In making this assessment, a lessee would consider contract-based, asset-based, marketbased and entity-based factors, similar to the assessment of renewal options (see 5.2.3). Observations New judgmental threshold applies to purchase options Under IAS 17, the existence of a bargain purchase option may indicate that the lease is a finance lease. Furthermore under IAS 17 the purchase option is included in the minimum lease payments if it is reasonably certain at inception of the lease that the purchase option will be exercised. Similarly, under the proposals, the existence of a purchase option could impact the classification of the lease as well as the measurement of the initial lease payments included in the lease liability. However, the current proposals use a new judgemental threshold of the lessee having a significant economic incentive to exercise the option, whereas IAS 17 uses reasonably certain. Determining whether a lessee has a significant economic incentive to exercise a purchase option would require careful consideration. 5.3 Initial measurement of the ROU asset Lease liability (see 5.2) + = Initial direct costs + Pre-paid lease payments Lease ROU incentives asset received ED 38(b), 40, App A ED B10 11 The ED proposes that the lessee would initially measure its ROU asset at cost, which equals the lease liability (see 5.2), plus any initial direct costs plus any pre-paid lease payments less any lease incentives received. Initial direct costs are defined as costs that are directly attributable to negotiating and arranging a lease and would not have been incurred without entering into the lease. The proposals include guidance that would assist a lessee in determining whether costs are directly attributable to negotiating and arranging a lease. That additional guidance includes the following types of costs as examples.

26 24 New on the Horizon: Leases Typical initial direct costs Include Exclude Commissions Legal fees Costs of evaluating the prospective lessee s financial condition Costs of evaluating and recording guarantees, collateral and other security arrangements General overheads Advertising costs Costs of soliciting potential leases Costs of servicing existing leases Costs of other ancillary activities Costs of negotiating lease terms and conditions Costs of preparing and processing lease documents Payments made to existing tenants to obtain the lease Observations Similar to costs of acquiring other non-financial assets Broadly, the proposed initial measurement of a lessee s ROU asset (a non-financial asset) is consistent with most other non-financial assets that are measured initially at cost e.g. assets measured in accordance with IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets. 5.4 Subsequent measurement of the liability Measurement basis ED 41(a) The ED proposes that after initial recognition, the lessee would measure its lease liability at amortised cost using the effective interest rate method. The lessee would not be permitted to measure its lease liability at fair value. Example Liability measured subsequently at amortised cost Lessee D has entered into a contract with Lessor L to lease a building for 7 years. The annual lease payments are 450, payable at the end of each year. D s discount rate is 5.04%. The initial recognition of the obligation to make lease payments is 2,600. At the end of Year 1, D pays the first annual lease payment of 450 to L: 131 (2,600 x 5.04%) is interest; and 319 ( ) is principal, which decreases the liability by 319. The carrying amount of the liability at the start of the second year is 2,281 (2, ).

27 New on the Horizon: Leases 25 Observations No option to measure lessee s lease liability at fair value The ED proposes a cost model for the lessee s lease liability, consistent with the subsequent measurement basis of a lessee s IAS 17 finance lease liability. One key argument that the IASB cites to support the prohibition on the lessee measuring its lease liability at fair value after initial measurement is that this would be inconsistent with the subsequent measurement of many other non-derivative financial instruments. However, because the IASB has rejected a components approach to accounting for the lessee s liability, there may be cases in which a lessee s lease liability contains features that would be identified as embedded derivatives under IAS 39 Financial Instruments: Recognition and Measurement and potentially measured at fair value Reassessment of lease payments and the discount rate ED The ED proposes that an entity assess whether facts and circumstances indicate a change since the previous reporting period, relating to: the lease term; relevant factors that result in the lessee having or no longer having a significant economic incentive to exercise a purchase option; amounts expected to be payable under residual value guarantees; and an index or rate used to determine lease payments during the reporting period. If any of the above items has changed since the previous reporting period, then the lessee would reassess the lease payments and compute a new carrying amount for its lease liability. ED 27 An entity is required to reassess the lease term if any of the following occurs: there is a change in any of the relevant factors noted in with the exception of market-based factors that results in the entity having or no longer having a significant economic incentive to exercise an option to renew or to not terminate the lease; or the lessee elects to exercise an option even though the entity had previously determined that a significant economic incentive to do so did not exist; or the lessee elects not to exercise an option, even though the entity had previously determined that the lessee had a significant economic incentive to do so. Changes in the carrying amount of the lease liability would be recognised as follows. Changes in carrying amount of lease liability due to: Reassessment of lease term, purchase option and residual value guarantees Variable payments based on index or rate Relates to future periods Relates to current period Adjust ROU asset Recognise in P&L

28 26 New on the Horizon: Leases ED A lessee would reassess the discount rate if there was a change in any of the following: lease term; relevant factors that result in the lessee having or no longer having a significant economic incentive to exercise a purchase option; or a reference interest rate, if variable lease payments are determined using that rate. The revised discount rate would be determined at the date of reassessment in the same manner as at the commencement date. Example Change in variable lease payments linked to an index Lessee C enters into a 5-year lease term with Lessor L for a retail building, commencing on 1 January 20X0. C pays 155 per year, in arrears. The rate that L charges C is 6%. Assume that the lease is classified as a Type B lease. Additionally, the lease contract states that lease payments for each year will increase on the basis of the increase in the CPI for the preceding 12 months. The CPI at the commencement date is 120. The carrying amount of the obligation to make lease payments is 655. C records the following entries at Year 1, assuming that initial direct costs are zero and there are no lease incentives. Debit Credit ROU asset 655 Lease liability 655 To recognise ROU asset and obligation to make lease payments at lease commencement date Lease expense 155 Lease liability (155 - (655 x 6%)) 116 Accumulated amortisation ROU asset 116 Cash (Year 1 lease payment) 155 To recognise the Year 1 lease expense and cash payment. The lease expense is determined as the total lease payments over the lease term allocated on a straight-line basis (775 / 5 years) Current period At the end of the first year of the lease, the CPI is 125. C calculates the payment adjusted to the CPI as 161 (155 x 125 / 120). Because the lease payments are variable lease payments that depend on an index, C adjusts the lease liability to reflect the index as at the end of the reporting period. The following entry would be required for the reassessment of the variable lease payment for the current period. Debit Credit Lease expense 6 Cash 6 To recognise the additional lease expense from reassessment of CPI ( )

29 New on the Horizon: Leases 27 Future period The lease liability would be adjusted to reflect annual lease payments of 161 over the remaining 4-year lease period. C would not reassess the discount rate as a change in variable lease payments that depend on an index does not require a reassessment of the discount rate. C s adjustment would be calculated as the difference between the original lease payments (155) and the reassessed payment (161) over the remaining 4-year lease term, currently valued at the original discount rate of 6%, which equals 21. Because the remeasurement relates to future periods, C would record the adjustment to the ROU asset as follows. Debit Credit ROU asset 21 Lease liability 21 To recognise the remeasurement relating to the variable lease payments. Observations Reassessment is a significant difference to current lease accounting The ED s proposal to reassess key judgements e.g. the lease term at the end of each reporting period is a significant change from IAS 17. It would no longer be possible for an entity to compute a lease amortisation schedule on lease commencement and roll that schedule forward at the end of each reporting period. Instead, entities would need to reassess key judgements and consider the need to remeasure lease balances each time they report. Remeasurements during the lease term would provide more up-to-date information to users of financial statements. However, this would also introduce new volatility in reported assets and liabilities which may impact an entity s ability to accurately predict and forecast its future statement of financial position. This would also be likely to require additional resources focused on lease accounting not only at lease commencement, but also at the end of each reporting period. Significant judgement is likely to be needed in determining whether there has been a change in relevant factors or a change in the lessee s economic incentive to exercise or not exercise renewal or termination options. Additionally, it is unclear how in practice an entity would ignore changes in market-based factors e.g. market rates when performing a reassessment of the lease term. The entity s reassessment of key judgements may in some cases have a significant impact on the lease amounts recognised in the statement of financial position and statement of profit or loss.

30 28 New on the Horizon: Leases 5.5 Subsequent measurement of the ROU asset Measurement basis ED 41(b), 53 ED 51 ED 52 The ED proposes that, after initial recognition, the lessee would measure the ROU asset at amortised cost. Alternatively, the lessee may measure ROU assets relating to a class of property, plant and equipment under the IAS 16 revaluation model, if the lessee applies the revaluation model to all assets in that class. Amortisation of the ROU asset differs depending on the classification of the lease (see and 5.5.3). The ED does not propose a new impairment model for the ROU asset; instead, the asset would be subject to the requirements of IAS 36 Impairment of Assets (see 5.5.4). The lessee may measure ROU assets relating to leased property in accordance with the fair value model in IAS 40 if the leased property meets the definition of investment property and the lessee applies the fair value model in IAS 40 to its other investment property (see 7.3). Observations Unclear if ROU asset is a tangible or intangible asset The ED does not specifically state whether the ROU asset is a tangible or intangible asset. Although the ROU asset seems to meet the definition of an intangible asset, the ED proposes that a lessee be permitted to apply a revaluation model if it meets the conditions to apply the revaluation model to property, plant and equipment. In particular, the ED would not impose the requirement in IAS 38 Technical Summary that fair value be determined with reference to an active market. Consequently, a lessee may apply a revaluation model to ROU assets even in circumstances in which the lessee would be limited to the cost model for other forms of intangible assets. The ED does not include specific guidance on other aspects of accounting for the ROU asset. For example, the ED does not discuss whether a lessee should identify components of an intangible asset and amortise those separately, as would be required for an item of property, plant and equipment in the scope of IAS 16. This could be an important practical consideration for lessees who currently lease bigticket items under operating leases and adopt a component approach to maintenance accounting e.g. engines in some aircraft leases Amortisation of the ROU asset in Type A leases ED The ED proposes that for Type A leases, the ROU asset would be amortised on a straight-line basis, unless another systematic basis is more representative of the pattern of use over the shorter of the lease term and the useful life of the ROU asset. The related expense would be presented as amortisation expense (see 5.6).

31 New on the Horizon: Leases 29 Example Type A lease Lessee F enters into lease for a 5-year lease term. Lessee F pays 155 per year, paid in arrears. The rate that Lessor G charges F is 6%, resulting in an initial lease liability of 655. For the purpose of illustrating the Type A lease model for lessees, the example assumes that the lease is classified as a Type A lease. Statement of financial position Profit or loss ROU Lease Interest Total Period Cash asset liability Amortisation expense expense Commencement Total Observations Type A lease will generally result in front-loaded profile of total lease expense The amortisation of a Type A lease in each period would be consistent with the requirements of existing IFRS for non-financial assets that are measured at cost. The lessee would generally amortise the ROU asset on a straight-line basis and measure the lease liability at amortised cost using the effective interest rate method. The lessee would separately present amortisation and interest expense arising from the lease. As a result, the total lease expense profile for Type A leases would generally be front-loaded, a result of straight-line amortisation of the ROU asset coupled with a declining interest expense as the lease liability is drawn down over the lease term. This simple fact pattern assumes that straight-line amortisation best reflects the economic consumption of the asset and, as such, the ROU asset is amortised by a straight-line amount over the lease term i.e. 655 / 5 years = 131. The interest expense is calculated on an amortised cost basis i.e. in Year 1, the liability of 655 x 6% = 39. The example in illustrates the same fact pattern, assuming that the lease is classified as a Type B lease.

32 30 New on the Horizon: Leases Amortisation of the ROU asset in Type B leases ED 50 The ED proposes that for Type B leases, the amortisation of the ROU asset for the period would be determined as the difference between: the periodic lease cost; and the periodic unwinding of the discount on the lease liability. However, the total lease expense recognised in a period cannot be less than the periodic unwinding of the discount on the lease liability in that period i.e. amortisation of the ROU asset can never be negative. Even so, the carrying amount of the ROU asset may increase due to other reasons e.g. on reassessment of the lease term (see 5.4.2). ED 42(b) For a Type B lease, a lessee would recognise a single lease cost (see 5.6) that would combine the unwinding of the discount on the lease liability with the amortisation of the ROU asset, calculated so that the remaining cost of the lease would be allocated on a straight-line basis over the remaining lease term. Example Type B lease For the purposes of illustrating the Type B lease model for lessees, the same fact pattern is used as in the example in 5.5.2; however, the example below assumes that the lease is classified as a Type B lease, rather than a Type A lease. Statement of financial position Profit or loss Period Cash ROU asset Lease liability Lease expense 1 Commencement Total Notes 1 Lease expense per year equals 775 / 5 years. 2 Amortisation of the ROU asset is net of the unwinding of the discount on the lease liability i.e. a balancing figure. For example, in Year 1 amortisation of 116 is calculated as the lease payment of 155 less interest of 39 (655 x 6%).

33 New on the Horizon: Leases 31 Observations ROU asset in a Type B lease is a balancing figure For a Type B lease, the lessee would still measure the lease liability at amortised cost using the effective interest rate method (consistent with the example in 5.5.2). However, the lessee would recognise the total lease expense on a straight-line basis. Therefore, the ROU asset would subsequently be measured each period as a plug or balancing figure, calculated by deducting the difference between the straight-line lease expense, less interest on the lease liability each period, from the initial ROU asset balance. In effect, the ROU asset and lease liability in a Type B lease would be treated as one unit of account for subsequent measurement. This is likely to be a controversial proposal a major compromise designed to make the proposals more palatable when applied to leases of property. In other words, this model would preserve straight-line expense recognition for most leases of property, similar to operating leases under IAS 17. The proposals not only allow but require straight-line expense recognition under a Type B lease even when another systematic basis might better represent the pattern of consumption of the underlying asset. The potential effects of reassessments and impairments will complicate the accounting, and increase the volatility in the income statement and statement of financial position Impairment of the ROU asset ED 51 Under the proposals, a lessee would determine whether the ROU asset is impaired and recognise any corresponding impairment loss in accordance with existing IAS 36. The amortisation of the ROU asset after an impairment charge would be dependent on lease classification as follows. Type A Type B Partial impairment Full impairment Continue amortising ROU asset on pre-impairment basis Amortise remaining lease expense on a straight-line basis Recognise expense from unwinding of the discount Always recognise expense from unwinding of the discount on the lease liability

34 32 New on the Horizon: Leases Observations Impairment testing adds complexity compared to current operating lease accounting Impairment testing of ROU assets would increase the financial reporting burden for lessees compared to current accounting under IAS 17, because operating leases are not currently required to be tested for impairment. Impairment testing of ROU assets under the proposals could result in different measurements under IFRS and US GAAP, due to differences in the applicable accounting standards for impairment. If the ROU asset in a Type B lease is fully impaired, then the lessee would continue to recognise the unwinding of the discount on the lease liability as a lease expense in the statement of profit or loss. That is, the lessee would present the debt service cost of a financial liability associated with a fully impaired ROU asset as an operating expense. A lessee would be required to perform an additional analysis of the effect of straight-line total lease expense recognition whenever it recognises an impairment of an ROU asset under a Type B lease in order to determine the appropriate subsequent accounting for the ROU asset. This would increase the record-keeping burden. Example Partial impairment of a Type B lease Modifying the example in 5.4.2, assume that in Year 3, the ROU asset is partially impaired by 315, reducing the beginning ROU asset balance to 101 ( ). The total remaining lease expense after impairment in Year 3 is 150 (ROU asset of remaining interest expense of 49). The lessee would recognise the remaining lease expense on a straight line basis resulting in total lease expense of 50 per year (150 / 3 years). The reduction of the ROU asset balance will be treated as a plug after deducting for the unwinding of the discount as follows. Year Start Year 3 End Year Total ROU asset Lease liability Lease expense unwinding discount Lease expense ROU amortisation Impairment Total expense Note 1 Note that the unwinding of the discount (interest expense) and the amortisation of the ROU asset will be presented as a single line item on the statement of profit or loss.

35 New on the Horizon: Leases 33 At the end of Year 3, Lessee C would record the following journal entries. Debit Credit Impairment expense 315 Accumulated amortisation ROU asset 315 To recognise impairment expense for the ROU asset Lease expense (150 / 3) 50 Lease liability (155-24) 131 Accumulated amortisation ROU asset (50-24) 26 Cash (Year 3 lease payment) 155 To recognise the Year 3 cash payment, lease expense, and amortisation of ROU asset Example Full impairment of Type B lease Modifying the example above, assume that at the beginning of Year 3, the ROU asset of 416 is fully impaired. Lessee C would record the following journal entries for the lease in Year 3. Debit Credit Impairment expense 416 Accumulated amortisation ROU asset 416 To recognise impairment expense for the full amount of the ROU asset Lease expense (416 x 6%) 24 Lease liability (155-24) 131 Cash (Year 3 lease payment) 155 To recognise the Year 3 lease expense and cash payment

36 34 New on the Horizon: Leases 5.6 Presentation ED The ED proposes that a lessee present the items arising from lease contracts in its scope as follows. Statement of financial position Statement of profit or loss and OCI Statement of cash flows Present obligation to make lease payments separately from other financial liabilities. Present lease liabilities arising from Type A leases separately from Type B leases. Present ROU assets within property, plant and equipment separately from other assets that the lessee owns. Present ROU assets arising from Type A leases separately from Type B leases and ROU assets measured at revalued amounts. Type A leases Present the unwinding of the discount on the lease liability separately from the amortisation of the ROU asset (interest and amortisation presented separately). Type B leases Present the unwinding of the discount on the lease liability together with the amortisation of the ROU asset (single line item). Type A leases Classify cash repayments of principal within financing activities. Classify unwinding of discount on lease liability in accordance with the requirements of IAS 7 for interest paid. Type B leases Classify any payments arising from Type B leases within operating activities. Other payments Classify variable lease payments and short-term lease payments not included in lease liability within operating activities. Observations Presentation is a key difference between Type A and Type B lease proposals IAS 17 does not contain any presentation requirements e.g. there is no requirement for a lessee in a finance lease to present the assets and liabilities arising from lease contracts separately from other assets and liabilities in its statement of financial position. For many entities, the ED s proposals would increase the number of line items in their statement of financial position. Under the ED s proposals, the presentation requirements would be significantly different for Type A and Type B leases. Notably, Type B leases would be presented in profit or loss and the statement of cash flows as if they were not financing transactions despite the fact that the lessee recognises a financial liability measured at amortised cost. The ED s proposal on presentation in the statement of cash flows is more prescriptive than current requirements and may represent a change in practice for many entities. The ED does not specify which line item short-term lease payments, variable lease payments, and payments for non-lease components should be presented. Similarly, lease payments on the statement of cash flows will also be disaggregated between multiple different line items between financing and operating activities. The lack of specific guidance could make it more difficult for users to make comparisons between different entities.

37 New on the Horizon: Leases Accounting models for lessors 6.1 Overview ED 68, 93 The ED proposes a dual model for lessors depending on lease classification. For Type A leases, the lessor would apply a complex new accounting model under which it would derecognise the underlying asset and recognise a lease receivable and a residual asset. A lessor in a Type B lease would apply a model similar to current operating lease accounting under IAS 17. Statement of financial position Statement of profit or loss Profile of total lease income Type A leases (non-property) Lease receivable Residual asset Profit on lease commencement Interest income on lease receivable Front-loaded Interest accretion on residual asset Type B leases (property) Underlying asset Lease income Straight-line Observations Lessor accounting for Type A leases is a development of finance lessor accounting, but more complex Lessor accounting for Type A leases can be seen, in broad terms, as a development of current finance lessor accounting and also as complementary to the lessee ROU model. In effect, the lessor in a Type A lease would account for a partial disposal of the underlying asset on deferred payment terms, in the same way that the lessee would account for the acquisition of the ROU asset. However, lessor accounting for Type A leases is notably complex. Much of the complexity would arise from the accounting issues associated with the residual asset. A finance lessor would recognise any unguaranteed residual value under IAS 17, but any such balance is small and is subsumed within the lease receivable. By contrast, the lessor s residual asset in a Type A lease may be much larger. For example, if a lessor leases out a new aircraft for the first 5 years of its 21-year life, then the residual asset would probably be much larger than the lease receivable. Observations Lessor accounting for Type B leases is similar to current operating lessor accounting, but inconsistent with the ED s other models Lessor accounting for Type B leases is, in broad terms, similar to current operating lease accounting. The proposal to retain a version of operating lease accounting for many property leases is likely to be welcomed by investment property groups.

38 36 New on the Horizon: Leases However, lessor accounting for Type B leases appears wholly inconsistent with the Boards initial objective of recognising the assets and liabilities that arise from lease contracts. It is certainly inconsistent with the proposals for lessee accounting. To take the most obvious example, in a Type B lease a lessee recognises a financial liability for its obligation to make lease payments; however, the lessor does not recognise a corresponding financial asset for its right to receive those lease payments. 6.2 Lessor accounting for Type A leases Initial recognition and measurement Type A Initial measurement Lease receivable Residual asset Up-front profit Present value of lease payments + Initial direct costs - Lease incentives Gross residual asset + Present value of expected variable lease payments - Unearned profit Lease receivable + Residual asset - Previous carrying amount of underlying asset Entries on lease commencement ED 68 On lease commencement, a lessor would derecognise the underlying asset and recognise: a lease receivable representing its right to receive lease payments; and a residual asset representing its interest in the underlying asset at the end of the lease term. The lessor would recognise profit at lease commencement on the portion of the underlying asset that is considered to be sold to the lessee. The total profit arising on lease commencement including the unearned portion is as follows. Fair value of underlying asset = Carrying amount of underlying asset Total profit Of this total profit, the amount that is recognised at lease commencement is as follows. Total profit Present value of lease payments Fair value of underlying asset = Profit recognised at lease commencement

39 New on the Horizon: Leases 37 Lease receivable ED 69(a), 70 The lessor would measure the lease receivable initially at the present value of the estimated future lease payments, discounted at the rate that the lessor charges the lessee, plus any initial direct costs. The estimate of future lease payments would be determined in a manner similar to the way that a lessee measures its lease liability (see 5.2.1). The lease receivable would include variable lease payments that depend on an index or a rate and variable lease payments that are in-substance fixed payments (see 6.2.3). However, the lessor does not include expected amounts receivable under residual value guarantees in the estimated future lease payments. Residual asset ED 71 ED 71 The lessor would initially measure the residual asset as an allocation of the previous carrying amount of the underlying asset. This would consist of: the gross residual asset the present value of the amount that the lessor expects to derive from the underlying asset at the end of the lease term, discounted at the rate that the lessor charges the lessee; plus the present value of expected variable lease payments (if the lessor has included an expectation of those variable lease payments in the rate that it charges the lessee, see 6.2.3); less unearned profit the portion of the total profit that is not recognised at lease commencement relating to the residual asset. The lessor recognises this net residual asset in its statement of financial position. This amount can be expressed as follows. Gross residual asset + = Present value of estimated variable lease payments included in determination of the rate the lessor charges the lessee Unearned profit Net residual asset Example Initial measurement under Type A leases Lessor L enters into a non-cancellable lease contract with Lessee E under which E leases a piece of equipment for 5 years. The total economic life of the equipment is estimated to be 10 years. There are no purchase, renewal or early termination options contained in the lease agreement. Assume that there are no initial direct costs. The annual lease payments, which are due at the end of each year, are 50,000 and Lessor L s discount rate is %. The present value of the right to receive lease payments is 185,281. The estimated future value of the asset at the end of Year 5 is 75,000, which is discounted at the rate that L charges in the lease agreement ( %) to give a gross residual asset of 44,719. The fair value of the equipment is 230,000, and at commencement of the lease the equipment has a carrying amount of 200,000. Therefore there is a total profit of 30,000, which is allocated between the amount recognised on lease commencement and the unearned portion that reduces the carrying amount of the net residual asset.

40 38 New on the Horizon: Leases As this is a Type A lease, Lessor L would record the following journal entries at lease commencement: Debit Credit Lease receivable 185,281 Gross residual asset 1 44,719 Equipment 200,000 Unearned profit 1 (30,000-24,167) 5,833 2 Gain on lease of equipment (30,000 (185,281 / 230,000)) 24,167 To recognise lease assets, derecognise portion of underlying asset, and recognise gain on lease agreement Notes 1. The net residual asset presented on the statement financial position is the gross residual asset of 44,719 less the unearned profit of 5, The total profit of 30,000 (230, ,000) is allocated between up-front profit and deferred profit (24, ,833). Observations New calculations on lease commencement The initial measurement of a lessor s lease receivable would be similar to initial measurement of the lessee s lease liability. The only differences in principle are: the inclusion of initial direct costs; the requirement that the lessor always use the rate it charges the lessee as the discount rate, whereas the lessee would use the lessee s incremental borrowing rate as the discount rate if the lessee cannot readily determine the rate that the lessor charges the lessee; and the exclusion of amounts expected to be received under residual value guarantees from the lease payments (the lessor considers any such amounts when testing the residual asset for impairment). However, other measurement differences may arise in practice due to information asymmetry e.g. different assessments as to whether the lessee has a significant economic incentive to exercise a renewal option. Only in rare circumstances would no up-front amount be recognised i.e. only in instances when the fair value of the underlying asset equalled the carrying amount. The calculations required to calculate the initial carrying amount of the lessor s residual asset appear complex. In practice, we expect that lessors would develop standard models to prepare such calculations; this would be essential for lessors entering into a high volume of small value leases e.g. equipment lessors Subsequent measurement in Type A leases The approach to subsequent measurement of the lessor s receivable and residual asset can be summarised as follows.

41 New on the Horizon: Leases 39 Type A subsequent measurement Lease receivable Amortised cost using the effective interest rate method Impairment in accordance with IAS 39 Reassessment if facts and circumstances indicate a change in any of the following: the lease term; the lessee having or no longer having a significant economic incentive to exercise a purchase option; and an index or rate used to determine variable lease payments Residual asset Accreted using the rate the lessor charges the lessee Impairment in accordance with IAS 36 Derecognition of a portion of the carrying amount if the estimated variable lease payments were included in the initial measurement (see 6.2.3) Profit or loss would include Interest income related to the lease receivable Interest income related to accretion of the gross residual asset Variable lease payments not included in the lease receivable A portion of remeasurements due to reassessments Impairment losses related to the lease receivable Impairment losses related to the residual asset ED 76, 84 ED The lessor would measure the lease receivable at amortised cost using the effective interest rate method. In addition, the lessor would test the lease receivable for impairment under IAS 39. The lessor would also be required to remeasure the lease receivable to reflect any changes to the lease payments or to the discount rate. The lessor would reassess lease payments if there is a change in any of the following: the lease term (see 5.4.2); relevant factors that result in the lessee having or no longer having a significant economic incentive to exercise a purchase option; or an index or rate on which variable lease payments are based. ED 78 ED 82, 85 Upon reassessment, the lessor would recognise any difference in the carrying amount of the lease receivable and the residual asset in profit or loss. The lessor would accrete the gross residual asset to its estimated future value at the end of the lease term using the rate that the lessor charges the lessee. Revaluation of the residual asset would not be permitted. In addition, the lessor would test the net residual asset for impairment under IAS 36.

42 40 New on the Horizon: Leases The unearned profit allocated to the residual asset would not be recognised until a reassessment occurs that affects the measurement of the residual asset, the underlying asset is either sold or re-leased, or an impairment of the residual asset is recognised. For guidance on accounting for variable payments, see Example Subsequent measurement under Type A leases Continuing the previous example, and assuming that the lease commenced on the first day of the lessor s annual reporting period, Lessor L would recognise the following entries at the end of Year 1. Debit Credit Cash 50,000 Interest income (185,281 x %) 20,188 Lease receivable (50,000-20,188) 29,812 To recognise receipt of first annual lease payment Interest on residual accretion (44,719 x %) 4,872 Net residual asset 4,872 To recognise accretion of residual asset in Year 1 Observations Front-loaded income and volatility for lessors in Type A leases The profile of the lessor s income recognition during the lease term on Type A leases would generally be front-loaded because interest income on the lease receivable would be calculated using the effective interest rate method. In addition, the lessor may recognise a profit or loss on lease commencement. The accretion of the residual asset reflects the unwinding of the discount on the gross residual asset made at lease commencement. Mathematically, this mechanism spreads income over the lease term and reduces the profit that would otherwise arise on sale of the residual asset or commencement of the next lease. However, it is difficult to rationalise this accretion conceptually it is effectively interest arising on a non-financial asset. Similar to lessee accounting, subsequent accounting for Type A leases will require reassessment of key estimates and judgements at the end of each reporting period including variable lease payments based on an index or rate, and whether a lessee has a significant economic incentive to exercise a renewal, termination, or purchase option. The potential effects of such reassessments would complicate subsequent accounting, and increase the volatility in the statement of profit or loss and statement of financial position. The relationship between the various elements of the lessor Type A model can be seen in the table below, which illustrates the impact on the lessor s statement of financial position and statement of profit or loss over the five year term of the contract. Note that the example assumes that there are no reassessments and no variable lease payments.

43 New on the Horizon: Leases 41 Statement of financial position Statement of profit or loss Period Lease receivable Gross residual asset Unearned profit Net residual asset Day 1 profit Interest income Residual accretion Net income 0 185,281 44,719 (5,833) 38,886 24, , ,469 49,591 (5,833) 43,758-20,188 4,872 25, ,408 54,994 (5,833) 49,161-16,939 5,403 22, ,745 60,986 (5,833) 55,153-13,337 5,992 19, ,087 67,631 (5,833) 61,798-9,342 6,645 15, ,000 (5,833) 69,167 4,913 7,369 12,282 Total 24,167 64,719 30, ,167 Observations Comparison with current operating lease accounting The lease in this example would be classified as an operating lease under IAS 17. Under current IAS 17 operating lease accounting, the lessor would have continued to recognise the underlying asset on its statement of financial position and net income would have amounted to 25,000 per year (lease payment of 50,000 less depreciation expense of 25,000) giving total net income of 125,000 over the lease term. The financial result under IAS 17 and the Type A proposals can be compared as follows. Type A lease accounting gives a front-loaded profile of lease income due to the Day 1 profit and the interest income, compared to the straight-line income recognised under IAS 17; and Type A lease accounting gives a slightly lower net income over the lease term than IAS 17, due to the deferral of the unearned profit on lease commencement. Total net income under Type A lease accounting can be reconciled to total net income under IAS 17 by adding back the unearned profit i.e. 119, ,833 = 125,000. Although this example of Type A lease accounting may appear complex on a first read, a number of simplifying assumptions have been made. The example would have been more complex if it had included variable lease payments, reassessments of the economic incentive to exercise renewal or termination options, and impairment charges on the lease receivable and residual asset Variable lease payments in Type A leases ED 70(b) (c) ED 72 The ED proposes that the initial measurement of the lease receivable would include variable lease payments that depend on an index or rate e.g. CPI or a market interest rate and variable lease payments that are in-substance fixed payments. When a lessor reflects an expectation of other variable lease payments in the rate that it charges the lessee and those variable lease payments are not included in the lease receivable, the lessor would adjust the residual asset on initial recognition. In subsequent periods, that adjustment would be unwound and a portion of the carrying amount of the residual asset would be transferred to profit or loss. Conversely, if the rate that the lessor charges the lessee does not reflect an expectation of variable lease payments, then no adjustment to the residual asset would be required.

44 42 New on the Horizon: Leases The proposed approach to variable lease payments can be summarised as follows. Are the VLPs: dependent on an index or rate; or in-substance a fixed payment? Yes Include in the initial measurement of the lease receivable No Does the rate that lessor charges the lessee reflect an expectation of VLPs? Yes Include in residual asset the present value of VLPs expected to be received during lease term No No adjustment to residual asset Subsequently, derecognise portion of residual asset in P&L based on expected amount of VLPs for period ED B20 The portion of the residual asset to derecognise each period would be calculated as follows. Amount of VLPs earned in current period Total VLPs expected to be earned Present value of total VLPs expected to be earned Carrying amount of underlying asset before lease commencement Total VLPs expected to be earned Observations Accounting for variable lease payments increases complexity The ED s proposals for variable lease payments add another layer of complexity to the Type A accounting model. However, the proposed adjustment to the residual asset on lease commencement seems appropriate without it the profit recognised by the lessor over the lease term would be overstated. Applying these requirements in practice could be difficult, because the proposals include limited guidance and no examples illustrating how to determine whether the rate that the lessor charges the lessee includes an expectation for variable lease payments.

45 New on the Horizon: Leases 43 The ED would require the lessor to subsequently derecognise a portion of the carrying amount of the residual asset in profit or loss based on the expected amount of the variable lease payments. Any difference between the actual and expected variable lease payments would not result in any further adjustments to the residual asset for variable lease payments. If variable lease payments are included in the rate the lessee charges the lessee, and therefore included in the initial carrying amount of the residual asset, then the net residual asset may not be equal to the gross residual asset less deferred profit at the end of the lease term (see 6.2.2). This is because the present value of the variable lease payments included in the initial measurement of the residual value will not necessarily eliminate by the end of the lease term Presentation of Type A leases ED The ED proposes that a lessor present the items arising from lease contracts in its scope as follows: Statement of financial position Statement of profit or loss and OCI Statement of cash flows Present the sum of all leased assets (lease receivable and residual asset) separately from other assets in the statement of financial position. Present the carrying amount of the lease receivable and residual assets separately in either the statement of financial position or in the notes. Presentation in profit or loss is dependent on the lessor s business model: If the lessor enters into leases in order to realise value from goods it would otherwise sell e.g. many manufacturers and dealers then the lessor would present revenue and cost of sales separately; or If the lessor uses leases for purposes of providing finance, then the lessor would present the profit or loss as a single line item. A lessor would present lease income separately in the statement of comprehensive income, or disclose it separately in the notes. All cash receipts from lease payments received by the lessor would be classified as operating activities in the statement of cash flows.

46 44 New on the Horizon: Leases Observations Lessor presentation significantly different for Type A and Type B leases Under the ED s proposals, the presentation requirements would be significantly different for Type A and Type B leases. Notably, Type B leases would be presented in profit or loss and the statement of cash flows as if they were not financing transactions. The ED does not specify which line item income from short-term leases, variable lease payments, and non-lease components should be presented. Lessors would be required to present all cash receipts from lease payments within operating activities on the statement of cash flows; however, it is unclear whether all such payments should be presented in a single or multiple line items. The lack of specific guidance could make it more difficult for users to make comparisons between different entities. 6.3 Lessor accounting for Type B leases ED For Type B leases, the lessor would continue to recognise the underlying asset and would recognise: lease payments as lease income, generally on a straight-line basis or on another systematic basis if that basis is more representative of the pattern in which income is earned from the underlying asset; initial direct costs as an expense on the same basis as it recognises lease income; and variable lease payments as income when earned. ED 97 The lessor would classify all cash receipts from lease payments as operating activities in the statement of cash flows. Observations Type B lessor accounting similar to current operating lease accounting Lessor accounting for Type B leases would follow an accounting model similar to current operating lease accounting under IAS 17. However, the definition of a lease, determination of the lease term, and the determination of lease payments would be different under the proposals. Profit recognition for Type B leases would generally be on a straight-line basis, with no interest income recognised. The lessor would not recognise up-front profit on lease commencement. The proposed accounting for Type B leases is likely to receive support from the real estate sector.

47 New on the Horizon: Leases Other lease accounting issues 7.1 Sale and leaseback transactions ED The ED proposes that the accounting treatment for a sale and leaseback transaction would depend on whether the transaction transfers control of the underlying asset to the transferee. An entity would apply the guidance on the satisfaction of performance obligations from the proposed revenue standard to assess whether a sale and leaseback transaction transfers control of the underlying asset from the transferor (lessee) to the transferee (lessor) i.e. whether the transfer of the underlying asset is a purchase and sale. Transferor/lessee Sale/transfer Transferee/lessor Leaseback ED BC289, ED 112 ED The control principle would be applied to the entire transaction, not just the sale portion. The existence of the leaseback would not, in isolation, prevent the buyer/lessor from obtaining control of the asset. However, if the leaseback provides the transferor with the ability to direct the use of and obtain substantially all of the remaining benefits of the asset then the transferee does not obtain control of the asset and the transfer is not a sale. Depending on whether the transaction meets the above conditions for a purchase/sale of the asset, a sale and leaseback transaction would be accounted for as follows. Transferor Transferee Purchase and sale Recognise a sale Apply the lessee accounting requirements Recognise a purchase Apply the lessor accounting requirements Not purchase and sale Do not derecognise the underlying asset Recognise amounts received as a financial liability Do not recognise the underlying asset Recognise amounts paid as a financial asset There are also new disclosure requirements for sale and leaseback transactions (see Section 8). Observations Reduced accounting incentive to enter sale and leaseback transactions In all instances, there would be significant differences between current accounting for sale and leaseback transactions under IAS 17 and the proposals.

48 46 New on the Horizon: Leases Under the proposals, there would be a reduced accounting incentive to conduct sale and leaseback transactions, because the transaction would always be on-balance sheet for the lessee/transferor. The only question is how and what the measurement of the asset and liability would be. If the transaction does not transfer control of the underlying asset, then the arrangement would be treated as financing for the lessee; if the transaction does transfer control of the underlying asset, then the leaseback would be on-balance sheet for the lessee under the ROU model. 7.2 Sub-leases ED App A The ED defines a sub-lease as a transaction in which an underlying asset is re-leased by the original lessee (or intermediate lessor) to a third party, and the lease (or head lease ) between the original lessor and the lessee remains in effect. A sub-lease arrangement can be illustrated as follows. Head lessor Original lessee/ Intermediate lessor Sub-lessee The intermediate lessor would account for assets and liabilities arising from the head lease under either the Type A or Type B lease accounting model for lessees, depending on lease classification. Similarly, the intermediate lessor would account for the sub-lease as a Type A or Type B lease depending on lease classification. When classifying a sub-lease, the intermediate lessor and the sub-lessee would evaluate the sub-lease with reference to the underlying asset, not with reference to the intermediate lessor s ROU asset under the original lease. Observations Accounting asymmetry for intermediate lessors The ED does not propose any recognition or measurement exceptions for sub-leases. The ED argues that the head lease and sub-lease are separate transactions, and that sub-leases should be measured on the same basis as other leases. In practice, this could lead to frequent asymmetry between the way in which an intermediate lessor accounts for a head lease and a sub-lease relating to the same underlying asset even if the terms of the two leases are similar. This asymmetry would be particularly pronounced for a head lease and sub-lease that are classified as Type B leases. In this case, the intermediate lessor would recognise a financial liability for its obligation to pay rentals to the head lessor, but would not recognise a financial asset for its right to receive rentals from the sub-lessee. Sub-leases are very common. It appears that intermediate lessors would now be required to account for many such arrangements gross, with no possibility of offset even if the terms of the head lease and sub-lease are similar.

49 New on the Horizon: Leases Investment property ED 52 If a lessee s ROU asset meets the definition of investment property, then the lessee would account for the ROU asset in accordance with IAS 40. This would include measuring the ROU asset at fair value through profit or loss if the lessee follows the IAS 40 fair value model for investment property. A lessee would initially measure a ROU assets classified as investment property in accordance with the proposals (see 5.3). If an entity elects to apply the cost model for ROU assets, then the entity would apply the proposed subsequent measurement requirements (see 5.5). Observations An extension to the scope of investment property accounting At present, an entity that holds investment property interests under operating leases can elect on a property-by-property basis whether to recognise those interests on-balance sheet as investment property. Under the ED, this election would be replaced by a requirement to classify all such interests as investment property. This in turn will require the entity to measure the property interest at fair value, either for financial statement measurement or disclosure in accordance with the general requirements of IAS 40. The fair value would be assessed on the ROU asset, not on the underlying asset itself. This will create additional valuation challenges. A lessee that applies the cost model under IAS 40 would still be required to disclose the fair value of the ROU asset. This requirement will apply not just to investment property companies, many of which currently elect to recognise their leasehold property interests as investment property. It would also apply to other entities e.g. a retail bank that has reduced the size of its branch network and is sub-leasing surplus property to third parties would need to assess whether the surplus space meets the definition of investment property. 7.4 Lease modifications ED 36 Substantial changes to the terms and conditions of an existing lease agreement e.g. a change in lease term or contractual lease payments would result in accounting for a new contract on the date from which the new terms become effective. Any changes between the carrying amounts of assets and liabilities resulting from the modification would be recognised in profit or loss. Observations Limited guidance on an important topic The ED provides only limited guidance on how to account for contract modifications. In our experience, lease modifications are common, particularly when economic conditions increase the risk of default by lessees. The ED s proposals could give counterintuitive results in some cases. For example, suppose that a lessee in a property lease with a remaining lease term of 10 years is suffering financial difficulties and obtains the lessor s consent to reduce rentals for the next year. Also assume that the lessee s incremental borrowing rate has increased significantly subsequent to lease commencement. The lessee would derecognise the existing lease balances and account for a new lease from the date on which the modifications become effective. Because the lessee would measure the new lease balances using its current incremental borrowing rate, it is possible that its new lease liability would be significantly lower than its previous lease liability. In other words, one accounting consequence of agreeing to a reduction in the current year rent would be recognition of a gain in profit or loss that includes the effect of the deterioration of the lessee s credit rating when applied to the (unchanged) obligation to pay rentals in future years.

50 48 New on the Horizon: Leases 8. Disclosures 8.1 General disclosure objective ED 58, 98 ED 60, 100 The ED proposes that an entity disclose quantitative and qualitative information to enable users of financial statements to understand how the amount, timing and uncertainty of an entity s future cash flows may be affected by leases. This general objective would be satisfied through the following proposed disclosures about the nature of lease arrangements: a general description of lease arrangements; the basis and terms on which variable lease payments are determined; the existence and terms of renewal and termination options; the existence and principal terms of any options for the lessee to purchase the underlying asset (lessor only); the existence and terms of residual value guarantees (lessee only); restrictions imposed by lease arrangements e.g. those relating to dividends, additional debt and further leasing (lessee only); and information about (changes to) significant assumptions and judgements, including: determination of whether a contract contains a lease; allocation of consideration between lease and non-lease components; calculation of discount rate (lessee only); and determination of residual value (lessor only). ED 120 If the accounting policy election for short-term leases is used, then both lessees and lessors are required to disclose that fact. Observations New disclosure requirements compared to current practice The ED follows other recent due process documents published by the IASB in setting out an overall objective for the proposed disclosures. The ED proposes that an entity assess the level of detail that will best satisfy the overall disclosure objective e.g. the level of aggregation at which information is disclosed. In taking this approach, the ED not only allows entities some flexibility in meeting the detailed disclosure requirements, but also requires entities to use their judgement to assess whether the detailed disclosures have met the overall objective. The proposals would also introduce a number of new, detailed requirements not contained in IAS 17. Such disclosures would have to be applied separately for Type A and Type B lease arrangements, which may increase the financial reporting burden of preparers.

51 New on the Horizon: Leases Additional disclosures for lessees ED 61, 64 ED 66 ED 67 ED A lessee would be required to disclose a reconciliation between opening and closing balances of ROU assets and obligations to make lease payments, disaggregated by class of underlying asset. Separate roll-forwards would be required for Type A leases and Type B leases (see example below). A lessee would also disclose the acquisition of ROU assets in exchange for lease liabilities as a supplemental non-cash transaction. The ED proposes that the requirement to disclose maturity analyses in accordance with paragraphs 39(a) and (b) of IFRS 7 would not apply to lessees. Instead, a lessee would disclose a maturity analysis of the obligation to make lease payments, showing the undiscounted cash flows on an annual basis for the first five years and a total of the amounts for the remaining years. In addition, the lessee would need to reconcile the undiscounted amount per the disclosure to the liability recognised in the statement of financial position. All disclosures applicable to the lessee would also apply to any sale and leaseback transactions. In addition, the lessee/transferor would disclose the main terms and conditions of the transaction and identify any gains or losses from the transaction separately from gains or losses on disposal of other assets. Example Lessee reconciliation roll-forward ROU assets Lease liability Type A Type B Type A Type B Balance at 1 January 201X Changes in estimate from: Options Variable lease payments Residual value guarantees Revaluations XXXX XX XX XX XX XXXX XX XX XX XX XXXX XX XX XX XX XXXX XX XX XX XX New rights of use/obligations XX XX XX XX Subtotal XXX XXX XXX XXX Impairments (XX) (XX) - - Accumulated amortisation at 1 January 201X Amortisation during the year Accumulated amortisation at 31 December 201X Disposals of rights-of-use/obligations Repayments of obligations (XXX) (XX) (XXX) (XX) - (XXX) (XX) (XXX) (XX) (XX) (XXX) (XX) (XXX) Balance at 31 December 201X XXX XXX XXX XXX

52 50 New on the Horizon: Leases Observations More extensive disclosures for lessees Generally, the proposed disclosure requirements for lessees are more extensive than those for finance lessees under IAS 17. These disclosures would apply to almost all leases, given the abolition of operating lease accounting for lessees. Some may question why the Boards propose to implement a fundamental change in the lessee accounting model and increase the disclosure burden at the same time. If the new accounting model is providing the information that users need, then one might expect to see a decrease in disclosures. The failure to reduce lessee disclosure requirements seems to suggest that the Boards do not have full confidence in the recognition and measurement proposals. 8.3 Additional disclosures for lessors ED 101 A lessor would be required to provide a tabular breakout of the separate components of lease income arising from Type A leases i.e. up-front profit and interest income attributed to the lease receivable and the residual asset as well as lease income relating to Type B leases, short-term leases and variable lease payments. Example Lessor reconciliation of lease income Lease income Type A leases Up-front profit at commencement date Interest income on lease receivable Interest income on residual asset Subtotal Lease income Type B leases Lease income from short-term lease payments Lease income from variable lease payments Total lease income XXX XX X XXXX XXX XX XXX XXXX ED The ED proposes that the lessor would be required to make separate disclosures for changes in opening and closing balances for both the lease receivable and the residual asset. Such disclosures would include all items that are useful in understanding the change in balance including, but not limited to, changes arising from: lease commencement/renewal; lease termination; unwinding of the discount; impairment; and business combinations.

53 New on the Horizon: Leases 51 ED 106, 109 ED 107 ED 116 The ED proposes that the requirement to disclose maturity analyses in accordance with paragraph 37(a) of IFRS 7 would not apply to lessors. Instead, a lessor would disclose a maturity analysis of the right to receive lease payments, showing the undiscounted cash flows on an annual basis for the first five years and a total of the amounts for the remaining years. The lessor would reconcile the minimum receivables per the maturity analysis to the amounts recognised in the statement of financial position. A separate reconciliation would be required to distinguish between Type A and Type B leases. A lessor would also be required to disclose information about how it manages its risk associated with residual assets. All disclosures applicable to the lessor would also apply to any sale and leaseback transactions. Observations More extensive disclosures for lessors Generally, the proposed disclosure requirements for lessors are more extensive than those for finance lessors under IAS 17. In some cases, the additional disclosure requirements arise as a consequence of the lessor accounting proposals, which include alternative approaches to lessor accounting with different assets and liabilities and types of income recognised under each approach. Arguably, the increased disclosure burden for lessors is a symptom of the complexity of the recognition and measurement proposals.

54 52 New on the Horizon: Leases 9. Transition 9.1 Lessee approach to transition ED App C2-C3,C6 A lessee would be permitted to: adopt the standard retrospectively; or follow a modified retrospective approach. ED App C8 C12 The application of the modified respective approach is dependent on how the lease was previously classified under IAS 17. The modified respective approach would be applied as follows. Modified respective approach Lessee Operating lease per IAS 17 Finance lease per IAS 17 Type A leases Type B leases ROU asset measured as a proportion of the lease liability that reflects the remaining duration of the lease relative to the initial lease Lease liability, measured at the present value of the remaining lease payments discounted at the lessee s incremental borrowing rate ROU asset measured at an amount equal to the lease liability Lease liability, measured at the present value of the remaining lease payments discounted at the lessee s incremental borrowing rate ROU asset measured at the carrying amount of the finance lease asset under IAS 17 Lease liability measured at the carrying amount of the finance lease liability under IAS 17

55 New on the Horizon: Leases Lessor approach to transition ED App C2-C3, C6 A lessor would be permitted to: adopt the standard retrospectively; or follow a modified retrospective approach. ED App C13 18 The application of the modified respective approach is dependent on how the lease was previously classified under IAS 17. The modified respective approach is applied as follows. Modified respective approach Lessor Operating lease per IAS 17 Finance lease per IAS 17 Type A leases Type B leases Derecognise the underlying asset Recognise a lease receivable measured at the present value of the remaining lease payments discounted at the rate the lessor charges the lessee Recognise a residual asset measured in accordance with the guidance in initial recognition of residual assets Recognise at the date of initial application an underlying asset measured at the previous carrying amount of the corresponding asset recognised under IAS 17 Measure the lease receivable at the previous carrying amount of the net investment in the lease under IAS 17 Subsequently measure lease receivable in accordance with the proposals (see 6.2) Do not apply reassessment criteria of lease receivable and subsequent measurement criteria for residual asset Present lease receivable and residual asset as a net investment for presentation and disclosure