Summary of IFRS Exposure Draft Leases

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2 The International Accounting Standards Board (IASB) recently issued a revised exposure draft (ED) relating to leases. Once these proposals are finalized the new guidance will replace the IAS 17 Leases. Highlights: For lessees all leases must be on balance sheet (if lease term > 12 months) Reassess each lease under the new requirements. If the lease term is 12 months or less (including optional renewal periods) the lessee can elect to simply expense the lease payments and not apply the proposed new requirements. There is a new lease definition based on the right to use an underlying asset Can the lessee direct the use and derive benefits from this asset? Consider substitution rights and barriers to prevent substitution. High-level Comparison between IAS 17 and Proposed Lease Accounting Model Current IAS 17 Model Operating All leases other than finance lease Lease contract Finance Transfer substantially all risks & rewards of ownership of an asset Proposed Lease Model Everything is on the balance sheet. Operating and finance leases are replaced by type A (lease term is significant compared to asset life) and type B (lease term is insignificant compared to asset life) leases. Type A Asset consumption more than insignificant Lease contract Type B Asset consumption not more than insignificant 2

3 Identification and Classification of a lease All leases are classified as either Type A or B based on the lessee s expected consumption of the economic benefits embedded in the underlying asset. An entity would determine whether a contract contains a lease by assessing whether: o Fulfilment of the contract depends on the use of the identified asset, and o The contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration. A contract conveys the right to control the use of an asset if the customer has the ability to direct the use and receive the benefits from use of the identified asset. Separable components of the lease shall be accounted for separately. Generally, property leases are type B leases. Lease term Noncancellable period Periods covered by an option to extend the lease* Periods covered by an option to terminate the lease** Lease Term *If the lessee has significant economic incentive to exercise that option ** If the lessee has significant economic incentive NOT to exercise that option 3

4 Lessee Accounting Requirements Accounting depends on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset. See the table and examples on the following pages for a summary of lessee Highlights For both types of leases, recognize a lease asset and liability. At lease inception, both are calculated the same way. (Present value of lease payments, discount rate = lease rate charged by the lessor. If this is not known, use the lessee s incremental borrowing rate.) Key differences between Type A and Type B lease treatment occur subsequent to lease inception. Subsequent to lease inception: For Type A Lease, recognize as separate line items on the statement of profit and loss: an amount to unwind the discount on the liability and an amount systematically amortizing the asset based on useful life. For Type B Lease, recognize lease expense as one line item. Lease expense = lease payment each month. Lease expense offsets lease liability and asset. Offset the liability by an amount that is equal to the unwinding of the discount with the remainder grinding down the asset. (i.e., the asset is not amortized systematically over its useful life.) Under certain circumstances, revalue the liability. Examples of circumstances that may lead to revaluation of the liability include change in lease term, change in indices or rates used to determine lease payments, loss of significant economic incentive to exercise purchase option, expected residual guarantees, etc. o Any adjustments to lease liability will generally offset the lease asset. o Exception: changes in rates or indices attributable to the current period will be recognized to profit or loss. accounting for Type A and B leases. 4

5 Table: Summary of Lessee Accounting Lease Commencement Type A Lease Record lease asset and liability. Lease liability = present value of fixed payments (less lessor incentives), certain variable lease payments, residual value guarantees, any purchase option that is deemed to be a significant incentive to the lessee plus lease termination penalties (if the lease term contemplates exercising the termination). Discount rate = the rate the lessor charges. If that rate is not available, use lessee s incremental borrowing rate. Lease asset = the amount recorded for the initial lease liability (per above) + initial direct costs incurred by the lessee + lease payments made to the lessor prior to commencement date less any lease incentives received from lessor. Type B Lease Same as Type A Lease Subsequent periods amounts to report in profit or loss or statement of financial position Profit or loss statement reports interest expense and depreciation expense. Unwind the discount on the lease liability as interest. Amortize the asset. (Recognized on a straightline basis or some other systematic manner that is representative of the pattern of use.) Useful life considers lease term and remaining life if there is significant incentive to recognize the purchase option at the end of the lease term. Profit or loss statement reports lease expense. Do not separately report components that relate to the unwinding of the discount on the lease liability or the amortization of the asset. Unwind the discount on the liability (calculated the same way as in A). Grind down the asset. The amount to grind down the asset = the residual amount derived from total lease expense less the amount to unwind the discount. 5

6 Highlights of some of the new financial statement presentation requirements Separate disclosure of lease asset and liability on the balance sheet. (Including separate disclosure of assets and liabilities arising from type A and B leases.) Separate disclosure of amortization of the asset and interest expense for unwinding the liability. Same as Type A Lease. Only one line item for lease expense (do not separately show amounts for amortization of the asset and interest expense for unwinding the liability). Highlights of some of the new financial statement note disclosure requirements IAS 36 Impairment of assets applies If the leased asset is investment property, apply IAS 40 Investment Property (fair value accounting) Lease details and terms (including covenants). Significant judgments applied. Leased asset reconciliations showing changes from opening to closing balances (separate reconciliations for type A and B leases). Lease liability reconciliations showing changes from opening to closing balances (separate reconciliations for type A and B leases). Summary of the annual undiscounted cash flows for each the first five years and total amounts for the remaining years. Yes Impairment testing standard applies for each period. Yes the lessee can elect to apply the revaluation model under IAS 16 if the lessee revalues all assets within that class of PP&E. Same as Type A Lease. Same as Type A Lease. Same as Type A Lease. Revaluation of lease liability under certain circumstances Yes Revaluation circumstances may be items such as: Change in lease term; Loss in significant incentive to exercise purchase option or disincentive for lease termination; or Change in rates to determine lease payments. Same as Type A Lease. 6

7 Example: Lessee Accounting Accounting for a lease under the proposed model Example case facts: On January 1, 2013, Company A enters into a lease of a piece of equipment for a period of 10 years. The annual lease payments are $75,000 per year and the rate implicit in the lease is determined to be 6.463%. The first lease payment is due on January 1, 2013, and payments are due on January 1 of each year thereafter. There are no renewal or cancellation clauses in the contract. Initial recording o The initial recording of this lease will be the same regardless of whether it is a type A or B lease. o Journal entry on January 1, 2013: DR Leased Equipment 575,000 CR Lease liability 500,000 CR Cash 75,000 Example type A (non-property) lease (lessee): The lease above is determined to be a type A lease because Company A determines that the lease term is a significant part of the total life of the asset. The total life of the asset is expected to be 10 to 12 years. Company A expects to consume the equipment evenly over the 10-year lease term. The journal entry on December 31, 2013 would be as follows: DR Interest expense 32,315 CR Lease liability 32,315 DR Depreciation expense 57,500 CR Leased equipment 57,500 DR Lease liability 75,000 CR Cash 75,000 The interest expense is calculated as the lease liability times the interest rate implicit in the lease (500,000 * 6.463% = 32,315). The lease schedule for the term of the lease would appear as follows: Date Leased Cash Lease liability equipment payments 575,000 (500,000) (75,000) Depreciation expense Interest expense January 1, 2013 (inception) January 1, ,500 (457,315) (75,000) 57,500 32,315 January 1, ,000 (411,870) (75,000) 57,500 29,555 January 1, ,500 (363,490) (75,000) 57,500 26,620 January 1, ,000 (311,985) (75,000) 57,500 23,495 January 1, ,500 (257,150) (75,000) 57,500 20,165 January 1, ,000 (198,770) (75,000) 57,500 16,620 January 1, ,500 (136,615) (75,000) 57,500 12,845 January 1, ,000 (70,445) (75,000) 57,500 8,830 January 1, ,500 - (75,000) 57,500 4,555 January 1, ,500 - (750,000) 575, ,000 7

8 Example type B (property) lease (lessee): The lease above is determined to be a type B lease because Company A determines that the lease term is an insignificant part of the total life of the asset. The total life of the asset is expected to be 20 to 25 years. The journal entry on December 31, 2013 would be as follows: DR Lease expense 75,000 CR Lease liability 32,315 CR Leased equipment 42,685 The credit to the lease liability is calculated as the lease liability times the interest rate implicit in the lease (500,000 * 6.463% = 32,315). The credit to the leased equipment is calculated as the lease expense less the credit to the lease liability (75,000-32,315 = 42,685). The lease schedule for the term of the lease would appear as follows: Date Leased Lease Cash Lease equipment liability payments expense January 1, ,000 (500,000) (75,000) (75,000) (inception) January 1, ,315 (457,315) (75,000) (75,000) January 1, ,870 (411,870) (75,000) (75,000) January 1, ,490 (363,490) (75,000) (75,000) January 1, ,985 (311,985) (75,000) (75,000) January 1, ,150 (257,150) (75,000) (75,000) January 1, ,770 (198,770) (75,000) (75,000) January 1, ,615 (136,615) (75,000) (75,000) January 1, ,445 (70,445) (75,000) (75,000) January 1, ,000 - (75,000) (75,000) January 1, (750,000) (750,000) Note that the lease liability column is the same as in a type A lease. 8

9 Lessor Accounting Requirements Accounting varies depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits of the underlying asset. See the table and on the following pages for a summary of lessor accounting for Type A and Type B leases. Highlights Accounting for Type A Leases: De-recognize the asset. Recognize a lease receivable = present value of fixed payments, certain variable payments, payments structured as residual value guarantees, purchase option or termination option (deemed to be significant incentive to the lessee), initial direct costs less any lease incentives. Discount rate = the rate the lessor charges. Recognize a residual asset representing the present value of the asset that the lessor expects to derive from the asset after the end of the lease term. Any residual amounts go to profit or loss. If fair value of underlying asset is greater than the carrying value at commencement date, allocate the difference between profit at commencement date and unearned profit (becomes part of residual asset). Portion to profit or loss = the proportion resulting from the present value of the lease payments divided by the fair value of the asset. Accounting for Type B Leases: No de-recognition of the leased asset. Recognize lease payments as income on a straight-line basis or other systematic basis. Recognize variable lease payments in profit or loss in the period they are earned. Recognize initial direct costs as an expense over the lease term to match leased assets. 9

10 Table: Summary of Lessor Accounting Lease Commencement Subsequent periods amounts to report on the profit or loss statement and balance sheet Type A Lease De-recognize the asset. Lease receivable = present value of fixed payments, certain variable payments, payments structured as residual value guarantees, purchase option or termination option (deemed to be significant incentive to the lessee), initial direct costs less any lease incentives. Discount rate = the rate the lessor charges. Recognize a residual asset representing the present value of the asset that the lessor expects to derive from the asset after the end of the lease term. Residual value = A+B-C A = present value of amounts the lessor expects to derive from the asset following the end of the lease term; discount rate = the rate the lessor charges the lessee. B = present value of variable lease payments not included in the lease receivable. C= unearned profit = fair value less carrying value (immediately before commencement date) less any profit already recognized at commencement date. Any residual amounts go to profit or loss. If the fair value of the underlying asset is greater than the carrying value at commencement date, allocate the difference between profit at commencement date and unearned profit (becomes part of residual asset). Portion to profit or loss is based on the proportion of the present value of the lease payments (using lessor s discount rate to lessee) divided by the fair value of the asset. For both the lease receivable and residual asset, unwind the discount as interest income. Recognize any variable lease payments in the period received that were not part of the initial lease receivable. Type B Lease Continue to measure and record the underlying leased assets under the applicable standard. (E.g., no derecognition.) Recognize lease payments as income on a straight-line basis or other systematic basis (if more representative of the pattern in which income is earned on the underlying asset). Recognize variable lease payments in profit or loss in the period they are earned. Recognize initial direct costs as an expense over the lease term to match leased assets. Not applicable. 10

11 Reassessment of lease receivable and residual asset Accounting for assets remaining at the end of the lease term or upon lease termination Highlights of some of the new financial statement presentation requirements Re-measure the lease receivable to reflect changes to lease payments and changes to discount rate. Differences between old and new carrying values (after re-measurement) are recognized to profit or loss. Reassess if there are revisions to lease payments, revisions to lease terms or loss of significant incentive to exercise the purchase option. May also have to reassess effects on the discount rates. Assess residual asset for impairment. Apply IAS 36 to determine if there is impairment. Reclassify any remaining assets to the appropriate balance category (e.g., PP&E or inventory). In early termination, test for impairment of remaining receivable and residual asset balance and reclassify the remaining assets to the appropriate balance sheet category. Cash flows from lease payments are recognized as cash flows from operating activities. Lease assets (sum of carrying value of lease receivables and residual assets) are shown separately on the balance sheet from other assets. Disclose carrying values of leased assets in the notes. Need to show lease income in the statement of profit or loss, or provide this information in the financial statement notes (if presentation by function). For leases used as a form of financing, present lease income as a single line item. (I.e., think of the old financing-type leases.) For leases used to allow the lessor an alternative means of realizing value from goods that it would otherwise sell, present revenue and costs of sales related to the leases as separate line items. (I.e., think of the old sales-type leases.) Not applicable. Not applicable. Show lease payment receipts as cash flow from operating activities. 11

12 Highlights of some of the new financial statement note disclosure requirements Revaluation of lease liability under certain circumstances Disclose significant judgments made in applying the standard. Provide information on the nature of the leases (e.g., description, terms, information about buyouts and extensions). Disclose maturity analysis of lease payments showing undiscounted cash flows to be received on an annual basis for a minimum of each of the first five years and the total of amounts for the remaining years. Separate disclosure for A and B leases. Note disclosure in a tabular form showing separate disclosure for amounts recognized to profit loss for type A leases, type B leases, variable lease payments (not included in measurement of lease receivable) and income from short-term leases (less than 12 months). For type A leases disclose amounts recognized as profit or loss at lease commencement and amounts for unwinding the discount on the receivable and residual asset. Provide reconciliation of opening and closing lease receivable and residual asset balances. Disclose how the issuer manages risk associated with residual assets. (E.g., overall strategy, extent of coverage through residual value guarantees, use of buy-back agreements or variable lease payments for use in excess of specified limits) IFRS 7 disclosure about nature and extent of risks arising from financial instruments (IFRS 7.32 to.42h). Yes Revaluation circumstances may be items such as: Change in lease term; Loss in significant incentive to exercise purchase option or disincentive for lease termination; or Change in rates to determine lease payments. Disclose significant judgments made in applying the standard. Provide information on the nature of the leases (e.g., description, terms, information about buyouts and extensions). Disclose maturity analysis of lease payments showing undiscounted cash flows to be received on an annual basis for a minimum of each of the first five years and the total of amounts for the remaining years. Separate disclosure for A and B leases. Note disclosure in a tabular form showing separate disclosure for amounts recognized to profit loss for type A leases, type B leases, variable lease payments (not included in measurement of lease receivable) and income from short-term leases (less than 12 months). Same as Type A Lease. 12

13 Transition Exposure Draft paragraphs C2 to C22 require recognition and measurement of leases at the beginning of the earliest period presented using either a modified retrospective approach or a full retrospective approach. Comparison Between Existing Lease Standard and Proposed Standards Identification of a lease Classification of lease Operating Classification of lease Finance Current IAS 17 Model Right to use an asset for an agreed period of time. Operating lease A lease other than a finance lease. Finance lease Transfer of substantially all of the risks and rewards incidental to ownership Transfer of ownership by end of lease term. Bargain purchase option Lease term is major part of economic life. Present value of minimum lease payments amounts to substantially all of the fair value of the leased asset Lease asset is of a specialized nature. Cancellation losses are borne by the lessee Gains / losses from fluctuation in fair value of residual accrue to the lessee Option to renew at below market price Proposed Lease Model The below changes should narrow the scope of the contracts that are considered to be leases. Concept of underlying asset The asset in a lease is specifically identified in the contract and supplier does not have substantive substitution rights. Control The lessee has the right to direct the use of the asset. Control The lessee has the ability to derive the benefits from use. Short-term lease election An entity can elect not to apply the guidance to any lease that has a term of 12 months or less. Type A lease (non-property) - Classify all nonproperty leases as type A unless: Lease term is insignificant part of total economic life of asset, or The present value of the lease payments is insignificant relative to the fair value of the lease asset. Type B lease (property) Lease term is for major part of total economic life of asset, or The present value of the lease payments accounts for substantially all of the fair value of the lease asset. 13

14 Accounting for finance leases Accounting for lessors Lease term Variable lease payments Finance lease Initial recognition: Recognize the leased asset and lease liability at an amount at the lower of: Fair value of leased property, or Present value of minimum lease payments. Minimum lease payment apportioned between the finance charge and the reduction of the outstanding liability. Finance charge allocated to produce a constant periodic rate of interest on the remaining balance of the liability. Depreciate asset in accordance with IAS 16 Property, Plant and Equipment. Finance lease Initial recognition: Recognize leased assets as a lease receivable at an amount equal to the net investment in the lease. Recognition of finance income is based on a pattern reflecting a constant period rate of return on the lessor s net investment in the finance lease. The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. No specific guidance on variable lease payments. However, guidance exists in IAS 39 Financial Instruments: Recognition and Measurement, Appendix A, Embedded derivatives. Type A lease (non-property) Initial recognition: Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments. Recognize the unwinding of the discount on the lease liability as interest separately from the amortization of the right-of-use asset. Type B lease (property) Initial recognition: Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments. Recognize a single lease cost, combining the unwinding of the discount on the lease liability with the amortization of the right-ofuse asset, on a straight-line basis. Type A lease (non-property) De-recognize the underlying asset and record a lease receivable and the value of the residual asset. Recognize the unwinding of the discount on both the lease receivable and the residual asset as interest income over the lease term. Recognize any profit relating to the lease at the commencement date. Type B lease (property) Continue to recognize the underlying asset. Recognize lease income over the lease term, typically on a straight-line basis. The lease term is the non-cancellable period of the lease together with: Periods covered by an option to extend the lease if the lessee has significant economic incentive to exercise that option. Periods covered by an option to terminate the lease if the lessee has significant economic incentive not to exercise that option. Variable lease payments are excluded if the payments are not linked to an index or a rate. 14

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