CHP Consulting Whitepaper. Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. 2014 Q3 Comprehensively revised September 2014 CHP Consulting Limited
CHP Consulting Limited CHP Consulting has been delivering systems and consultancy services to the global leasing and asset finance industry since 1990. Our best practice methodologies and specialised knowledge of asset finance mean that we deliver the largest system implementations and most complex business change projects. With a 100% delivery record over our 20 years in the industry, CHP s track record is unrivalled. ALFA Systems, our class-leading software solution, is used by many of the world s top leasing and asset finance companies for full-lifecycle management of portfolios, ranging from the most complex structured loans to high-volume flow transactions. ALFA is a fully scalable, enterprise-wide solution that provides end-to-end integration and workflow automation. Setting a new standard for operational excellence, ALFA makes next-generation technologies available today; with an intuitive, highly customisable web-based user interface, easy deployment and transactional transparency. CHP has offices in London, Paris, Detroit and Sydney. For more information, visit www.chpconsulting.com.
In May 2013, the International Accounting Standards Board (IASB) and US Financial Accounting Standards Board (FASB) issued a revised proposal for a new lease accounting standard. Although this revised proposal was generally considered an improvement over the original Exposure Draft published in August 2010, it nevertheless attracted much comment, with many respondents disagreeing with various aspects of both lessee and lessor accounting. Towards the end of 2013 the Boards began to redeliberate their proposals. In this update of our whitepaper, CHP provides an overview of the current accounting standards, condenses the Exposure Draft feedback, summarises the tentative decisions made by the Boards in their redeliberations for both lessor and lessee accounting, and considers the systems implications for lessors. This paper represents the opinions of individuals within CHP Consulting Limited and is based on their understanding of the second Exposure Draft, published in May 2013, together with notes from the Boards redeliberation meetings, up to July 2014. Board meetings are continuing and further changes may be expected before the final standard is issued. The following text does not constitute formal advice of any kind.
CHP Consulting Whitepaper. Introduction The aim of the lease accounting project is to provide new standards under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) to resolve perceived problems with existing accounting, especially with respect to lessees. The work is part of a larger programme of work to achieve a convergence of the two sets of standards. 1 The balance sheet is a statement that summarises a company s assets, liabilities and shareholders equity. 2 Financial leverage refers to the use of debt to acquire assets. Existing lease accounting is governed by IAS17 within IFRS, and by ASC840 (formerly FAS13) under US GAAP. These standards are fairly similar. Under both IFRS and US GAAP, existing accounting includes the classification of leases into two categories: operating leases and finance leases (known under US GAAP as capital leases). If a lease is classified as a finance lease it is shown as an asset and a liability on the lessee s balance sheet 1, whereas for an operating lease the lessee simply accounts for the lease payments as expenses over the lease term. This means that investors and other users of financial statements must estimate the effect of operating leases on financial leverage 2 and earnings. In 2008 David Tweedie, then chairman of the IASB, said memorably: One of my great ambitions before I die is to fly in an aircraft that is on an airline s balance sheet. It looks as if his wish will be granted. 01 WHO WILL THE CHANGES AFFECT? The new standard will be mandated for all lessors and lessees who prepare their accounts under IFRS or US GAAP. Although lessee accounting is regarded as requiring more attention than lessor accounting, up until the publication of the 2013 Exposure Draft there was a desire to maintain consistent accounting between lessors and lessees, Countries that require or permit IFRS Countries seeking convergence with the IASB or pursuing adoption of IFRS FASB (United States) 2
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. and the changes to lessor accounting were significant. However, during the Boards subsequent redeliberations there have been substantial changes and so now, although lessor accounting is still in scope of the new standard, there are only minor changes proposed. Significant changes to lessee accounting remain proposed. The scope will include leases of property (land and buildings), plant and equipment. This paper is concerned primarily with the leasing of plant and equipment. In the United States, US GAAP is required for domestic publicly listed companies. There is no centralised control of financial reporting for privately owned companies, although in practice many such companies have contractual requirements to use US GAAP as part of credit agreements with financiers. Within the EU, IFRS is mandated for publicly listed companies. Cut-down versions have been adopted by local jurisdictions, such as the UK Accounting Standards Board, for privately held organisations and SMEs. 02 PROJECT TIMELINE Proposed major changes to accounting standards are typically published as an Exposure Draft for public comment. The first lease accounting Exposure Draft was published in August 2010, and following substantial changes a second Exposure Draft was published in May 2013. Following the second set of feedback, the Boards are now redeliberating most aspects of their proposals. The final standard can be expected in 2015, although the timing is still to be confirmed. Refer to the Adoption section for an explanation of the comparative accounts timeline. Jan 2017 Comparative accounts IFRS 2006 Leasing project commenced Aug 2010 Exposure Draft issued Early 2015 Projected final standard 2018 Projected effective date 2009 Discussion paper issued May 2013 Re-Exposure Draft Jan 2016 Comparative accounts US publicly listed companies 3
CHP Consulting Whitepaper. Current Standards 01 LEASE CLASSIFICATION US GAAP and IFRS contain broadly similar definitions of a lease, as an agreement conveying the right to use an asset for an agreed period of time. Both standards include a lease classification applied by lessors and lessees: FAS13 IAS17 3 For lessee classification, a lease is classified as an operating lease or capital lease. For lessor classification a lease is classified as an operating lease or direct finance lease. The two terms are often used interchangeably. 4 The lessee has an option to purchase at a price lower than the fair market value. 5 Present value means the value of a future cash flow movement expressed at today s value. A payment of $1,000 in a year s time is worth less than $1,000 received today. The present value is calculated at the rate implicit in the lease. 6 Sales-type and leveraged leases are defined on pages 10 and 12 respectively. A lease is classified as an operating lease or a direct finance lease/capital lease 3 according to four rules ( brightline tests). A lease is a direct finance lease if any of the following tests are met: There is automatic transfer of title. There is a bargain 4 purchase option. The lease term is equal to or greater than 75% of the leased asset s useful life. The present value 5 of the minimum lease payments is equal to or greater than 90% of the asset s fair market value. Sales-type and leveraged leases are varieties of direct finance lease 6. A lease is classified as a finance lease or operating lease based on whether it transfers substantially all the risks and rewards incidental to ownership of the asset. The following indicators that a lease is a finance lease are provided: There is automatic transfer of title. There is a bargain purchase option. The lease term is the major part of the leased asset s useful life. The present value of the minimum lease payments is substantially all of the leased asset s value. The asset is of a specialised nature. The lessee guarantees the lessor s investment if the lessee can cancel the lease. The lessee receives the residual upside and bears the residual losses at lease end. There are bargain renewal options. In practice, the FAS13 bright-line tests are often used to interpret the IAS17 indicators. Classification by lessor and lessee could differ should they use different inputs. For example, from the lessee s perspective, the discounted lease payments might be less than 90% of the fair market value and so it is classified as an operating lease. In contrast, the lessor might have a residual value guarantee from a third party, so the minimum lease payments (which include the residual value) exceed 90% of the fair market value and it is classified as a finance lease. 4
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. 02 LESSEE ACCOUNTING 7 The rate the lessee would have incurred either under a similar lease (IAS17) or to borrow over a similar term the funds necessary to purchase the asset (FAS13). 8 The rate that, when applied to the minimum lease payments and residual value, causes their aggregate present value at the start of the lease to be equal to the value of the leased equipment. The lessee uses the implicit rate if they know it (or the lower of the two under FAS13). The lessee will only know the lease s implicit rate if it is aware of the assumptions made by the lessor; for example, if the lessee guarantees the residual value or has a guaranteed purchase option price. 9 Amortisation is the same as depreciation, but in practice amortisation is used for intangible assets; while either term is used for tangible fixed assets. Intangible assets are non-monetary amounts that lack physical substance. Under IFRS and US GAAP, finance leases are capitalised on the lessee s balance sheet. At lease commencement, the lessee shows a right-of-use asset and an equal and opposite liability to make the lease payments. These are calculated as the present value of the lease payments, discounted at the lessee s incremental borrowing rate 7 or the rate implicit in the lease 8. The asset is amortised 9 in accordance with the depreciation policy for owned assets, typically on a straight-line basis over the lease term. The finance charge is allocated at a constant rate according to the outstanding liability, so is greater at the start of the lease. Annual Lease Expense $18 000 $16 000 $14 000 $12 000 $10 000 $8 000 $6 000 $4 000 $2 000 $0 Total expense Asset depreciation Finance lease interest Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Operating leases are off balance sheet. The rentals are recognised as an operating expense, usually on a straight-line basis over the lease term. $14 000 $12 000 Operating lease rental expense Annual Lease Expense $10 000 $8 000 $6 000 $4 000 $2 000 $0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 It is this lessee accounting for operating leases that is one of the main driving forces for the lease accounting project. There is a desire to capitalise operating leases on to the balance sheet to provide the users of accounts (such as stock and credit analysts) with a better view of a business s assets and liabilities. 5
CHP Consulting Whitepaper. 03 LESSOR ACCOUNTING For operating leases under both IAS17 and FAS13, the lessor holds the underlying asset on its balance sheet and depreciates it (typically on a straight-line basis) to its assumed residual at the end of the lease. The lessor accounts for the rentals as income, usually on a straight-line basis over the lease term. 10 In this example, the asset is $100,000 and the residual value is $20,000. The total depreciation is $80,000. The asset is depreciated by $8,000 every year for 10 years. The total rentals are $129,200. $12,920 is recognised as income every year, so the net income is $4,920. 10 Annual Lease Income $14 000 $12 000 $10 000 $8 000 $6 000 $4 000 $2 000 $0 -$2 000 -$4 000 Rental income Operating lease net income -$6 000 -$8 000 Asset depreciation -$10 000 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 For finance leases, the lessor records on its balance sheet the net investment in the lease, comprising the lease receivables and the residual value discounted using the implicit rate in the lease. If the lessor had previously recognised the underlying asset, this is removed from the balance sheet. The lessor recognises the net interest income to Profit & Loss (P&L), as illustrated below. 11 Using the same figures as above, the net interest income is $49,200. This interest is recognised in proportion to the outstanding balance, and consequently greater income is recognised at the start of the lease than at the end. 11 Annual Lease Income $8 000 $7 000 $6 000 $5 000 $4 000 $3 000 $2 000 Net finance lease income $1 000 $0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 6
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. Summary of the 2013 Exposure Draft In our August 2013 whitepaper we described the key features of the 2013 Exposure Draft, so we summarise them only briefly here. 01 LEASE DEFINITION AND CLASSIFICATION Lease Definition The 2013 Exposure Draft tightened the definition of a lease, and required both lessees and lessors to separate out the lease and non-lease components of a contract. For example, for a fully maintained lease of a vehicle or office equipment, the maintenance component of the rentals must be identified and accounted for separately. Most respondents to the 2013 Exposure Draft thought that the proposed definition of a lease was an improvement over both the 2010 Exposure Draft and existing accounting; although many also thought there was insufficient guidance to be able to apply the standard consistently. There was also general support for the separation of lease and non-lease components, although a number of practical problems in applying the proposed guidance were noted. Lease Classification 12 Property means land, and/or a building, or part of a building. 13 Plant and equipment leases would have been Type A leases unless either the lease term is for an insignificant part of the total remaining economic life of the leased asset, or the present value of the lease payments is insignificant to the fair value of the underlying asset at the lease commencement date. Conversely, property leases would have been Type B leases unless either the lease term is for the major part of the remaining economic life of the leased asset, or the present value of the lease payments accounts for substantially all of the fair value of the leased asset. One of the more controversial proposals of the 2013 Exposure Draft, and one which received many feedback comments, was the classification of leases as Type A and Type B based on a principal of consumption of the economic benefits of the asset. For practical purposes the classification was based on whether the leased asset was property 12 or plant and equipment 13. The majority of respondents were negative about the proposed classification, in particular raising concerns about the use of subjective terminology and the classification based on property versus plant. Several respondents proposed a classification in line with the existing IAS17 classification. Short-Term Leases There was an exemption proposed for short-term leases, which could continue to be accounted for by both lessees and lessors using existing operating lease accounting. Short-term leases were defined as leases that can have a term, including any renewal options, of no longer than 12 months. Many respondents supported this exemption as a means of reducing compliance costs; although many disagreed with the proposed definition of a short-term lease, noting that leases with a maximum possible term of 12 months are rare. Lease Term The 2010 Exposure Draft had proposed that the lease term be defined as that more likely than not to occur, which required subjective judgment and estimation of the lessee s likelihood of exercising any options to extend or terminate, and reassessment each reporting period. 7
CHP Consulting Whitepaper. By contrast, the 2013 Exposure Draft proposed to consider (at both lease commencement and in subsequent reporting periods) only extension and termination options that the lessee had a significant economic incentive to exercise. These 2013 changes were generally well received, although there were still concerns regarding the requirement for both lessors and lessees to reassess any change in the lessee s significant economic incentive to exercise an option. Contingent Rentals 14 Contingent rentals are defined as lease payments that are not fixed amounts, but are based on factors including usage, price indices and market rates of interest. There were also substantial changes to the treatment of contingent rentals 14 in the 2013 Exposure Draft. While in 2010 all contingent rentals were included in the definition of lease payments, in 2013 this was changed to include only those rentals linked to a rate or index thereby excluding usage-based rents. These variable rate rentals would be included in the balance sheet presentation of lease receivables. When the underlying rate changed, the receivables would need to be reassessed with any change recognised in profit and loss. Most respondents to the 2013 Exposure Draft supported these changes, although some still preferred the 2010 proposals. However, most respondents disagreed with the requirement to remeasure due to cost and complexity. 02 LESSEE ACCOUNTING The 2010 Exposure Draft proposed a single approach for lessee accounting, similar to the current standards for finance/capital leases. However, this caused concerns over the front-loading of the lease expense, especially with respect to property leases (which in turn led to the proposed lease classification described above). This example shows an agreement where the rentals increase year on year: 15 The actual cash flow expenditure increases each year. Under existing operating lease accounting, the total rentals are expensed on a straight-line basis (the same amount each year). Under the proposals, the expense would be greater at the start of the lease and would decrease year on year. 15 Annual Lease Expense $18 000 $16 000 $14 000 $12 000 $10 000 $8 000 $6 000 Proposed amortisation Proposed interest expense Proposed lease expense Existing operating lease expense Cash flow $4 000 $2 000 $0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 The 2013 Exposure Draft proposed that while all leases would still be capitalised as a right-of-use asset and a liability on the balance sheet, for Type B leases the right-of-use asset would be amortised as a balancing figure such that the total lease expense is recognised on a straight-line basis, as illustrated below. 8
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. $14 000 $12 000 Proposed total expense Annual Lease Expense $10 000 $8 000 $6 000 $4 000 Proposed amortisation Proposed interest expense $2 000 $0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Type A leases would continue to amortise the right-of-use asset on a straight-line basis, so the total lease expense would be front-loaded. Since many operating leases of plant and equipment would be reclassified as Type A leases under the proposed 2013 lease classification, this would cause their lease expense profiles to move from straight-line to front-loaded. 16 Disclosures are notes provided with the financial statements that provide additional information about a company s leases and currently include, among other items, an analysis of lease commitments over future periods, operating lease and contingent rentals expensed in the reporting period, and a description of a lessee s material lease arrangements including the existence of renewal and purchase options. The majority of respondents to the 2013 Exposure Draft supported the recognition of assets and liabilities for operating leases although some respondents said that they did not think one model would satisfy the requirements of all users, and that therefore users requirements are better met simply through increased disclosures 16 in the accounts. The different lessee expense profile by lease type was more contentious. Many respondents supported the dual lessee accounting model for lessees lease expenses because they thought it reflected the differing economics of different types of leases but others disagreed, arguing that it was inconsistent with the requirement to capitalise all leases and created the possibility of structuring, which is a criticism of the current lease accounting. Some respondents argued for finance lease-type accounting for all leases, while others proposed a single straight-line expense for all leases. 03 LESSOR ACCOUNTING 17 Accretion means the gradual increase of the residual value. The year-on-year increase of the present value of the residual is recognised as income. The 2013 Exposure Draft proposed that Type B leases would continue to be accounted for using existing operating lease accounting, and that Type A leases would be accounted for under the receivable and residual (R&R) approach. In its basic form, the R&R model was similar to the current treatment of finance leases, but separately recognised a right to receive lease payments, discounted at the implicit rate, and a residual asset. Over the lease term the interest component of the lease payments would be recognised at a constant rate according to the outstanding balance, and the residual value would be accreted 17. 9
CHP Consulting Whitepaper. Annual Lease Income $8 000 $7 000 $6 000 $5 000 $4 000 $3 000 $2 000 Residual Receivable Finance leases under IAS17 $1 000 $0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 In the feedback, the 2013 Exposure Draft was welcomed as a significant improvement over the proposals of the 2010 Exposure Draft. However the majority of respondents did not support changing the existing model, arguing that it is well understood, does not require the users of accounts to regularly adjust the lessor s financial statements, and as such should not be changed just because lessee accounting is changing. Accounting for Sales Profit 18 Under US GAAP, a lease is defined as a sales-type lease if it meets the finance lease criteria and gives rise to a manufacturer s or dealer s profit. Normally, sales-type leases will arise when manufacturers or dealers use leasing as a means of marketing their products. If there is a difference between the accounting book value and the fair market value of the asset before lease commencement, there is a sales profit or loss. Under current accounting rules, this is recognised in full upfront on finance leases 18 and is in effect spread over the term for operating leases, as the asset is retained on the balance sheet and depreciated from its book value. Within Type A lease accounting the 2013 Exposure Draft proposed that the lessor would recognise a portion of the sales profit upfront, and the remainder on sale of the asset at the end of the lease. This would have been advantageous for current operating leases. However, a lessor need not be a dealer to realise dealer s profit (or loss) on a transaction. For example, if a rail car lessor writes a new lease (not a renewal) for a used wagon, the asset may have a fair value that is greater or less than its carrying amount. Annual Lease Income (bars) $16 000 $14 000 $12 000 $10 000 $8 000 $6 000 $4 000 Existing finance lease Existing operating lease Proposed $70 000 $60 000 $50 000 $40 000 $30 000 $20 000 Total Income (lines) $2 000 $10 000 $0 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 $0 Some respondents thought that the lessor should not recognise any profit until the end of the lease, noting that there could be profit reversal if the lease is terminated early; whereas others thought that the full sales profit should be realised on lease commencement, arguing that it is complex and unintuitive to split into a realised and unrealised portion. 10
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. Initial Direct Costs 19 Initial direct costs are costs that are directly attributable to negotiating and arranging the lease, which would not have been incurred had the lease transaction not been made. They include, for example, commissions and legal fees. 20 Refer to page 17 of our August 2013 whitepaper for an explanation of this calculation. For Type A leases, the 2013 Exposure Draft proposed that initial direct costs 19 should be included on the balance sheet within the right to receive lease payments and amortised as an offset to interest income, similarly to existing finance lease accounting. However, because the residual asset in the R&R approach would be accreted at the implicit rate, unadjusted for the initial direct costs, a separate rate had to be imputed in order to reduce the receivable balance to zero at the end of the lease term 20. This method slightly deferred the earnings profile in comparison to existing finance lease accounting, as illustrated below. Annual Lease Income $6 000 $5 000 $4 000 $3 000 $2 000 $1 000 $0 Existing finance lease accounting Proposed lease receivable interest Proposed total interest Proposed residual interest Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Very few comments were made about the treatment of initial direct costs. Sale and Leasebacks 21 A sale and leaseback involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negotiated as a package. In the 2013 Exposure Draft the accounting for sale and leasebacks 21 would be dependent on whether a sale of the asset to the lessor is deemed to have occurred, which would be determined using the relevant revenue recognition standard. If a sale has not occurred, the contract would be accounted for as a financing arrangement under the revenue recognition standard. If a sale has occurred, the contract would be accounted for as a lease: the lessor will account for the purchase of the entire underlying asset and for the lease using the standard R&R approach. Most respondents to the Exposure Draft did not comment on the proposed guidance, but amongst those that did there was broad support for aligning the accounting for the sale with the revenue recognition standard, although some application issues were highlighted. Back-to-Back Leases 22 In a back-to-back lease, an intermediary acts as a lessee to lease an asset from a head lessor, and as a lessor to lease the same underlying asset to a sub-lessee in a sublease agreement. The 2013 Exposure Draft proposed that back-to-back leases 22 (head lease, sublease arrangements) would be accounted for as separate transactions. The intermediate lessor, as lessee in the head lease agreement, would evaluate the sublease with reference to the underlying asset (as opposed to the right-of-use asset arising from the head lease) and account for its assets and liabilities in accordance with the proposed lessee accounting. As lessor in the sub lease agreement, it should account for its assets and liabilities in accordance with proposed lessor accounting. Few respondents provided feedback, and those that did were concerned that there could be asymmetry between how an intermediate lessor accounts for a head lease and a sublease relating to the same underlying asset, and how to account for intercompany sublease transactions. 11
CHP Consulting Whitepaper. US leveraged leases 23 A leveraged lease is a type of direct finance lease. In a leveraged lease, a long-term creditor provides substantial leverage to the lessor and is non-recourse to the lessor s general credit, and the lessor s net investment declines during early periods and rises during later periods. 24 Grandfathering means continuing to account for existing leases according to current accounting standards. US GAAP has specific accounting for leveraged leases 23. The 2013 Exposure Draft eliminated leveraged lease accounting. As might be expected most respondents did not comment on this, but those that did disagreed with the proposal on the grounds that these leases are based on tax benefits and therefore the existing accounting reflects the transaction more accurately. These respondents also thought that applying the new rules retrospectively to existing contracts (see Transition, below) would be very costly while providing little benefit, so requested that existing leases be grandfathered 24. Disclosures The 2013 Exposure Draft introduced a number of qualitative and quantitative changes to existing disclosure requirements to allow the users of lessors and lessee s financial statements to better understand the cash flows arising from the leases. In their feedback, most users supported the proposals, whereas the majority of preparers thought they were excessive and complex. 12
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. Proposed Standard (based on redeliberations to date) The two Boards began redeliberations of the proposed standard in November 2013. Since then, through to July 2014, they have discussed the lessee and lessor accounting models, lease classification, measurement (lease term and variable lease payments, for example), the definition of a lease, sale and leaseback transactions, and lessors disclosures. Still on the agenda are lessees disclosures, transition, the effective date of the new standard, leveraged leases and a cost-benefit assessment. There are also a few topics that need to be revisited. None of the decisions described below are set in stone; all are subject to revision until the final standard is produced. 01 LEASE DEFINITION Lease Definition In their redeliberations, the Boards have reconfirmed the lease definition approach proposed in the 2013 Exposure Draft, and agreed to provide additional guidance in the final standard. The Boards also reconfirmed that both lessors and lessees would be required to separate lease and non-lease components of a contract and account for the non-lease components in accordance with the revenue recognition standard. Lessees would do this by using observed or estimated stand-alone prices, so lessors should be able to avoid having to disclose to their customers proprietary information about how they price their contracts. The Boards also decided that lessors and lessees would need to reallocate the lease rental when a contract is modified or upon reassessment of the lease term. Exemptions The Boards discussed and reaffirmed the proposed exemption for short-term leases, and tentatively decided to apply the 12-month limit to the lease term (as defined below), rather than the maximum lease term as proposed in the 2013 Exposure Draft, as a result of which more leases should become eligible for the exemption. 25 In such an exception, the standard would include a stated percentage of net assets. 26 Small-ticket leases are individually small in value and not specialised in nature, for example personal computers and other office equipment. In addition, the Boards discussed additional options in order to reduce the cost and complexity of the accounting for lessees. They considered but discounted an explicit materiality exception 25. They also considered an exemption for small-ticket leases 26. There was support for this approach from some of the Board members, but also a concern that the aggregate values of these leases could be material as a whole. Following further research the Boards are expected to revisit this option later. The Boards also considered allowing lessees to account for similar leases at a portfolio level. In general the Boards supported this approach. Lease Term Other than changes in terminology to be more consistent with the existing standards, the Boards have reconfirmed the definition of the lease term in the 2013 Exposure Draft. However, the Boards also decided to remove the requirement for lessors to reassess the lease term after inception; only lessees will have to reassess the lease term, and only if there is a significant change directly attributable to the actions of the lessee. 13
CHP Consulting Whitepaper. Contingent Rentals The Boards confirmed the scope set out in the 2013 Exposure Draft. Only variable lease rentals linked to an index or rate should be included in the initial measurement of lease receivables. However, for lessees, the Boards did not agree on how these payments should be measured subsequently. The IASB decided that lessees should remeasure the variable lease payments whenever the contractual cash flows changed as a result of a change in the underlying index or rate, whereas FASB decided that the variable payments should only be remeasured when the lease liability is remeasured for other reasons. For lessors, the Boards agreed that lessors should not have to remeasure variable lease payments, so any change will be recognised as income in the periods in which it occurs. Many lessors will already take this approach where their contracts are encoded and accounted for using the prevailing interest rate at lease commencement. However, for those who restructure their leases in event of a change in index, including for changes in tax rates, this could be a significant change. 02 LESSEE ACCOUNTING The Boards have reconfirmed that (excluding any exemptions) all leases should be on the lessee s balance sheet, and consequently discussions have been focused on the lessee s recognition of the lease expense. In the discussions to date, the Boards have not come to agreement, and as such it currently seems likely that the new standard will diverge between IFRS and US GAAP. The IASB favours Type A accounting for all leases, thereby removing the need for any lease classification by lessees. They think this model reflects the views of most users that all leases create assets and debt-like liabilities; it is easy to understand a lessee expenses asset amortisation and interest expense corresponding to the balance sheet recognition; it avoids any risk of lease structuring; it reduces complexity; and should be simpler to implement because leased assets will be amortised in the same way as owned assets. Conversely, the FASB favours keeping a form of lease classification, similar to the existing IAS17 classification. Generally existing finance leases would be classified and accounted for as Type A leases, and existing operating leases would be Type B leases, although because of the differences between US GAAP and IFRS lease classification it is possible that some operating leases could be classified as Type A, and some capital leases could be classified as Type B. They think that this approach reflects the views that Type B leases are not effectively purchases of the underlying asset; provides the best reflection of the lease economics; and achieves the aims of the project in capitalising these leases on to the balance sheet but without impacting lessees overall expense profile. 03 LESSOR ACCOUNTING Following the feedback from the 2013 Exposure Draft, the Boards have decided that wholesale changes to the existing accounting model are not required. Leases will be classified as Type A or Type B using an approach similar to the existing principles in IAS17. Further, they decided not to adopt the R&R approach set out in the Exposure Draft, which means that Type A leases will be accounted for in an approach substantially similar to the finance lease/capital lease accounting in the existing standards. However, the proposed changes to lease definition, lease term, and the inclusion of variable rate rentals in the definition of the minimum lease payments will still apply. 14
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. Accounting for Sales Profit As part of dropping the R&R approach, the Boards also dropped the deferral of some of the sales profit until the end of the lease. However, the Boards diverged in their views of how sales profit should be treated. The IASB proposes to allow lessors to recognise any sales profit upfront on all Type A leases; whereas the FASB will only allow sales profit to be recognised if the lessee obtains full control of the leased asset. Thus, if a lease is classified as Type A due to the existence of a third party residual guarantee, the lessee will not have been passed full control and sales profit cannot be realised on lease commencement. Instead, sales profit is recognised through higher interest income over the term of the lease. This differs from existing US GAAP treatment of a sales-type lease. $16 000 $70 000 Annual Lease Income (bars) $14 000 $12 000 $10 000 $8 000 $6 000 $4 000 IFRS proposed US GAAP proposed $60 000 $50 000 $40 000 $30 000 $20 000 Total Income (lines) $2 000 $10 000 $0 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 $0 Initial Direct Costs In their redeliberations the Boards revised the definition of the rate implicit in the lease to include any initial direct costs, so the problem of having to calculate and recognise interest using an imputed rate is no longer an issue. Sale and Leasebacks In their redeliberations to date the Boards have reaffirmed that the revenue recognition standard should be used to determine whether a sale has occurred. Under US GAAP, a sale will not have occurred if the leaseback transaction would result in a Type A lease, and under IFRS it will not have occurred if the lessee may repurchase the asset (FASB is performing additional analysis on this issue). Back-to-Back Leases The Boards have ratified the proposals in the 2013 Exposure Draft that the head lease and sublease should be accounted for as two separate transactions, although the IASB tentatively decided that the sublease classification should be based on the remaining right of use asset resulting from the head lease; whereas FASB reaffirmed the 2013 proposal to classify with reference to the underlying asset. Where the standard diverges between lessor and lessee accounting, including for example the treatment of variable interest payments, the intermediate lessor will account for the difference on their balance sheet and profit and loss statement. 15
CHP Consulting Whitepaper. Disclosures Although the Boards have decided that lessor accounting should be essentially unchanged, they have decided that additional disclosures would still be beneficial for users. They have removed the requirements for lease receivables and residual asset reconciliation, but will require a maturity analysis of the lease cash flows with reconciliation to the balance sheet that is more comprehensive than the existing disclosures. 16
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. Adopting the New Standard The Boards have not yet discussed the transition requirements in their redeliberations. In the 2013 Exposure Draft it was proposed that the new standard would be retrospective, meaning it will apply to all contracts existing on the date of initial application. 01 ADOPTION TIMING Effective Date The effective date is the date from which companies will need to apply the new standard. They will use the new standard in their first financial year on or after the effective date. With the final standard likely to be issued in the first half of 2015, an effective date of January 2018 is most likely. Date of Initial Application For major changes in accounting policy, companies must provide comparative accounts using the new standard for reporting periods before the effective date, having originally filed their accounts for those periods under the existing rules. The date of initial application is the beginning of the first comparative period presented in the financial statements. The periods for which this applies is dependent on the jurisdiction and type of company. US publicly listed companies must provide two years of comparative accounts. Assuming an effective date of January 2018, the transition rules for the new standard will apply from January 2016. US private companies do not need to provide comparatives. Companies subject to IFRS must provide one year s comparative accounts. Assuming an effective date of January 2018, the transition rules for the new standard will apply from January 2017. 02 TRANSITION APPROACH The transition (i.e. restatement) from the old to the new accounting standards will now be of relatively little concern for lessors with portfolios of simple operating and finance lease products. However, for lessors where the proposed changes to lessor accounting have an impact, and for all lessees with operating leases, transition remains a significant concern.. The 2013 Exposure Draft proposed the option of a full retrospective or modified retrospective approach. Under the full retrospective approach, each lease must be restated from lease commencement, based on inputs evaluated as at the lease commencement date, whereas under the modified approach leases would still be restated from their original commencement, but reliefs would make this simpler to apply than the conventional full-retrospective approach. 27 Retained earnings are historical earnings that are kept by the business to be reinvested or pay back debt, as opposed to being paid out to shareholders as dividends. Feedback to these proposals was mixed, with most users favouring the full transition approach, and not liking that preparers may choose between the two options, which could result in different outcomes and reduce comparability. By contrast, preparers were concerned about the costs of maintaining two sets of accounts during the transition period, so liked the flexibility of the two approaches. To reduce complexity many respondents recommended making a cumulative adjustment to retained earnings 27 in place of restating the comparative periods. The Boards are still to redeliberate the transition approach. 17
CHP Consulting Whitepaper. Systems Implications for Lessors In this section, we consider the likely software changes required to support the new standard, how to manage the transition, and the overall implementation approach. 01 SOFTWARE CHANGES For lessors, the Boards reversion to a model similar to existing lease accounting should mean required system changes are small. Nevertheless there could be several changes required, depending on the system s functionality and the lessor s portfolio. Lease Classification If systems include any US GAAP lease classification rules, these may need to be updated to reflect the IAS classification, and to incorporate the exemption for short-term leases if required. Sales Profit On Lease Commencement For manufacturer lessors, under the existing standards it is probable that sales profit on existing finance leases is realised by the sale recorded on the manufacturer s inventory system and the asset s fair value is booked as the asset cost on the lease administration system. Under FASB s proposals, where control is not fully passed to the lessee, lessors will have to record the book value of the asset instead. This could just be a process change to record the book value as the sales proceeds in the inventory system and as the cost in the lease administration system, but lessors may need to record both the carrying value and fair value in the lease administration system in order to account for the contract correctly while providing customer-facing values based on the fair value. Variable Rate Rentals Most leases will already be encoded and accounted for using the prevailing interest rate at lease commencement, so little change is required now that lessors do not need to remeasure the remaining lease payments in event of a change in rate. On some systems there may currently be some finance leases that are booked with capital repayments only which will require the interest amounts to be pre-calculated and included in the balance sheet presentation of receivables. Conversely, some lessors may currently restructure their leases in event of a change in index, so if remeasurement is precluded again system changes may be required. For lessors with tax variable clauses, determining the period in which adjustment income is recognized could be problematic. Segregation Of Lease And Service Payments Some lessors may price and record within their systems a single rental amount that covers the lease and service element of a full-maintenance contract, such that it is not possible to readily separate and account for the lease and non-lease income streams. The service elements may need to be recorded and accounted for separately in accordance with the Revenue Recognition standard. 18
Lease Accounting Reform: The Systems Impact for Asset Finance Lessors. Head Leases For lessors with head leases, their lease administration and accounting systems need to support the new lessee accounting standard. Disclosures More likely than not, any additional disclosures can be supported through reporting over existing systems data, but some systems may not record all of the data required in a systematic way. Supporting lessees As fewer changes are required to support lessor accounting, perhaps more lessors will take time to consider system changes they could make to assist their customers with the changes. Many lessees only have operating leases (for example for their property leases, office equipment and cars) and will not have any centralised systems in place for their administration and accounting. Consider a company that has a large fleet of car leases. These leases might be administered by an HR team on a spreadsheet, with the monthly expenditure accounted for via payroll. Lessees accounting under IFRS (note that the new standard will not, at least initially, apply to SMEs in the EU, or be mandated for privately owned companies in the US) will require more sophisticated systems and processes to manage their lease expenditure. Some lessors may assist and provide this information as part of their service offering; others will neither want to share information with their lessees (for example, presenting the split of finance rental and maintenance), nor assume the risk of incorrect accounting. Also, since under the proposals expenditure moves from operating to capital expenditure budgets, decision making will move towards the Chief Financial Officer. Lessor systems, especially sales systems, may need to provide more information to support lessee decision making. New Product Offerings The burden of administering lease accounting may cause some lessees to consider alternative methods of finance. For those companies for which off balance sheet accounting is important, they might push for more service contracts or short-term leases, although it is important to note that the value that will be on the balance sheet for what were operating leases will still be significantly less than if the asset were purchased. Some lessor systems may be very restricted in the products they can administer, so system changes will be required to offer a wider product range. 02 TRANSITION Now that lessors operating leases no longer need to be restated to the R&R approach, transition should no longer be such a challenge. However, although transition requirements are still to be redeliberated, assuming that existing leases will not be grandfathered there may still be requirements to provide comparative accounts for leases whose classification has changed between US GAAP and the proposed IAS17- based classification, the inclusion of variable rate payments, changes in the recognition of sales profit, and/or the elimination of leveraged lease accounting. 19
CHP Consulting Whitepaper. Where retrospective restatement is required, lessors and lessees may need to source additional data required for the new standard and upload it manually or automatically to existing contracts. Then, all of the contracts existing at the date of initial application will need to be restated under the new standard. A method is required to restate the contracts in bulk, preferably carried out automatically to avoid expensive and error-prone manual input. Then, between the date of initial application and the effective date, the contracts will need to be accounted for under the existing and new standards to provide the comparative accounts. The approach will depend on the system. Two possible approaches are (i) to repeat the bulk restatement for each reporting period, or (ii) to raise concurrent accounting entries under both standards. Where concessions allow existing leases to be accounted for under existing standards, with new leases being accounted for under the new standards, lessors will need to maintain support for both standards within their systems until the expiry of the last of the existing leases. 03 APPROACH Now that the system changes are comparatively small, most lessors should be able to make any required changes to their existing systems; a full systems replacement project is very unlikely to be justified by the accounting changes alone. However if changes are required, then lessors that rely on in-house systems or those based on legacy technology in particular should be aware of the risks of changing core parts of their systems, and of key-man dependencies. Any changes will require considerable testing, especially from comparatively small Finance teams, so businesses will want to maximise the benefits of the disruption. There may be a case for incorporating the accounting changes into a wider systems upgrade project to deliver improved efficiency, flexibility, product offerings and customer satisfaction. 04 NEXT STEPS Given the volatility of the proposals to date, it is tempting for lessors and lessees to wait for the final standard before thinking about its implementation in any detail. Certainly businesses who have delayed implementing the changes proposed in the 2013 Exposure Draft have been justified. However, with the redeliberation following the 2013 Exposure Draft, a final standard now seems much closer. The Boards have reaffirmed their intention to capitalise all leases on the lessee s balance sheet, and have confirmed the inclusion of lessor accounting within the scope of the project, albeit with few changes now compared to the existing standards. Further prolonged outreach seems unlikely, and the Boards expect to issue the final standard in 2015. The effective date is still to be discussed, but assuming it is January 2018, and assuming comparative period accounts will still be required, then the Date of Initial Application under US GAAP will be as soon as January 2016 and for those reporting under IFRS will be January 2017. Leases active on these dates will need to be restated under the new standard, so almost all new leases being written now will be subject to the new rules. 20