New on the Horizon: LEASES FOR BANKS July 2013 IFRS Global Banking The revised lease proposals will affect banks in their capacity as lessees and in their capacity as lessors. Banks will also need to assess the effect of the proposals on their customers. The impacts could be farreaching. Colin Martin, Head of UK Assurance Services, Banking, KPMG Banks said that the 2010 lease accounting proposals were complex, costly and would reduce comparability. The Boards have published revised proposals. The IASB s and the FASB s joint leases project continues to be a hot topic for banks. The Boards published revised proposals in May 2013. This publication looks at the potential impact of the revised proposals on banks, discusses whether previous concerns expressed by banks have been addressed and highlights new issues relevant to banks. Highlights l The new lease accounting proposals may have a significant impact on banks compliance with capital and other regulatory requirements. l The proposed dual model and new lease classification test may impede comparability. l The proposals may affect the covenant arrangements of customers with significant lease commitments, and the complexity of the proposals could impact leasing business generally. l The exclusion of some sale and leaseback transactions from the lease proposals could increase volatility in profit or loss. l The future tax treatment of leases is uncertain in some jurisdictions as tax authorities consider the proposals.
2 New on the Horizon: Leases for Banks The proposals at a glance Key facts The IASB and FASB published ED/2013/6 Leases (the ED or the proposals) on 16 May 2013. 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 expected to be 1 January 2017. The accounting for lease receivables may be affected by the IASB s proposals on impairment. The proposed expected loss model could replace the current incurred loss model under IAS 39 Financial Instruments: Recognition and Measurement. Details of the proposals can be found in our publication New on the Horizon: Financial instruments Expected Credit Losses. Although the IASB and the FASB have addressed some of the banks concerns with the 2010 proposals on lease accounting, many issues remain for banks. Additionally, there are a number of areas in which it is still unclear how the revised leases proposals would be applied by banks and what the ultimate impact would be. Some fear that banks may need to invest significant amounts in new information systems to implement and apply the new lease models. This publication focuses on the challenges facing banks, but for a full discussion of the revised proposals, see our cross-sector publication New on the Horizon: Leases. We encourage you to consider the proposed changes and to provide your feedback via the comment letter process as the Boards have invited comments on the revised leases proposals by 13 September 2013.
New on the Horizon: Leases for Banks 3 The proposals at a glance Key impacts Headline New accounting may have a significant impact on banks compliance with capital requirements Proposed dual model and new classification test may impede comparability Proposals may affect the covenant arrangements of customers with significant lease commitments Complexity of proposals could impact leasing business generally Exclusion of some sale and leaseback transactions from the lease proposals could increase volatility in profit or loss Future tax treatment of leases is uncertain in some jurisdictions as tax authorities consider the proposals What is the impact of the revised proposals? Banks that have lease arrangements e.g. property leases as a lessee would need to bring leases on to the balance sheet. This would increase the bank s assets and liabilities and, consequently, would have an impact on its regulatory capital. As a lessee, banks would be required to record all leases (including current finance leases) as ROU assets. This may have a significant impact on their Tier 1 common equity. The increase in the asset base and Tier 1 capital may also impact a bank s leverage ratio. The proposals include a new lease classification test based on the extent of consumption of the underlying asset over the lease term. The test takes into account the nature of the leased asset i.e. whether or not it is a property. Lessees would apply either the accelerated (or interest and amortisation) model to Type A leases or a straight-line model to Type B leases. Lessors would apply the receivable and residual model to Type A leases and an operating lease model similar to that in IAS 17 Leases to Type B leases. The lessee and lessor accounting models are not symmetrical. In particular, under the model for Type B leases, the lessee would recognise a financial liability for its obligation to make lease payments but the lessor would not recognise a corresponding financial asset for its right to receive lease payments. Bringing operating leases onto the balance sheet would increase lessees gearing and impact key ratios and covenants. The presentation and expected front loading of total lease expense for nonproperty leases would affect profitability ratios, EBITDA and interest cover. As a consequence, banks will need to model and assess the effects of these changes on a customer s credit rating if the customer is a party to a leasing transaction. Implementing the lease proposals would be really challenging and potentially costly for many lessee customers because they would need to identify all their leases, extract key data, make new estimates and judgements and perform new calculations. Some banks customers-lessees may need to upgrade or acquire new IT systems to account for leases under these proposals. The complexity in reassessing lease payments and the potential cost of implementing new systems and processes to account for leases in the future may influence customers to seek alternative sources of funding or to request simpler lease arrangements. Many leases currently accounted for as sale and finance leaseback arrangements would be outside the scope of the new Leases standard and would fall within the financial instruments accounting standard, which is expected to be IFRS 9 Financial Instruments when the Leases standard becomes effective. Under IFRS 9, leases containing certain variable payments and options may have to be accounted on a fair value basis as the criteria for amortised cost basis under IFRS 9 may not be met. This could increase volatility in profit or loss. In some countries, the tax treatment depends on aspects of the accounting and therefore changes would be required to the existing legislation. This creates uncertainties as to what the tax impact could be and whether any new tax proposals could add further complexity.
4 New on the Horizon: Leases for Banks Key issues for banks 1. New lease accounting may have a significant impact on banks compliance with capital and other regulatory requirements Proposal For each lease other than a short-term lease, a bank acting as lessee would recognise an ROU asset and a corresponding liability. It would measure the lease liability initially at the present value of the lease payments discounted using either the rate that the lessor charges the lessee or, if such rate is not available, its incremental borrowing rate. It would measure the ROU asset initially at the amount of the lease liability, adjusted for any prepaid rentals, plus initial direct costs. A bank acting as lessor in a Type A lease would not recognise the underlying asset but would instead recognise a lease receivable and a residual asset. A bank acting as lessor in a Type B leases would continue to apply a model similar to current operating lease accounting under IAS 17. Banking industry implications Bank as lessee Many banks have significant property leases that are currently accounted for as operating leases and therefore not recorded on the balance sheet. Under the proposals, banks would be required to bring all leases (except for short-term leases 1 ) onto the balance sheet. This would increase the banks assets and liabilities and consequently, significantly impact its regulatory capital as explained below. A key question for banks is how the ROU asset should be classified for regulatory purposes. If the ROU asset is treated as an intangible asset for regulatory purposes, then it will reduce Tier 1 common equity. If this occurs, banks may need to raise additional capital to ensure that they meet the increased Basel 3 capital requirements. The increase in the asset base and Tier 1 capital may also impact a bank s leverage ratio. The above would require careful consideration and liaison with the regulators, accounting advisors and auditors. Bank as lender/lessor Banks as lessors would need to reassess whether the lease arrangements with their customers are Type A or Type B leases. Under the proposed classification criteria, a lease that is currently classified as an operating lease under IAS 17 could be classified as a Type A lease. Lessors with property, plant and equipment under IAS 17 and risk weighted at 100% may end up with lease receivables and residual assets on their balance sheets if such leases are assessed as Type A. Lease receivables are risk weighted at a percentage depending on the credit quality of the obligor. This means that a lower risk weight could apply if operating leases under IAS 17 become Type A leases. There is, however, uncertainty as to how the residual asset would be assessed for regulatory purposes possibly as property, plant and equipment and risk weighted at 100%. Overall, the impact on capital ratios will require further analysis. Likelihood of Impact Potential Impact Likelihood of Impact Potential Impact High High High Moderate 1 A short-term lease is a lease that, at the commencement date, has a maximum possible term under the contract, including any options to extend, of 12 months or less. Any lease that contains a purchase option is not a short-term lease.
New on the Horizon: Leases for Banks 5 2. Proposed dual model and new classification test may impede comparability Proposal Currently IAS 17 Leases distinguishes between operating and finance leases. Leases under which significantly all the risks and rewards of ownership of an asset are transferred to the lessee are defined as finance leases and are capitalised by lessees on the balance sheet. The income and expenses for such leases are front loaded in the early years. Leases other than finance leases are defined as operating leases. They are not capitalised by lessees and the related expense is generally recognised on a straight-line basis over the term of the lease. FASB ASC Topic 840 Leases also distinguishes between an operating and a capital lease based on similar guidance; however, it also contains bright-line quantitative tests based on the present value of the future minimum lease payments and the economic life of the underlying asset. The proposals introduced a dual model for both lessors and lessees with new classification criteria to determine the pattern of the income or expenses of the lease rather than to determine whether the lease would be capitalised or not. The classification also impacts how a lessor presents the asset i.e. as a receivable and residual asset or as property, plant and equipment. Underlying asset Non-property Property Lease classification Type A, unless: 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. Type B, unless: 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 accounts for substantially all of the fair value of the underlying asset at the commencement date. Banking industry implications Bank as lessee or lender/lessor The proposals do not define what is significant or insignificant in the context of the total economic life of the underlying asset, but in practice this may lead to the application of bright -line tests or uncertainties and inconsistencies. Under the proposals, economically similar leases i.e. with similar lease terms and lease payments may be classified differently depending on whether the underlying asset is property. This may impede comparability. For a Type B lease, a lessee would recognise a lease liability but no interest cost on the liability would be presented, potentially distorting the lessee s key ratios. Under the proposals, the lessee and lessor accounting models are not symmetrical. In particular, under the Type B models, the lessee would recognise a financial liability for its obligation to make lease payments but the lessor would not recognise a corresponding financial asset for its right to receive lease payments. In addition, most non-property leases would be Type A leases and would be accounted for in a similar way to current finance leases. Therefore, there would be more front loading of expenses for lessees and front loading of income for lessors. Although the front loading of lease expenses is not good news for lessees, lessors are likely to see more consistency between the pattern of income and the pattern of interest costs on borrowings to finance the underlying asset. Likelihood of Impact High Potential Impact High
6 New on the Horizon: Leases for Banks 3. Proposals may affect the covenant arrangements of customers with significant lease commitments Proposal The proposals will impact both the balance sheet and the income statement of banks customers-lessees, who would be required to recognise liabilities for all leases, including current operating leases. The proposed presentation and front loading of total lease expense for non-property leases would impact lessees profitability ratios, EBITDA and interest cover. Banking industry implications Bank as lessee or lender/lessor The effect of recording operating leases as liabilities would most likely be an increase in lessees gearing. This would consequently have an impact on lessees key ratios and covenants with their financiers. Banks would need to adjust their credit rating systems for assessing the credit quality of their customers-lessees to whom they lend or act as a derivative counterparty. Likelihood of Impact Moderate Potential Impact Moderate
New on the Horizon: Leases for Banks 7 4. Complexity of the proposals could impact leasing business generally Proposal Lessees and lessors would be required to use judgement to determine the key components of the lease i.e. lease term, purchase options (including termination penalties), residual value guarantees and variable lease payments on initial measurement. Under the proposals, variable lease payments would be included in the lease liability only if they depend on an index or a rate (such as the Consumer Price Index or a market interest rate), measured using the index or rate as at each reporting date, or if they are in-substance fixed payments. The lease payments would then be recomputed at each reporting date if there is a significant change in such components. The income and expense profile is dependent on lease classification. Interest and tax variation clauses are common terms found in a lease arrangement. Changes to interest and tax rates subsequent to the commencement or transition dates are likely to be assessed as significant. In addition, purchase options are also common terms found in lease arrangements. All these are likely to result in accounting challenges. Banking industry implications Bank as lessee or lender/lessor Lessees would be required to reassess the future cash flows and to adjust the ROU asset to reflect changes in lease payments and discount rates, if significant. In some cases, the lessee may not have all of the necessary information to allocate the change between future and past periods particularly if the lease is a complex tax-based lease and/or if the lessee does not know the lessor s assumed residual value. The lessor, however, would be more likely to have sufficient information and may find it less difficult to perform the reassessment and adjustments, when required. Nonetheless, banks may face an operational challenge as they may be inundated with requests for information from lessees with variable rental arrangements and be compelled to satisfy such requests in order to retain customers who may be turning to alternative sources of funding or simpler lease arrangements. Likelihood of Impact High Potential Impact High
8 New on the Horizon: Leases for Banks 5. Exclusion of some sale and leaseback transactions from the lease proposals could increase volatility in profit or loss Proposal Under the proposals, if a sale and leaseback transaction does not transfer control of the underlying asset in accordance with the Boards revenue proposals, then the transaction would be accounted for as a financing, and not as a lease transaction. A significant issue for banks as either lessee or lessor is that if a sale and leaseback arrangement is not treated as a sale but as a financing arrangement under the proposed changes, then it would be accounted for in accordance with the financial instruments standards. Banking industry implications Bank as lessee For lessees, the exclusion from the Leases standard will mean that lease liabilities would be accounted for under IAS 39 and, when effective, IFRS 9. The classification requirements for financial liabilities under IFRS 9 are expected to be similar to those under IAS 39. Under both standards, options or other variations in a sale and leaseback arrangements may be treated as embedded derivatives. Depending on whether such embedded derivative is separable or not from the host contract, the embedded derivative or the entire contract may be measured at fair value through profit or loss. The related fair value changes could result in volatility in profit or loss. Bank as lender/lessor For lessor, the exclusion from the Leases standard will also mean that lease receivables would be accounted for under IAS 39 and, when effective, IFRS 9. If this occurs, then lease arrangements that have options or tax and other variations may fail the solely payment of principal and interest test under IFRS 9 and will consequently have to be fair valued through profit or loss. This could increase volatility in profit or loss. This treatment would differ from the current accounting treatment of lease receivables under IAS 17. Likelihood of Impact Potential Impact Likelihood of Impact Potential Impact High High High High
New on the Horizon: Leases for Banks 9 6. Future tax treatment of leases is uncertain in some jurisdictions as tax authorities consider the proposals In some countries, the tax laws are dependent on the accounting treatment under IFRS. The tax authorities in such countries or jurisdictions may have responded differently to the proposed changes. For example, in the UK, the tax authority initially decided to freeze taxation with reference to the accounting standards under IAS 17 as a stop-gap solution, which would impact lessors and lessees tax compliance positions. Therefore, there has been dialogue between the UK tax authority and both the leasing industry and advisers over these concerns and that there will be a consultation process on changes to lease taxation, which are intended to reflect the impact of the new accounting standards. It is therefore possible that similar consultation processes may occur in other jurisdictions where the tax laws refer to the accounting under IFRS. This will create uncertainty and complexity about the tax treatment of new and existing leases.
10 New on the Horizon: Leases for Banks Your next steps KPMG member firms Leasing and Banking specialists work with some of the world s leading lessors, lessees and financiers to address their operational, regulatory and growth agendas. The proposed changes to lease accounting will have an impact on banks as lessors and lessees as well as their lessees-customers. With hands-on experience across multiple industries such as financial services, real estate, transportation, telecommunication, retail and utilities, KPMG professionals have the insight to help banks assess the impact of the lease accounting changes on them as well as their customers. KPMG member firms are well positioned to help you understand the potential impacts of the lease accounting proposals on your business. Our credentials include the following. Client An investment bank Details of work KPMG member firms have performed on IFRS change We reviewed the lease contracts to identify the lease terms relevant to the calculation of the leases within the leasing companies. Assisted the client in checking the accuracy of the numbers by re-computing the leases on a portfolio basis. Reviewed and commented on the client s assessment of the financial statement impact of the transaction and in particular provided assistance with the interpretation of IFRS in relation to IAS 17, IAS 39 and consolidation analyses. An aerospace company (lessee) A global fleet and vehicle management company We modelled, calculated and provided feedback on a selection of aircraft, engine and non-aircraft leases to assist the client in its assessment of the lease accounting proposals. We calculated more than 150,000 lease contracts to check the accuracy of the client s transitional adjustments in relation to an IFRS conversion project. Financial and organisational considerations The following are three key questions that many banks will be asking themselves. Will lease accounting be a fundamental change for me? Are my systems and people up to the task? How will the new requirements affect leasing products? Key factors to consider in response to questions: The impact of all leases (except short-term leases) on the balance sheet of your customers Likely impact on yours and your customers future profitability. The effect on gearing and loan covenants for your customers. Possible impact on your capital and leverage ratios. The quantity and quality of data required by you to assess and calculate the accounting numbers. Whether to change your current system or application to perform the lease accounting calculation. How current lease accounting may be affected by new lease classification criteria and judgements. Whether your customer requires assistance to assess the quantity and quality of data required to assess the decision to buy or lease and to calculate the accounting numbers. Whether renegotiation of existing lease arrangements is required. KPMG provides a framework for dealing with this accounting change. KPMG has developed a Web-based tool to assist organisations with their readiness for eventual adoption of the new leases standard. The tool can help banks make the conversion to the new leases standard more efficient. The Web-based tool is hosted in our private cloud allowing for easy maintenance and future upgrades. In addition, by allowing KPMG to host the tool, companies can benefit from greater efficiency and flexibility in terms of data storage, processing and security. KPMG can also offer companies the option to install the tool within their IT environment through a licensing agreement. In addition, KPMG member firms are also licensed to use lease evaluation tools to assess the impact of the proposals on both the banks and their customers financial statements.
New on the Horizon: Leases for Banks 11 Contacts Global Head of Banking Global Head of Capital Markets David Sayer Michael J Conover KPMG in the UK KPMG in the US T: +44 20 7311 5404 T: +1 212 872 6402 E: david.sayer@kpmg.co.uk E: mconover@kpmg.com Argentina Israel South Africa Mauricio Eidelstein Danny Vitan Vanessa Yuill T: + 54 11 43165793 T: +972 3 684 8000 T: +27 11 647 8339 E: geidelstein@kpmg.com.ar E: dvitan@kpmg.com E: vanessa.yuill@kpmg.co.za Australia Italy Spain Adrian Fisk Roberto Spiller Ana Cortez T: +61 2 9335 7923 T: +39 026 7631 T: +34 91 451 3233 E: adrianfisk@kpmg.com.au E: rspiller@kpmg.it E: acortez@kpmg.es Brazil Japan Sweden Fernando Alfredo Tomomi Mase Anders Torgander T: +55 11 21833379 T: +81 3 3548 5102 T: +46 8 7239266 E: falfredo@kpmg.com.br E: Tomomi.Mase@jp.kpmg.com E: anders.torgander@kpmg.se Canada Korea Switzerland Mahesh Narayanasami Michael Kwon Patricia Bielmann T: +1 416 777 8567 T: +82 2 2112 0217 T: +41 58 249 4188 E: mnarayanasami@kpmg.ca E: ykwon@kr.kpmg.com E: pbielmann@kpmg.com China Mexico UK Caron Hughes Ricardo Delfin Colin Martin T: +85 22 913 2983 T: +52 55 5246 8453 T: +44 20 73115184 E: caron.hughes@kpmg.com E: delfin.ricardo@kpmg.com.mx E: colin.martin@kpmg.co.uk France Netherlands US Jean-François Dandé Evelyn Vinke-Smits Michael Hall T: +33 1 5568 6812 T: +31 206 567256 T: +1 212 872 5665 E: jeanfrancoisdande@kpmg.fr E: vinke-smits.evelyn@kpmg.nl E: mhhall@kpmg.com Germany Portugal Andreas Wolsiffer Ines Viegas T: +49 69 9587 3864 T: +35 121 011 0002 E: awolsiffer@kpmg.com E: iviegas@kpmg.com India Singapore Manoj Kumar Vijai Reinhard Klemmer T: +91 22 3090 2493 T: +65 6213 2333 E: mkumar@kpmg.com E: rklemmer2@kpmg.com.sg Acknowledgements We would like to acknowledge the efforts of the principal authors of this publication: Charlotte Lo and Brian O Donovan.
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