FAQ 14 SEPTEMBER 2010 IASB PROJECT ON LEASE ACCOUNTING These FAQs reflect current views and understanding of the IASB project. In August 2010, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB; together the Boards ) published an exposure draft (ED) on Leases. The FAQ addressed below are: 1. Why are the standard-setters looking at leases? 2. How do the proposals address problems with today s accounting for leases? 3. What does the ED propose for lessees? 4. What about options to extend? 5. What about contingent rentals, residual value guarantees and term option penalties? 6. What if things don t turn out as expected? 7. What does the ED propose for lessors? 8. Are there any new disclosure requirements? 9. Are all lease transactions covered by the proposals? 10. Are there any exemptions for short-term or non-core leases? 11. Does this affect contracts currently covered by IFRIC 4? 12. Will there be any tax effects? 13. What are the transitional arrangements? 14. What happens next? 15. How is ICAEW responding? 1
1. Why are the standard-setters looking at leases? The current IASB standard, IAS 17 Leases, differentiates between two types of lease: A finance lease is a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. The lessee acquires rights and obligations that are similar to those acquired by an outright purchase of the legal title of an asset. An operating lease is a lease where the lessee does not acquire the majority of such rights and obligations. An operating lease is any lease other than a finance lease. The classification of leases is based on the definitions of finance and operating leases given above. IAS 17 gives several indicators of situations, which individually or in combination could indicate that a transfer of substantially all the risks and rewards of ownership has occurred. If a lease is classified as a finance lease, it appears on the lessee s balance sheet along with a related lease liability. If a lease is classified as an operating lease, it is off balance sheet in the lessee s accounts, with rental costs simply expensed over the life of the lease, normally on a straight-line basis. These differing accounting treatments are said to be confusing for investors and other users of financial statements. In some cases they can mean that economically similar transactions can be accounted for differently, making it hard to compare entities. It can also lead to entities structuring a lease in a particular way to achieve their preferred accounting treatment. The current accounting from a lessor s perspective is not regarded as quite so problematic. Nonetheless, the standard-setters are also proposing changes in this area to ensure that there is a consistent accounting model for both lessors and lessees. The proposals would furthermore bring about convergence between IFRS and US GAAP in most significant areas of lease accounting, completing another significant step along the road to convergence. 2. How do the proposals address problems with today s accounting for leases? The proposals in the ED remove the distinction between finance leases and operating leases, meaning that for the first time, assets and liabilities arising from lease contracts will be recognised on the lessee s balance sheet. Investors will no longer need to make arbitrary adjustments to a company s accounts to adjust for off balance sheet items as more detailed information will be provided. Moreover, it is argued that comparability will be further improved as there will be less opportunity to structure a lease to achieve a particular accounting outcome. 3. What does the ED propose for lessees? The ED proposes a right of use model for all leases under which lessees will recognise: A right-of-use asset reflecting its right to use the leased asset for the lease term; and A lease liability, reflecting its obligation to make lease payments. Both the asset and the liability will be recognised on balance sheet at the commencement of the lease. 2
The right-of-use asset is calculated at the present value of the lease payments, discounted using the lessee s incremental borrowing rate (ie, the rate of interest that, at the date of inception of the lease, the lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to purchase a similar underlying asset) or, if this can be readily determined, the rate the lessor charges the lessee, plus any initial direct costs. It will then be amortised over the life of the lease and tested for impairment where appropriate. A lessee could choose to revalue such assets. The lease liability is calculated at the present value of the lease payments, discounted using the lessee s incremental borrowing rate or, if it can be readily determined, the rate the lessor charges the lessee. It is subsequently accounted for using the amortised cost method, with interest expense recorded on the outstanding obligation. This new accounting model can be presented thus: Lessee model all leases within scope Balance sheet Right-of-use asset Liability to make lease payments Income statement Amortisation expense Interest expense This is significantly different from current practice for leases classified as operating leases under IAS 17. 4. What about options to extend? Many leases will have lessee options to extend the lease at the end of the primary rental period. When calculating the present value of the lease payments, the lease term is taken as the longest possible term that is more likely than not to occur. Paragraph B17 of the ED gives an illustration of how to apply this principle. An entity determines the lease term considering all explicit and implicit options included in the contract and given effect by the operation of statutory law. Examples of considerations when assessing the probability of each possible lease term include: Contractual factors such as termination penalties or discounted rentals during the secondary period; Non-contractual factors, such as the existence of significant leasehold improvements that would be forgone if the lease was not extended; Business factors, such as whether the underlying asset is specialised or crucial to the lessee s operations; and Other lessee-specific factors, such as the lessee s intentions or past experience. This determination will involve considerable judgement. This is a significant change from current practice. Under IAS 17, the lease term only includes such options to the extent it is reasonably certain that the lessee will exercise them. As a result is likely that in some cases the lease term used under the proposed model will be longer than that currently used. 3
5. What about contingent rentals, residual value guarantees and term option penalties? Many leases will include some or all of the following: Contingent rentals, whereby future lease payments vary because of facts and circumstances occurring after the date of the lease. For example, in the retail sector it is common for an element of rentals to be contingent on the level of sales achieved by the lessee. In many cases rentals may also be index linked. Residual value guarantees, whereby the lessee guarantees that the fair value of the underlying asset that they will return to the lessor will be at least a specified amount. If the fair value is less than that amount, the lessee is obliged to pay the difference to the lessor. Term option penalties whereby the lessee will have to pay a penalty in some circumstances, for example if it terminates the lease early or fails to extend it into a secondary period. When calculating the present value of the lease payments these factors should be considered. An expected outcome approach should be adopted ie, lease payments should be calculated as the present value of the probability-weighted average of the cash flows for a reasonable number of outcomes. This will again involve considerable judgement. This is a significant change from current practice. Under IAS 17, contingent rentals are generally excluded from the calculation of minimum lease payments, regardless of the probability of payment. 6. What if things don t turn out as expected? The ED requires the lessee to reassess the carrying amount of its lease obligation in each reporting period if facts or circumstances indicate that there would be a significant change in the liability since the previous reporting period. If there is a change in the expected lease term, the lessee would adjust the carrying amount of the lease obligation and the right-of-use asset. If there is a change in the timing or amount of expected payments of contingent rentals, residual value guarantees or term option penalties, these would be recorded in the income statement if they arise from current or prior periods. Where they relate to future periods, the adjustment would be recorded as an adjustment to the carrying amount of the lease obligation and the right-of-use asset. Determining whether a reassessment of a lease obligation is required will once again be a matter of considerable judgement. Where a reassessment is required this may involve a significant amount of work, especially if a large number of leases are affected by similar factors. 7. What does the ED propose for lessors? Although the IASB discussion paper published in March 2009 focussed solely on lessee accounting, the ED includes proposals for lessor accounting in order, it states, to ensure that there is a consistent accounting model for both lessors and lessees. 4
The ED describes two accounting models for lessors, as follows: The performance obligation approach; and The derecognition approach. The lessor determines which model to apply based on its exposure to the significant risks or benefits of the underlying asset during or subsequent to the expected term of the lease. This will depend largely on the business model adopted. If the lessor retains exposure to the significant risks or benefits of the underlying asset, it adopts the performance obligation approach. The underlying asset remains on the lessor s balance sheet and is depreciated as normal. In addition, the lessor will recognise an asset reflecting its right to receive lease payments and a lease liability reflecting the lessor s obligation to permit the lessee to use the underlying asset over the lease term. Each of these items will be presented together on the balance sheet, with a total representing the net lease asset or liability. The asset reflecting the lessor s right to receive lease payments is accounted for using the amortised cost method, with interest income on the outstanding balance recognised in the income statement. As the lessor fulfils its performance obligation, lease income is recognised on a systematic or rationale basis reflecting the pattern of use of the underlying asset by the lessee. This approach can be summarised as follows: Performance obligation approach Balance sheet Underlying asset Right to receive lease payments Lease liability Income statement Lease income Depreciation expense Interest income If the lessor does not retain exposure to the significant risks or benefits of the underlying asset, it adopts the derecognition approach. Under this approach, a portion of the leased asset is removed from the lessor s books and an asset reflecting its right to receive lease payments is recognised. It is possible that this could lead to a gain being recorded at the commencement of the lease, as is the case today under IAS 17. The asset reflecting the lessor s right to receive lease payments is accounted for using the amortised cost method, with interest income on the outstanding balance recognised in the income statement. The residual asset is not remeasured in subsequent periods unless there is a change in the lease term or the asset is impaired. This approach can be summarised as follows: Derecognition approach Balance sheet Residual asset Right to receive lease payments Income statement Revenue Cost of sales Interest income 5
8. Are there any new disclosure requirements? The revised disclosures proposed in the ED aim to enable users to evaluate the nature, amount, timing and uncertainty of cash flows arising from lease contracts and how the entity manages those cash flows. The disclosures proposed include: Nature of lease contracts; Maturity analysis; Income recognition information; Discount rates used; Roll forward of right-of-use asset and liability to make lease payments in the lessee s accounts; and Roll forward of right to receive lease payments and lease liability or residual asset in the lessor s accounts 9. Are all lease transactions covered by the proposals? No. The following items would not be affected by the proposals: Contracts that are labelled as leases but are actually purchase or sale arrangements are not covered by the proposals. The accounting for some specialised assets will remain unaffected. Lessors with investment properties accounted for at fair value under IAS 40 Investment property will continue to apply the requirements in IAS 40. The accounting for biological assets will remain within IAS 41 Agriculture. It is argued that the requirements in those standards already provide sufficient useful information. Leases of intangible assets (eg, software, patents and licences) and leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources are excluded until the IASB can consider such items more broadly. 10. Are there any exemptions for short-term or non-core leases? No. All leases other than those covered by the scope exemptions above are within scope of the proposed standard. This would include very short-term leases where they are material. However, there is a simplified approach available to both lessees and lessors for short-term leases. These are defined as leases that, at the date of commencement of the lease, have a maximum possible lease term, including options to renew or extend, of twelve months or less. Lessees that have short-term leases may elect on a lease-by-lease basis to measure, both at initial measurement and subsequently: The liability to make lease payments at the undiscounted amount of the lease payments; and The right-of-use asset at the undiscounted amount of lease payments plus initial direct costs. Such lessees shall recognise lease payments in profit or loss over the lease term. A lessor that has a short-term lease may elect on a lease-by-lease basis to neither recognise assets or liabilities arising from the lease in the balance sheet nor derecognise any portion of the underlying asset. 6
Such lessors shall continue to recognise the underlying asset in accordance with other IFRSs and shall recognise lease payments in profit or loss over the lease term. 11. Does this affect contracts currently covered by IFRIC 4? The proposals use existing guidance by incorporating the principles in IFRIC 4 Determining whether an arrangement contains a lease into the ED. 12. Will there be any tax effects? The presumption in the UK is that the measurement of taxable profit follows any changes in IFRS or UK GAAP. However, should any implementation questions arise in due course they would be taken up with HMRC by the ICAEW Tax Faculty. There will be deferred tax implications as the ED will give rise to new temporary differences for many entities involved in leasing transactions. 13. What are the transitional arrangements? All outstanding leases as at the date of initial application will be subject the proposals. The ED provides guidance on restatement for both lessees and lessors. 14. What happens next? The proposals are a key element of the IASB-FASB convergence agenda and represent one of the projects due to be completed by the summer of 2011. However, the Boards have indicated that there will be a long transition period. In view of the number of new standards to be issued around the same time, the various effective dates might be staggered to ease the burden. It is difficult to say when the leasing standard will be effective, but it is unlikely to be before 2014. In Europe this will be subject to the usual endorsement process. The IFRS for SMEs - which may well replace UK GAAP in due course - is also likely to be amended in due course to take account of the requirements of the new standard. The consultation period for the ED runs to 15 December 2010. 15. How is ICAEW responding? The Financial Reporting Faculty recognises that the proposals are controversial. It has assembled a working party comprising a wide spectrum of constituents; this includes representatives of preparers, auditors and practitioners. The working party will prepare a response to the ED for discussion by the ICAEW Financial Reporting Committee. We will also be responding to FEE and EFRAG so that our views can be taken into account in the drafting of their own responses, and will be liaising with the CBI and the ASB. The Exposure Draft will be highlighted in monthly ICAEW member-alerts as well as in Accountancy, and a blog on the subject will be published on Talk Accountancy. The draft response will be posted to the ICAEW website for comment by members when it is at a reasonably advanced stage. 7
The proposals will be covered at Faculty roadshows in September and October 2010. A round table event with the IASB may be held at Chartered Accountants Hall (details to follow). Further material and events/webcasts may be developed as appropriate as questions arise and the accounting implications and implementation timetable become clearer. We particularly welcome any views you may have on the current proposals, which can be emailed to eddy.james@icaew.com. Copyright ICAEW 2010 All rights reserved. This document may be reproduced without specific permission, in whole or part, free of charge and in any format or medium, subject to the conditions that: it is reproduced accurately and not used in a misleading context; the source of the extract or document, and the copyright of ICAEW, is acknowledged; and the title of the document is quoted. Where third-party copyright material has been identified application for permission must be made to the copyright holder. icaew.com As a world-class professional accountancy body, the ICAEW provides leadership and practical support to over 134,000 members in more than 160 countries, working with governments, regulators and industry to maintain the highest standards. Our members provide financial knowledge and guidance based on the highest technical and ethical standards. They are trained to challenge people and organisations to think and act differently, to provide clarity and rigour, and so help create and sustain prosperity. The ICAEW ensures these skills are constantly developed, recognised and valued. Because of us, people can do business with confidence. Chartered Accountants Hall T +44 (0) 20 7920 8100 Moorgate Place, London F +44 (0) 20 7920 0547 icaew.com E frfac@icaew.com 8