Changes to LEASE Accounting, What Are the MAIN PROPOSALS?

As mentioned before in my post “Latest Changes for Lease Accounting”, on 16 May 2013, the IASB and the FASB published for public comment a revised ED outlining proposed changes to the accounting for LEASES. The proposal aims to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an organization uses in its operations and the risks to which it is exposed from entering into leasing transactions.

In detail, the core principle of the proposed requirements is that an entity should recognize assets and liabilities arising from a lease. This represents an improvement over existing leases requirements, which do not require lease assets and lease liabilities to be recognized by many lessees.

In accordance with that principle, a lessee would recognize assets and liabilities for leases with a maximum possible term of more than 12 months. A lessee would recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the leased asset (the underlying asset) for the lease term.

The recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee would depend on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset. For practical purposes, this assessment would often depend on the nature of the underlying asset.

For most leases of assets other than property (for example, equipment, aircraft, cars, trucks), a lessee would classify the lease as a Type A lease and would do the following :

1. recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments; and
2. recognized the unwinding of the discount on the lease liability as interest separately from the amortization of the right-of-use asset.

For most leases of property (i.e land and/or a building or part of a building), a lessee would classify the lease as a Type B lease and would do the following :

1. recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments; and
2. recognize a single lease cost, combining the unwinding of the discount on the lease liability with the amortization of the right-of-use asset, on a straight-line basis.

Similarly, the accounting applied by a lessor would depend on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset. For practical purposes, this assessment would often depend on the nature of the underlying asset.

For most leases of assets other than property, a lessor would classify the lease as a Type A lease and would do the following :

1. derecognize the underlying asset and recognize a right to receive lease payments (the lease receivable) and a residual asset (representing the rights the lessor retains relating to the underlying asset);
2. recognize the unwinding of the discount on both the lease receivable and the residual asset as interest income over the lease term; and
3. recognize any profit relating to the lease at the commencement date.

For most leases of property, a lessor would classify the lease a a Type B lease and would apply an approach similar to existing operating lease accounting in which the lessor would do the following :

1. continue to recognize the underlying asset; and
2. recognize lease income over the lease term, typically on a straight-line basis.

When measuring assets and liabilities arising from a lease, a lessee and a lessor would exclude most variable lease payments. In addition, a lessee and a lessor would include payments to be made in optional periods only if the lessee has a significant economic incentive to exercise an option to extend the lease, or not to exercise an option to terminate the lease.

For leases with a maximum possible term (including any options to extend) of 12 months or less, a lessee and a lessor would be permitted to make an accounting policy election, by class of underlying assets, to apply simplified requirements that would be similar to existing operating lease accounting.

An entity would provide disclosures to meet the objective of enabling users of financial statements to understand the amount, timing and uncertainty of cash flows arising from leases.

On transition, a lessee and a lessor would recognize and measure leases at the beginning of the earliest period presented using either a modified retrospective approach or a full retrospective approach (HRD).

Read Also :

1. FASB-IASB Propose Major Changes to Lease Accounting
2. New Accounting Proposal on Leasing Portends Big Changes

Latest Changes for LEASE Accounting

On 16 May 2013, the International Accounting Standards Board (IASB) and the US based Financial Accounting Standards Board (FASB) published for public comment a revised Exposure Draft (ED) outlining proposed changes to the accounting for leases. The proposal aims to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an organization uses in its operations and the risks to which it is exposed from entering into leasing transactions.

Background of the Changes

The existing accounting model for leases under IFRS and US GAAP requires lessees and lessors to classify their leases as either FINANCE Leases or OPERATING Leases and account for those leases differently. For example, it does not require lessees to recognize assets and liabilities arising from operating leases, but it does require lessees to recognize  assets and liabilities arising from finance leases.

Further, the IASB and the FASB initiated a joint project to improve the financial reporting of leasing activities under IFRS and US GAAP in the light of criticisms that the existing accounting model for leases fails to meet the needs of users of financial statements by developing a revised draft standard on LEASES. The boards developed the proposals in this revised ED after considering responses to their Discussion Paper titled Leases : Preliminary Views, which was issued in March 2009, and the IASB’s initial ED Leases and the proposed FASB Accounting Standards Update, Leases (Topic 840), which were issued in August 2010.

In particular :

1. many, including the US Securities and Exchange Commission (SEC) in its report on off-balance-sheet activities issued in 2005 and a number of academic studies published over the past 15 years, have recommended that changes be made to the existing lease accounting requirements to ensure greater transparency in financial reporting and to better address the needs of users of financial statements. Many users often adjust the financial statements to capitalize a lessee’s operating leases. However, the information available in the notes to the financial statements is often insufficient for users to make reliable adjustments to a lessee’s financial statements. The adjustments made can vary significantly depending on the assumptions made by different users.
2. the existence of two very different accounting models for leases in which assets and liabilities associated with leases are not recognized for most leases, but are recognized for others, means that transactions that are economically similar can be accounted for very differently. That reduces comparability for users and provides opportunities to structure transactions to achieve a particular accounting outcome.
3. some users have also criticized the existing requirements for lessors because they do not provide adequate information about a lessor’s exposure to credit risk (arising from a lease) and exposure to asset risk (arising from its retained interest in the underlying asset), particularly for leases of assets other than property that are currently classified as operating leases.

The boards decided to address those criticisms by developing  a new approach to lease accounting that requires an entity to recognize assets and liabilities for the rights and obligations created by leases. The new approach would require a lessee to recognize assets and liabilities for all leases with a maximum possible term (including any options to extend) of more than 12 months.

This approach should result in a more faithful representation of  a lessee’s financial position and, together with enhanced disclosures, greater transparency of a lessee’s financial leverage.

The new approach also proposes changes to lessor accounting that, in the board’s view, would more accurately reflect the leasing activities of different lessors.

Who would be affected by the proposals?

The proposed requirements would affect any entity that enters into a lease, with some specified scope exemptions. The proposed requirements would supersede IAS 17 Leases (and related interpretations) in IFRSs and the requirements in Topic 840, Leases, (and related Subtopics) of the FASB Accounting Standards Codification.

The ED is open for comments until 13 September 2013.

The ED of this proposed changes of lease accounting can be downloaded from here : www.ifrs.org

What are the threshold of criteria #3 and #4 of IAS 17 have to be met to be classified as a finance lease ?

IAS 17 Leases stipulates that whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.

Situations that, individually or in combination, would normally lead to a lease being classified as a finance lease are :

1. the lease transfers ownership of the asset to the lessee by the end of the lease term;
2. the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
3. the lease term is for the major part of the economic life of the asset even if title is not transferred;
4. at the inception of the lease the present value of the minimum lease payments amounts  to at least substantially all of the fair value of the leased assets; and
5. the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

Of the third criterion, it may stir a question about the threshold of the ‘major part of the economic life of the asset’. IAS 17 was not clearly explained this definition. But, if we refer to the US GAAP of SFAS 13 Accounting for Leases, in paragraph 7c, the standard stated that the lease term is equal to 75 percent or more of the estimated economic life of the leased property. So, if the lease term met the 75% of the estimated economic life of the leased asset, it fulfilled the third criteria and the lease has to be classified as a finance lease.

Besides, a query may also arise from the fourth criterion that defines what are essentially arrangements to fully compensate the lessor for the entire value of the leased property as financing arrangements. Under IAS 17, such quantitative threshold is not provided. While the US GAAP of SFAS 13 in paragraph 7d states that the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. So, based on the US GAAP, the threshold of the present value of minimum lease payments amounts must be at least 90% of leased asset fair value to be classified as a finance lease (Hrd).

Effect of Operating and Finance Leases on Lessee Financial Statements and Key Financial Ratios

As stated in IAS 17 : Leases, there are two classifications of lease transaction that applicable in the financial statements of the lessee : (1) Operating leases and (2) Finance leases.

Followings are the effect of operating and finance leases on lessee financial statements and key financial ratios which was taken from : International Financial Reporting Standards - A Practical Guide by Hennie van Greuning.

(1) Balance Sheet

Operating Lease - Non effect because no assets or liabilities are created under the operating method

Finance Lease - A leased asset (equipment) and a lease obligation are created when the lease is recorded. Over the life of the lease, both are written off, but the asset is usually written down faster, creating a net liability during the life of the lease

(2) Income Statement

Operating Lease – The lease payment is recorded as an expense. These payments are often constant over the life of the lease.

Finance Lease – Both interest expense and depreciation expense are created. In the early years of the lease, they combine to produce a higher expense than is reported under the operating method. However, over the life of the lease, the interest expense declines, causing the total expense trend to decline. This produces a positive trend in earnings. In the later years, earnings are higher under the finance lease method than under the operating method. Over the entire term of the lease, the total lease expenses are the same under both methods.

(3) Statement of Cash Flows

Operating Lease – The entire cash outflow paid on the lease is recorded as an operating cash outflow

Finance Lease – The cash outflow from the lease payments is allocated partly to an operating or financing cash outflow (interest expense) and partly to a financing cash outflow (repayment of the lease obligation principal). The depreciation of the leased asset is not a cash expense and, therefore, is not a cash flow item.

(4) Profit Margin

Operating Lease – Higher in the early years because the rental expense is normally less than the total expense reported under the finance lease method. However, in later years, it will be lower than under the finance lease method.

Finance Lease – Lower in the early years because the total reported expense under the finance lease method is normally higher than the lease payment. However, the profit margin will rend upward over time, so in the later years it will exceed that of the operating method.

(5) Asset Turnover

Operating Lease – Higher because there are no leased assets recorded under the operating method

Finance Lease – Lower because of the leased asset (equipment) that is created under the finance lease method. The ratio rises over time as the asset is depreciated.

(6) Current Ratio

Operating Lease – Higher because no short-term debt is added to the balance sheet by the operating method.

Finance Lease – Lower because the current portion of the lease obligation created under the finance lease method is a current liability. The current ratio falls farther over time as the current portion of the lease obligation rises.

(7) Debt to Equity Ratio

Operating Lease – Lower because the operating method creates no debt

Finance Lease – Higher because the finance lease method creates a lease obligation liability (which is higher than the leased asset in the early years). However, the debt-to-equity ratio decreases over time as the lease obligation decreases

(8) Return on Assets

Operating Lease – Higher in the early years because profits are higher and assets are lower

Finance Lease – Lower in the early years because earnings are lower and assets are higher. However, the return on asset ratio rises over time because the earnings trend is positive and the assets decline as they are depreciated.

(9) Return on Equity

Operating Lease – Higher in the early years because earnings are higher

Finance Lease – Lower in the early years because earnings are lower. However, the return on equity rises over time because of a positive earnings trend.

(10) Interest Coverage

Operating Lease – Higher because no interest expense occurs under the operating method

Finance Lease – Lower because interest expense is created by the finance lease method. However, the interest coverage ratio rises over time because the interest expense declines over time.

How is the treatment of Land and Buildings lease transaction ?

Formerly, based on IAS 17 Leases (2003 amendment) para. 14, leases of land and buildings are classified as operating or finance leases in the same way as leases of other assets (read also my previous post regarding the criteria which one of them a lease agreement has to meet to be classified as a finance lease in the financial statements of the lessee : The right way to classify a lease). However, a characteristic of land is that normally has an indefinite economic life and, if title is not expected to pass to the lessee by the end of the lease term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be an operating lease. A payment made on entering into or acquiring a leasehold that is accounted for as an operating lease represents prepaid lease payments that are amortised over the lease term in accordance with the pattern of benefits provided.

Para. 15 stated that the land and buildings elements of a lease of land and buildings are considered separately for the purpose of lease classification. if title to both elements is expected to pass to the lessee by the end of the lease term, both elements are classified as a finance lease, whether analysed as one lease or as two leased, unless it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership of one or both elements. When the land has an indefinite economic life, the land element is normally classified as an operating lease unless title is expected to pass to the lessee by the end of the lease term, in accordance with paragraph 14. The buildings element is classified as a finance or operating lease in accordance with paragraphs 7-13.

However, based on IAS 17 Leases (2009 amendment), both para. 14 and para. 15 of IAS 17 (2003 amendment) were eliminated, replaced with para. 15A which states that when a lease includes both land and buildings elements, an entity assesses the classification of each element as a finance or an operating lease separately in accordance with paragraphs 7-13. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life.

Why para. 14 and para. 15 of IAS 17 (2003 amendment) was eliminated ?

As prescribed in the Basic for Conclusions on IAS 17 Leases, para. BC8A (IFRS 2010 as at 1 Januari 2010 Part B) that as part of its annual improvements project in 2007, the Board reconsidered the decisions it made in 2003, specifically the perceived inconsistency between the general lease classification guidance in para. 7-13 and the specific lease classification guidance in para. 14 and 15 related to long-term leases of land and buildings. The Board concluded that the guidance in para. 14 and 15 might lead to a conclusion on the classification of land leases that does not reflect the substance of the transaction.

For example, consider a 999-year lease of land and buildings. In this situation, significant risks and rewards associated with the land during the lease term would have been transferred to the lessee despite there being  no transfer of title.

The Board noted that the lessee in leases of this type will typically be in a position economically similar to an entity that purchased the land and buildings. The present value of the residual value of the property in a lease with a term of several decades would be negligible. The Board concluded that the accounting for the land element as a finance lease in such circumstances would be consistent with the economic position of the lessee.

Further, as explained in para. BC8D, the Board noted that this amendment reversed the decision it made in amending IAS 17 in December 2003. The Board also noted that the amendment differed from the International Financial Reporting Interpretations Committee's agenda decision in March 2006 based on the IAS 17 guidance that such long-term leases of land would be classified as an operating lease unless title or significant risks and rewards of ownership passed to the lessee, irrespective of the term of the lease. However, the Board believed that this change improves the accounting for leases by removing a rule and an exception to the general principles applicable to the classification of leases.

Some respondents to the exposure draft proposing this amendment agreed with the direction of this proposal but suggested that it should be incorporated into the Board's project on leases. The Board acknowledged that the project on leases is expected to produce a standard in 2011. However, the Board decided to issue the amendment now because of the improvement in accounting for leases that would result and the significance of this issue in countries in which property rights are obtained under long-term leases. Therefore, the Board decided to remove this potential inconsistency by deleting the guidance in paragraphs 14 and 15  (Hrd).

The shocking overhaul lease accounting standard

As I mentioned before in here : Exposure Draft of IAS 17 Leases, a new approach to lease accounting, on 17 August 2010, the global accounting standard-setter of IASB and the U.S accounting standard-setter of FASB have published for public comment a joint proposal to improve the financial reporting of lease contracts.

Soon after the publication, such ED becomes a hot topic of discussion and commenting amongst the accounting practices.

The proposal would require that all lease obligations be recorded on the balance sheet at the present value of the expected lease payment, along with an asset representing the right to use the leased asset. While the current accounting standard recognizes the capital (which places the lessee's asset and liability on the balance sheet) and operating lease (which goes off the balance sheet) method.

Before the publication of such ED, Reuters on August 15, 2010 published an article titled “Rulemakers plan global overhaul of lease accounting.” 

"Operating leases have long been considered one of the major off-balance sheet obligations, so there was this view that in an operating lease, the lessee has incurred an obligation and that it should be reflected on the balance sheet," said JanetPegg, an accounting analyst at UBS Investment Bank as reported by Reuter in the article.

Further, it reported that "while some investors may welcome the change to lease accounting because it will provide more clarity, many companies are fearful that the change will force their balance sheets to balloon overnight, and change all sorts of leverage and debt ratios, forcing them to renegotiate covenants with their lenders."

The Economist on August 19, 2010 in an article titled ”Shocking new accounting rules - You gonna buy that?” reported among others that "today, companies can opt either for a “capital lease”, which goes on the balance-sheet, or an “operating lease”, which does not. This distinction makes a certain sense. But the IASB and FASB think it is open to abuse. By labeling leases as “operating”, firms can appear less indebted than they really are. The new rules would put the right to use the leased item in the assets column. The obligation to pay for it would go in the debit column."

Leslie Seidman, FASB board member told WebCPA as reported in the article “Accounting Boards Propose Leasing Standards”  published on August 17, 2010 that "This proposal would put an asset on the books and amortize it, sort of like a depreciation expense, and then put a liability up and record interest expense related to it. First you’ve changed what you’re calling these P&L items, and then you’re changing the pattern of it because the asset will be amortized ratably and then interest expense will be recognized based on a declining liability amount. The pattern is just different from before, but again it’s intended to simulate the accounting if you were to buy it and finance it.”

Another related articles :

1. New lease accounting standard criticised for complexity (Accountancy Magazine)
2. New Accounting Rules Will Shatter The High Corporate Cash Mirage (Business Insider)
3. IASB and FASB propose to overhaul lease accounting
4. New leasing rules could hit bank lending (AccountancyAge)
5. Businesses await new standard for lease accounting (AccountingWeb)
6. FASB, IASB Ink Proposal to Put Leases on Balance Sheets (ComplianceWeek)

Exposure Draft of IAS 17 Leases, a new approach to lease accounting

On 17 August 2010, The IASB and US FASB published for public comment joint proposals to improve the financial reporting of lease contracts. As mentioned in the press release, the proposals are one of the main project included in the board's MoU. The proposals, if adopted, will greatly improve the financial reporting information available to investors about the financial effects of lease contracts. The proposed requirements would supersede IAS 17 Leases in IFRSs and the guidance in Topic 840 on leases in US GAAP.

The exposure draft (ED) is open for public comment until 15 December 2010.

In the ED, the boards propose to define a lease as a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration. In the boards' view, this definition retains the principle in the definition of a lease in both IFRSs and US GAAP.

Current IAS 17 Leases defines a lease as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for a agreed period of time. A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. An operating lease is a lease other than a finance lease.

IFRSs and US GAAP classify leases into two categories : finance leases (called capital leases under US GAAP) and operating leases. Categorisation is based on various factors. If a lease is classified as a finance lease, assets and liabilities are shown on the lessee's balance sheet. However, for an operating lease the lessee does not show any assets or liabilities on the balance sheet. The lessee simply accounts for the lease payments as an expense over the lease term. Hence, investors have to estimate the effect of operating leases on financial leverage and earnings, and routinely have to adjust the financial statements of lessees for the effects of operating leases. Such adjustments are either arbitrary or based on estimates.

As the solution, the proposed model of lease accounting would reflect assets and liabilities arising from all lease contracts. All leases have to be recorded on the balance sheet. So, investors would no longer need to adjust the amounts presented in the balance sheet and the income statement to reflect the assets, liabilities and finance costs arising from lessees' operating leases.

In the ED, the boards also proposing a 'right-of-use' model in accounting for all leases (including leases of right-of-use assets in a sublease) where both lessees and lessors record assets and liabilities arising from lease contract. The assets and liabilities are recorded at the present value of the lease payments, and subsequently measured using a cost-based method.

In conjunction with revaluation issue, the ED proposes the approaches to the revaluation of right-of-use assets as follows :

(a) lessees using IFRSs would have the option to revalue right-of-use assets

(b) lessees using US GAAP would not be permitted to revalue right-of-use assets unless required to do so to recognise an impairment loss.

The ED proposes that if an entity applying IFRSs revalues a right-of-use asset, it should revalue the entire class of asset (ie the entire class of assets comprising all owned and leased assets) to which the underlying asset belongs.

The IASB Press Release and Exposure Draft are available to download in here : Exposure Draft and Comment Letter

Read also (updated December 2, 2010) :

1. Proposal Would Require Most Leases to Appear on the Balance Sheet (Journal of Accountancy)
2. Taking the "Ease" Out of "Lease"?

The Right Way to Classify A Lease

Definitions

A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.

An operating lease is a lease other than a finance lease.

Classification of Leases

The classification of a lease as either a finance lease or an operating lease is critical as significantly different accounting treatments are required for the different types of lease. The classification is based on the extent to which risks and rewards of ownership of the leased asset are transferred to the lessee or remain with the lessor. Risks include technological obsolescence, loss from idle capacity, and variations in return. Rewards include rights to sell the asset and gain from its capital value.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards of ownership to the lessee. If it does not, then it is an operating lease. When classifying a lease, it is important to recognize the substance of the agreement and not just its legal form. The commercial reality is important. Conditions in the lease may indicate that an entity has only a limited exposure to the risks and benefits of the leased asset. However, the substance of the agreement may indicate otherwise. Situations that, individually or in combination, would usually lead to a lease being a finance lease include :

• transfer of ownership to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price that is expected to be lower than its fair value such that the option is likely to be exercised
• the lease term is for a major part of the economic life of the asset, even if title to the asset is not transferred
• the present value of the minimum lease payments is equal to the substantially all of the fair value of the asset
• the leased assets are of a specialized nature such that only the lessee can use them without significant modification

Situations that, individually or in combination, could lead to a lease being a finance lease include :

• if the lessee can cancel the lease, and the lessor’s losses associated with cancellation are borne by the lessee
• gains or losses from changes in the fair value of the residual value of the asset accrue to the lessee
• the lessee has the option to continue the lease for a secondary term at substantially below market rent

It is evident from the descriptions that a large degree of judgment has to be exercised in classifying lease; many lease agreements are likely to demonstrate only a few of the situations listed, some of which are more persuasive that others. In all cases, the substance of the transaction needs to be properly analyzed and understood. Emphasis is placed on the risks that the lessor retains more than the benefits of ownership of the asset. If there is little or no related risk, then the agreement is likely to be a finance lease. If the lessor suffers the risk associated with a movement in the market price of the asset or the use of the asset, then the lease is usually an operating lease.

The purpose of the lease agreement may help the classification. If there is an option to cancel, and the lessee is likely to exercise such an option, then the lease is likely to be an operating lease (Hrd).

Source : IFRS Practical Implementation Guide and Workbook (2nd Edition) - Abbas Ali Mirza, Magnus Orrell & Graham J. Holt