The International Accounting Standards Board (IASB) has recently reissued an exposure draft setting out its intended approach for the recognition and measurement of leases. A discussion paper was issued in 2009 and an exposure draft (ED) in 2010, with comments on the latter indicating that the income statement effect of the lessee model was disliked because of the 'front-loading' to profit or loss.
This is caused by the combination of a decreasing interest charge over time as the lease liability is repaid and the straight-line amortisation of the right-of-use asset. The new ED includes proposals to mitigate the front-loading of profit or loss for certain types of leases. As regards lessors, comment indicated that the current model actually did create decision-useful information.
The new ED would represent a major change in accounting by requiring many companies to report larger amounts of assets and liabilities on balance sheets than at present. Under current rules, many entities classify a significant number of leases as operating leases and keep them off their balance sheets. For example, many airlines lease their planes and show no assets or liabilities for their future commitments. Under the ED, an airline entering into a lease for an aircraft would show an asset for the 'right to use' the aircraft and an equal liability based on the current value of the lease payments it has promised to make. The ED would create a new, converged approach to lease accounting that would remove the old distinction between operating and finance leases.
The ED will not apply to leases of intangible assets, biological assets, exploration rights, and certain service concessions. The ED has incorporated IFRIC 4, Determining whether an arrangement contains a lease, into its guidance. The IFRIC deals with contracts that do not take the legal form of a lease, but conveys a right to use an asset. There could be a change in the guidance concerning these arrangements, especially as there is more useful guidance in the ED to supplement IFRIC 4. For example, contracts for capacity rather than use of the identified asset are not considered leases. Service contracts determined not to contain a lease would not be in the leasing standard and would not be recognised in the balance sheet.
Under the proposed standard, lessees would initially recognise a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the asset for the lease term. This concept is intended to align with the control concept in the IASB's joint revenue recognition project. The lease liability would be the present value of the fixed lease payments less any lease incentives receivable from the lessor. The lease liability also includes any variable payments that may be linked to an index or rate and any amounts payable under residual value guarantees. For example, if the rental were to vary based on the Consumer Price Index then the initial value would be based on the current level of the index. The values of the asset and liability would be updated every year as the index changed. Variable rents based on performance or usage are excluded and are recognised in profit or loss as incurred.
The right-of-use asset would be measured at cost, based on the amount of the lease liability plus lease prepayments less any lease incentives received. The right-of-use asset also includes any costs incurred that are directly related to entering into the lease. The lease liability would be measured in the same way regardless of the nature of the underlying asset.
At the commencement of the lease, it should be classified as either Type A or Type B. Type A leases normally mean that the underlying asset is not property, while Type B leases normally mean the underlying asset is property. Leases of property would be classified as Type B leases, unless either of the following conditions exists:
- The lease term is for the major part of the asset's remaining economic life.
- The present value of the lease payments accounts for substantially all of the asset's fair value.
Leases of assets that are not property would be classified as Type A leases, unless either of the following conditions exists:
- The lease term is for an insignificant part of the asset's total economic life.
- The present value of the lease payments is insignificant compared with the asset's fair value.
If a lease contains both property and non-property then it would be classified based on the nature of the primary asset within the lease.
After initial recognition, lessees would recognise the interest expense using the effective interest method and lease payments would reduce the liability.
Subsequent measurement of right-of-use assets would differ by lease type. For Type A leases, the asset would be amortised on a straight-line basis unless another systematic basis better represents the pattern of its consumption. The aggregate of interest expense on the lease liability and amortisation of the right-of-use asset would generally result in a front loading of the expense.
In contrast, the lease payments made in a Type B lease would represent amounts paid to provide the lessor with a return on its investment in the underlying asset, ie a charge for the use of the asset. The return or charge would be expected to be relatively even over the lease term. Essentially, the lessee would recognise a single lease expense on a straight-line basis. Right-of-use assets would be subject to impairment testing.
A lessee will recognise the following in profit or loss:
- Type A leases: the unwinding of the discount on the lease liability as interest and the amortisation of the right-of-use asset.
- Type B leases: the lease payments will be recognised in profit or loss on a straight-line basis over the lease term and reflected in profit or loss as a single lease cost. The single lease cost will be allocated to the actual unwinding of interest on the liability and any remaining lease cost is allocated to the amortisation of the right-of-use asset.
The lease term is defined as the non-cancellable period for which the lessee has contracted with the lessor. It includes periods covered by options to extend or terminate the lease where there is an economic incentive/disincentive. Lessees and lessors could make an accounting policy election, by class of asset, to apply a method the same as the current operating lease accounting to leases with a maximum possible lease term, including any options to renew, of 12 months or less.
A contract modification will result in a reassessment of lease assets and liabilities. The difference between the carrying amounts of assets and liabilities under the old lease and the new lease is recognised immediately in profit or loss.
Right-of-use assets and lease liabilities for each type of lease would be presented separately on a gross basis; amortisation expense and interest expense for Type A leases would be presented separately on the income statement; and the periodic expense for Type B leases would be presented as a single line item of lease or rent expense.
The ED sets out that for Type A leases, a lessor would initially derecognise the asset and recognise:
- A lease receivable for the right to receive lease payments.
- A residual asset representing the lessor's right to the underlying asset being the sum of the present value of any unguaranteed residual.
- A profit for the portion of the underlying asset leased if applicable.
- The unwinding of interest on the lease receivable and residual asset in profit or loss over the lease term.
Lease receivables and residual assets would be subject to the impairment testing. Lessors would show lease receivables and residual assets separately. The lessor does not have to take into account variable lease payments in the measurement of the lease receivable.
However, this has to be taken account in the measurement of the residual asset. A reassessment in the expected lease payments, excluding the impact of credit risk, will be reflected immediately in profit or loss.
Income from Type B leases will be recognised in profit or loss on a straight-line or other systematic basis over the lease term, similar to current operating lease accounting for lessors. The leased asset will not be derecognised or reclassified, but will be depreciated using the principles in IAS 16, Property, Plant and Equipment.
There seems to be little doubt that there will be substantial opposition to the new proposal. There were dissenting votes on both the IASB and US Financial Accounting Standards Board (FASB), with complaints made that the new proposal went too far. There may be a delay in making the new rules effective, probably until 2017, to give companies time to comply and, in some cases, to renegotiate loan agreements that may be violated if leases are put on the balance sheet.
Users of equipment leases are some of the most vocal opponents of the new ED's front-loaded approach. One of the main distinctions between the 2010 ED and new ED was that the prior draft would have required the same treatment for all leases, while the current version offers the dual approach that offers different treatments to reflect the underlying economics of the transaction.
The original ED in 2010 proposed a single lease model based on the right of use, but this was criticised on the basis that the expense recognition pattern did not reflect the economics of the different types of leases. Hence, the introduction of the two-lease model.
As this is one of the convergence projects, the FASB has issued a corresponding ED. Comments on the proposals close on 13 September 2013.
Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School