Graham Holt looks at the proposed changes to lease accounting, including how they will affect those using IFRS for the first time
This article was first published in the December 2010 edition of Accounting and Business magazine.
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The International Accounting Standards Board (IASB) is currently looking at the accounting for leases and has issued an exposure draft. Its proposals would significantly affect the accounting for lease contracts for both lessees and lessors. Lessees would recognise assets and liabilities for all leases and the lease classification in the current lessee accounting model (IAS 17, Leases) would no longer exist. However, many entities, including public bodies, are still grappling with the current IAS 17 standard and the related provisions of IFRS 1, First-Time Adoption of International Financial Reporting Standards.
This article looks at some of the issues that first-time adopters and other users of IAS 17 will face. Accounting for leases can have a significant impact on the financial statements of both lessees and lessors.
Leases are classified as finance or operating leases at inception, depending on whether substantially all the risks and rewards of ownership transfer to the lessee. The legal form of the transaction is not the determining factor. Under a finance lease, the lessee has substantially all of the risks and reward of ownership. All other leases are operating leases.
Under a finance lease, the lessee recognises an asset held under a finance lease and a corresponding obligation to pay rentals. The lessee depreciates the asset. The amount recognised as an asset and liability by the lessee is either the fair value of the leased asset or the present value of the minimum lease payments using the interest rate implicit in the lease, whichever is lower. The lessee may need to estimate this interest rate but if this is not possible, the lessee should use its incremental borrowing rate. Lease rentals are split into two components: an interest charge and the reduction in the lease receivable.
The lessor recognises the leased asset as a receivable. The receivable is measured at the 'net investment' in the lease, which is the minimum lease payments receivable, discounted at the internal rate of return of the lease, plus the unguaranteed residual which accrues to the lessor. Lease rentals are allocated between a reduction in the receivable and finance income so that finance income recognised represents a constant percentage rate of return on the net investment.
Under an operating lease, the lessee does not recognise an asset and lease obligation. The lessor continues to recognise the leased asset and depreciates it. The rentals paid are normally charged to the income statement of the lessee and credited to that of the lessor on a straight-line basis.
There are certain criteria, which help to determine the classification of a lease. These criteria are used as a guide and often the substance of the transaction is the overriding factor. The criteria that would normally lead to classification as a finance lease are:
- Ownership is transferred to the lessee at the end of the lease term.
- The lessee has an option to buy the leased asset at the end of the lease term, and it is reasonably certain that the option will be exercised.
- The lease term is for the majority of the economic life of the asset.
- At inception, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
- The leased assets are highly specialised and only the lessee can use them without major modification.
Additional indicators may point to the lease being a finance lease; they revolve around the 'risks and rewards of ownership' criteria - for example, the lessee benefits from fluctuations in the fair value of the residual by receiving rent rebates.
The IASB deleted the specific guidance regarding classification of leases of land as from 1 January 2010, so as to eliminate inconsistency with the general guidance on lease classification. As a result, leases of land should be classified as either finance or operating, using the general principles of IAS 17.
IAS 17 does not include an assumption that land is always an operating lease. This is to be applied retrospectively to existing leases if the necessary information is available at the inception of the lease. Otherwise, land leases should be reassessed on the date of adoption of the amendment.
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. Whenever necessary in order to classify and account for a lease of land and buildings, the minimum lease payments are allocated between the land and the buildings in proportion to the relative fair values of the leasehold interests. If the lease payments cannot be allocated reliably between these two elements, then the entire lease is normally classified as a finance lease.
If leased land and buildings meet the definition of investment property under IAS 40, Investment Property, then even if the land would normally be classified as an operating lease, it can be measured and recognised as a finance lease, provided that the investment property is subsequently measured at fair value.
Lessors sometimes provide incentives for lessees to enter into operating leases. But whatever the form of an incentive, it should be spread over the lease term on a straight-line basis. In effect, this reduces the cost of the rentals taken to profit or loss, so that the true rental cost to the lessee is reflected.
There may be transactions which do not have the legal form of a lease but which contain a lease. Under IFRIC 4, Determining Whether an Arrangement Contains a Lease, arrangements which are not legally a lease are accounted for as leases if the fulfilment of the arrangement is dependent on the use of a specific asset and the arrangement conveys the right to use a specific asset.
An example of this type of arrangement is an outsourcing contract. A public body may, for example, outsource its refuse collection to a private sector provider. The private sector provider purchases the vehicles and uses them exclusively for the public body. The public body can use the vehicles and the vehicles are used in this connection for the major part of the asset's life, which means that the arrangement conveys the right to use all but an insignificant part of the asset. In this situation it is likely that the public body may have to recognise a finance lease.
In the case of the public sector, some of these arrangements may have to be accounted for under IFRIC 12, Service Concessions. This applies where there is a contract with a private sector partner and the public sector has control of the services and a residual interest in the assets.
IFRIC 12 may require the recognition of an asset in these circumstances. An amendment to IFRS 1 allows a first-time adopter to apply the transitional provisions in IFRIC 12, which are that IFRIC 12 must be applied retrospectively unless doing so is impracticable.
Many entities including public bodies are adopting IFRS for the first time. There are no explicit exemptions or exceptions in IFRS 1 from retrospective application of IAS 17 leases. A first-time adopter is therefore required to recognise all assets held under finance leases at the date of transition. This involves the determination of the fair value of the asset at inception of the lease or the present value of the minimum lease payments, if lower, depreciated to the date of transition and calculating the finance lease liability based on the net present value of the minimum lease payments, amortised using the rate implicit in the lease.
It can be difficult and impracticable to determine the fair value of the asset acquired in the lease. The entity may elect at the date of transition to measure the asset capitalised at fair value by using the fair value as deemed cost exemption available to property, plant and equipment.
An entity pays a premium of $6m for a lease of property in 2009. This is capitalised as a fixed asset under local GAAP. On 1 January 2010, the date of transition to IFRS, the asset is revalued to $7m. The entity determines that at 1 January 2010, the relative values of the land and buildings are $2m for the land and $5m for the buildings.
The entity has determined that the building is a finance lease and the land an operating lease. The fair value as deemed cost exemption is available to property, plant and equipment but not to the operating lease prepayment. Thus the building asset may be stated at $5m but the prepayment must be restated to original cost, with the resultant debit to revaluation reserve.
IFRS 1 provides an exemption from the requirements of IFRIC 4. Instead of determining retrospectively whether an arrangement contains a lease at the inception of the arrangement, entities may determine whether arrangements in existence on the date of transition to IFRS contain leases by applying IFRIC 4 at the date of transition.
In 2009, an additional exemption provided further relief where the first-time adopter had under its previous GAAP made an assessment as to whether an arrangement contained a lease at a date other than that required by IFRIC 4; the first-time adopter need not reassess the position when it first applies IFRS if the outcome would have been the same.
Under IFRS, in the lessor's financial statements, a finance lease debtor is recognised at an amount equal to the net investment in the lease. On transition, the debtor at the inception of the lease should be determined and full retrospective adoption should be applied.
The carrying amount at the date of transition should be determined using a constant periodic rate of return on the lessors' net investment and any differences with current carrying amounts treated as an adjustment to retained earnings.