As we wait for a definitive leasing standard, Graham Holt explores the original 2013 exposure draft and the current state of play
First published in the March 2015 UK edition of Accounting and Business magazine.
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Leasing is an important activity for many organisations with the majority of leases not currently reported on a lessee’s statement of financial position. The existing accounting models for leases require lessees and lessors to classify their leases as either finance leases or operating leases and to account for those leases differently.
The existing standards have been criticised for failing to meet the needs of users of financial statements because they do not always provide a faithful representation of leasing transactions.
"The existing standards have been criticised for... not always [providing] a faithful representation of leasing transactions. "
The exposure draft (ED), Leases (May 2013), attempted to solve the lease accounting problem by requiring an entity to classify leases into two types - type A and type B - and recognise both types on the statement of financial position. The ED was the result of a joint project by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Boards (FASB) (the boards).This article sets out the current deliberations of the boards as at the end of 2014 and, therefore, as such, the final leasing standard may vary from the discussions below.
Type A or B
The ED sets out that type A leases would normally mean that the underlying asset is not property, while type B leases mean that the underlying asset is property. However, the entity classifies a lease other than a property lease as type B if the lease term is for an insignificant part of the total economic life of the asset; or the present value of the lease payments is insignificant relative to the fair value of the underlying asset at the lease’s commencement date.
Conversely, the entity classifies a property lease as type A if 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. At this date, the lessee discounts the lease payments using the rate the lessor charges the lessee, or if that rate is unavailable, the lessee’s incremental borrowing rate.
Assets and liabilities
The lessee recognises the present value of lease payments as a liability. At the same time it recognises a right-of-use (ROU) asset equal to the lease liability, plus any lease payments made to the lessor at or before the commencement date, less any lease incentives received from the lessor; and any initial direct costs incurred by the lessee. After the commencement date, the liability is increased by the unwinding of interest and reduced by lease payments made to the lessor.
A lessee will recognise in profit or loss, for type A leases, the unwinding of the discount on the lease liability as interest and the amortisation of the ROU asset and, for 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.
Following the feedback received on the ED, the FASB still remains supportive of the dual-model approach to bringing leases on to the statement of financial position.
"The FASB still remains supportive of the dual-model approach. "
Under this approach, a lessee would account for most existing finance leases as type A leases and most existing operating leases as type B leases. Both type A and B leases result in the lessee recognising a ROU asset and a lease liability. However, the IASB has stated that feedback on the 2013 ED indicates that the dual model is too complex and, therefore, has opted currently for a single lessee model that is ‘easy to understand’. The IASB decided on a single approach for lessee accounting where a lessee would account for all leases as type A leases.
"The IASB... has opted currently for a single lessee model that is ‘easy to understand’."
The boards decided that a lessor should determine lease classification (type A or type B) on the basis of whether the lease is effectively a financing or a sale, rather than an operating lease. A lessor would make that determination by assessing whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset. A lessor will be required to apply an approach substantially equivalent to existing International Financial Reporting Standards (IFRS) finance lease accounting to all type A leases.
Definition of a lease
A lease is currently defined by the boards as ‘a contract that conveys the right to use an asset for a period of time in exchange for consideration’. An entity would determine whether a contract contains a lease by assessing whether the use of the asset is either explicitly or implicitly specified and the customer controls the use of the asset. The definition of a lease does not require the customer to have the ability to derive the benefits from directing the use of an asset.
The boards have decided that the leases guidance should not include specific requirements on materiality and retain the recognition and measurement exemption for a lessee’s short-term leases (12 months or less) with the IASB specifically favouring a similar exemption for leases of small assets for lessees.
The boards have decided that, when determining the lease term, an entity should consider all relevant factors that may affect the decision to extend, or not to terminate, a lease. The lease term should only be reassessed when a significant event occurs or there is a significant change in circumstances that are within the control of the lessee. A lessor should not be required to reassess the lease term.
Variable lease payments
Only variable lease payments that depend on an index or a rate should be included in the initial measurement of leases and the IASB has determined that reassessment of variable lease payments would only occur when the lessee re-measures the lease liability for other reasons. A lessor will not be required to reassess variable lease payments that depend on an index or a rate.
The definition of the discount rate remains unchanged as the rate implicit in the lease, as does the requirement for a lessee to reassess the discount rate only when there is a change to either the lease term or the assessment of whether the lessee is (or is not) reasonably certain to exercise an option to purchase the asset.
Modification of a lease
A lease modification for both a lessee and a lessor should be accounted for as a new lease, separate from the original lease, when:
- the lease grants the lessee an additional right-of-use not included in the original lease, and
- the additional right-of-use is priced commensurate with its standalone price in the context of that particular contract.
In terms of the initial direct costs for both lessors and lessees, they should include only incremental costs that would not have incurred if the lease had not been executed. These include commissions or payments made to existing tenants to obtain the lease. A lessor in a type A lease should include initial direct costs in the initial measurement of the lease receivable and they should be taken into account in determining the rate implicit in the lease.
A lessor in a type A lease who recognises selling profit at lease commencement should recognise initial direct costs as an expense. A lessor in a type B lease should expense such costs over the lease term on the same basis as lease income. A lessee should include initial direct costs in the initial measurement of the right-of-use asset and amortise those costs over the lease term.
Sale and leaseback
The guidance in the ED has been retained for sale and leaseback transactions with a sale having to meet the requirements of a sale as set out in IFRS 15. A buyer-lessor should account for the purchase of the underlying asset consistent with the guidance that would apply to the purchase of any non-financial asset.
An end in sight?
This article sets out the deliberations of the IASB/FASB as regards lease accounting at the end of December 2014. The IFRS is due for publication in 2015, but it seems that the FASB and IASB will have differing views on several recognition and measurement issues when the IFRS is finally published. There may yet however be further changes of opinion.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School