Extracting value Issue 11 - An update on lease accounting
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On 17 August 2010 the IASB and the FASB published Exposure Draft ED/2010/9 Leases with the intention of developing a new approach to lease accounting that will require that assets and liabilities arising under leases are recognised in the statement of financial position. Since issuing the exposure draft the IASB has commenced redeliberation of the topic following receipt of numerous comment letters and extensive outreach and made some tentative decisions which differ from the proposals in the exposure draft.
“One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet”
Sir David Tweedie, Chairman International Accounting Standards Board
The exposure draft proposes that lessees (and lessors) should apply a right-of-use model in accounting for all leases (with some specific exceptions, including leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources). For leases within the scope of the draft IFRS, this means that a lessee would recognise an asset representing its right to use the leased asset for the lease term (the ‘right-of-use’ asset) and a liability to make lease payments.
Although the IASB still has a number of issues to discuss before finalising the project and issuing a final standard, the proposed changes will have a significant impact on the financial reports of companies in the energy and resources sector given the extensive use of leases within the industry. Below is a snapshot of some of the recent decisions made by the IASB, further updates will be provided in future issues of Extracting Value.
Definition of a lease
The exposure draft defines a lease as “A contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for consideration”. The definition broadens the scope of the lease accounting compared to AASB 117 Leases which may now extend to certain service contracts. Outsourcing arrangements, take or pay arrangements and distributions contracts which are dependent upon the use of a specific asset and convey the right to use the asset might be considered a lease and will be required to be accounted for in accordance with the new model.
For those contracts that combine service and lease components the liability to make lease payments would exclude payments arising from distinct service components. For example, the specific assets associated with contract mining arrangements might be required to be separately accounted for as leased assets on the balance sheet of the contracting entity whereas the distinct service components would not.
The exposure draft does provide for an exception for short-term leases, that is, leases which have a term, including all options to renew, of twelve months or less. Although an exception is still expected to be provided, the IASB has tentatively decided that short-term leases (for lessees) will continue to be accounted for as we currently account for operating leases.
Determination of lease term
The exposure draft defined the lease term as “the longest possible term that is more likely than not to occur”. Subsequent to the receipt of comment letters the IASB has tentatively decided that lease term should be defined as the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a “significant economic incentive” to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease. While significant economic incentive is yet to be defined potentially the discovery of additional resources and/or the extension of a mine’s life could amount to a significant economic incentive to increase the lease term of certain assets such as mining machinery. In such cases an entity will be required to reassess the lease term and adjust the lease liability.
Determination of lease payments
The proposals would have required a lessee to determine the lease payments payable during the lease term using an expected outcome approach, including contingent rentals. It is now proposed that only variable lease payments that are “reasonably certain” should be included in the lessee’s liability to make lease payments. Where rentals are subject to a rate or index escalation the amount of the liability is based on the prevailing rate (spot rate). Any other contingency payments, for example, usage or performance-based payments are included if it is “reasonably certain” that the payments will be made.
The exposure draft had proposed a single right-of-use approach for all leased assets. The IASB has tentatively decided that there should be two different types of leases (finance and other-than-finance) and the profit or loss recognition pattern for a finance lease would be consistent with the proposal in the exposure draft and for an other-than-finance lease would be straight-line. The determination of whether a lease is a finance or other-than-finance lease would be based on a number of factors. The tentative decision to have two types of leases may resolve the issue around the expense recognition pattern for many lessees, although under both a right-to-use asset and related liability would be recognised. However, the factors that would be used for determining the type of lease are still being developed, so it is unclear whether the split between a finance and other-than-finance lease will be similar to today’s split between finance and operating leases. It is also uncertain about how the straight-line expense amount would be calculated and presented in profit or loss.
Issues for consideration
In applying the proposals preparers of financial statements are required to make a number of significant judgements. In contemplating these issues, consideration should be given to whether amendments will be required to existing systems in order to collate and assess all contracts and arrangements entered into to determine whether the contracts and arrangements contain a lease.
Firstly, entities will be required to review all existing contracts and arrangements (with the exception of short-term leases) to determine whether the arrangement is dependent upon the use of a specific asset and whether the contract conveys the right to use that asset. The right to use an asset might be conveyed if:
- The entity has the right to operate the asset while obtaining more than a significant amount of the output of the asset
- The entity has the right to control physical access or restrict the access of others to the output while obtaining more than an insignificant amount of the output
- For ’take or pay arrangements’ the entity will obtain all but an insignificant amount of output and the price is not per unit of output.
Secondly, having determined that a lease arrangement exists the entity should determine the term of the lease and therefore the value of the right of use asset and the liability to make lease payments. This will require consideration of the options periods within the lease and whether there is significant economic incentive to exercise the option and extend the lease’s life.
Where to from here?
The target date for a finalised standard was initially June 2011 with an expected implementation date of 1 January 2013. However the IASB has recently updated their project timetable and the final standard is not expected to be issued until early in the second half of 2011. Given the IASB’s commitment to at least a 12 month period between issuance and adoption of standards and the level of complexity, estimation and judgement required to implement it is our understanding that the IASB are considering a 1 January 2015 implementation date.