Lease accounting - a matter of priority
When in June 2010 the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) refocused their priorities for completion of joint projects, four project areas were identified as top priorities. These are financial instruments, revenue recognition, leases and insurance contracts. Each of these is seen as being in the 'must do' category of standards for completion by June 2011.
The objective of the project on leases is to develop a comprehensive lease accounting model addressing both lessee and lessor accounting that would eliminate the current accounting treatment afforded to operating leases to ensure all assets and liabilities arising under lease contracts are recognised in the statement of financial position. In pursuit of this objective, the IASB and the FASB published a joint exposure draft (ED) of a proposed standard in August 2010 with an invitation to comment and express any views by December 2010.
Development of standard
Leasing is a global business and a common transaction irrespective of nature or size of entity. Differences in treatment required by accounting standards, and within individual standards, can lead to considerable non-comparability. In recognition of this, the IASB initiated an active research project in 2003 working jointly with the UK Accounting Standards Board to address the primary issue of developing an approach to lease accounting that is more consistent with the conceptual definition of assets and liabilities. From an early stage, it was recommended that the application of consistent asset and liability recognition principles in respect of assets owned, assets held under finance leases and assets held under operating leases should provide more relevant, reliable and comparable financial information.
In 2006, under the IASB-FASB Memorandum of Understanding, the two Boards agreed on a joint leasing project. They formed an international working group to carry out a comprehensive reconsideration of all aspects of lease accounting which subsequently led to the publication of a joint discussion paper in March 2009 and an exposure draft in August 2010. A lengthy process but one that seems to be coming to fruition and on which both Boards appear to have reached agreement on a way forward.
A number of issues have been discussed at length at the joint meetings since 2006, including the choice of an appropriate accounting model. From an early stage there was agreement that the current IASB accounting model would have to be replaced.
The current international standard is IAS 17 'Accounting for Leases', which in its revised form was issued by the IASB in December 2003. It applies to the majority of leases, with certain categories excluded, and classifies leases between finance and operating leases dependent on the substance of the transaction rather than the form. The standard provides examples of criteria that would normally lead to a lease being classified as a financial lease, which include the following:-
- The lease transfers ownership of the asset to the lessee by the end of the lease term
- The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower
- than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised
- The lease term is for the major part of the economic life of the asset, even if title is not transferred
- 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 asset
- The lease assets are of a specialised nature such that only the lessee can use them without major modifications being made
- If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee
- Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments)
- The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent
The assessment of whether a lessee should account for a lease as a finance or operating lease will determine whether both the asset and the liability are presented on the balance sheet or whether it is to be treated as an off balance sheet financing arrangement. For lessors, an asset will be carried on balance sheet with classification as a receivable or as property, plant or equipment dependent on whether it is a finance or operating lease.
Proposed new standard
The proposals in the joint exposure draft would significantly affect the accounting for lease contracts for both lessees and lessors. The most significant change for lessees is that assets and liabilities would be recognised for all leases and the principle of 'lease classification' between finance and operating leases in the current IAS 17 would no longer exist.
The lessee accounting model is based on a 'right-of-use' approach. Upon lease commencement, the lessee obtains a right to use an asset for a specified period and would recognise an asset reflecting that right and a liability for its obligation to pay rentals. Other than for short-term leases, the initial measurement of the obligation to make lease payments would be at the present value of lease payments, discounted using the lessee's incremental borrowing rate or the rate the lessor charges the lessee, if it can be readily determined. The right-to-use asset would be initially measured at an amount equivalent to the obligation.
The proposed standard puts forward a number of proposals which could lead to significant complexity and the exercise of a greater level of judgement in some instances than under the current standard. Areas where this may arise include the determination of both the lease term and the amount of lease payments, depending on the features of the lease.
The ED defines lease term as 'the longest possible term that is more likely than not to occur' which brings into consideration such matters as explicit or implicit renewal options and/or early termination options included in the lease contract. The ED lists factors which entities could consider in the determination but many see the probability-based measurement criteria as requiring more judgement than the current IAS 17 which requires renewal options to be included in the lease term if they are 'reasonably certain' of being exercised. Current practice has generally interpreted 'reasonably certain' as a high threshold and therefore renewal options are rarely taken into account.
The ED would require a lessee to determine lease payments using an expected outcome approach - 'the present value of the probability-weighted average of the cash flows for a reasonable number of outcomes'. The lease payments would include estimates of contingent rentals, payments under residual value guarantees and payments to the lessor under term option penalties. The inclusion of contingent rentals represents a significant change from IAS 17, and the need for such a high level of judgement and estimation could prove costly and time-consuming for entities.
There are proposed significant changes also for lessor accounting and in such areas as sale and leaseback accounting which will require careful examination by entities involved in those areas and certain complexities will have to be addressed.
What is clear is that the relatively 'bright line' approach adopted by the current IASB and FASB standards will be replaced by a joint standard which may require a higher level of judgement and estimation. Companies where leasing is a significant part of their financing structure should start thinking about how the proposals could affect their financial statements and should consider the possibility of having to make changes to lease structuring, performance metrics, debt covenants, accounting policies and systems.
The proposed changes will improve consistency of accounting treatment and enhance transparency of financial reporting. Such developments are always welcome.
First published in Finance Dublin online