A re-exposure draft (RED) of the proposed new international lease accounting standard is due to be issued in the second quarter of 2013. After so much discussion about the standard since the initial exposure draft was published in August 2010, the substance of the new rules should be well known to most, although a recent survey did find that more than 45 per cent of lessee firms are unaware of the impending changes.
That said, given the number of key proposals which have been reversed by the joint standard setting bodies throughout consultation, it is worth summarising what is currently being proposed; especially as this new approach could cause assets and liabilities to increase at some companies, potentially causing breaches of loan covenants.
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The key objective of the proposed standard is to require lessees to bring operating leases on to their balance sheets. The question is, how should these rentals be expensed in the lessee’s profit and loss account? In the RED, the joint standard setting bodies will propose different methods by which to account for equipment leases and property leases. Equipment leases will generally be expensed on a front-loaded profile, whereas property leases will generally be expensed on a straight-line basis.
However, there will be provision for some exceptions on either side. It is proposed that real estate leases with insignificant residual value will be expensed like equipment leases, and some equipment leases with high residual value can be expensed like the majority of real estate leases. The exception for real estate leases is likely to be of particular relevance to the UK commercial property market, as this would apply to the 99-year leases sometimes used in the UK which are currently classified as finance leases. The exception for equipment leases is likely to apply only to a very narrow range of short leases of long life assets, as most short term leases – those which cannot extend for more than 12 months – will in any case be excluded from the capitalisation rule.
It is hoped lessors are less likely to have concerns about the new rules. Under the proposals they will generally be subject to the ‘receivable and residual’ (R&R) model that provides for a front loaded income recognition profile, similar to the current rules for finance leases. With R&R a lessor recognises a lease receivable and the residual asset, but not the underlying asset. Over the lease term the lessor may also recognise interest income on the asset and any potential income on any appreciation of the residual asset. The impact therefore for lessors is considerably less likely to be as detrimental to the balance sheet as it is for lessees. The greater concern for lessors is likely to be any potential negative commercial impact that the proposals have on their existing and prospective customers. However, we will have to wait until the RED is published to see whether that is truly the case.
Joanne Davis is a partner in DWF’s banking and asset finance team
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