David Maxwell summarises
proposed new lease accounting standards published on 17 August 2010
by the International Accounting Standards Board and the US
Financial Accounting Standards Board.
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Scope
A lease is defined as “a contract
in which the right to use a specified asset is conveyed, for a
period of time, in exchange for consideration”.
However, certain leases falling
within this definition are specifically excluded from the
requirements of the proposed new standard, such as leases of
intangibles, leases falling within IAS 40 or IAS 41 or leases that
are treated by the standard as being purchases or sales.
The latter applies to contracts
where title automatically passes at the lease-end or where there is
a bargain purchase option (such as in the case of hire purchase
contracts). The proposals leave uncertainty as to how to account
for the excluded contracts.
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Lessee
accounting
Under the proposals, lessees would
no longer classify leases as either finance leases or operating
leases, but instead all leases would be brought on to the balance
sheet of lessees.
The lessee would recognise a
right-of-use asset and a liability to make lease payments and,
except in the case of short-term leases (being leases with a
maximum term of less than twelve months), these would initially be
at the present value of the expected rentals, discounted at the
lessee’s incremental borrowing rate or the rate charged by the
lessor.
No present valuing will be required
for short-term leases. The right-of-use asset would be amortised
over the lease term and interest would be recognised on the
liability, in a similar way to the current accounting for finance
leases.
Note that the rentals included in
the initial recognition are not the minimum lease payments (as
under existing lease standards), but would include estimates of
contingent rentals and, where the lease term can vary due to
options to extend or terminate, would be based on the longest
possible lease term that is more likely than not to occur.
Consequently, the lessee’s
liability would be based on the lessee’s expectations rather than
being a contractual obligation and so arguably does not meet the
definition of a liability as set out in the International
Accounting Standard Board’s (IASB) framework.
Where the lease contains a purchase
option, the option price would not be included in the lease
payments and, where the lessee has given a guarantee of the asset’s
residual value, this would be included only to the extent that a
payment is expected under the guarantee.
The expected lease payments and
lease term would be regularly reassessed and the liability to make
lease payments adjusted as necessary.
Changes in respect of the current
or past periods would be recognised in profit or loss, but the
right-of-use asset would be adjusted for changes in respect of
future periods, except interest adjustments which would always go
through profit or loss.
The discount rate would not be
varied except where the rentals vary with interest rates.
The proposals regarding interest
variations could give rise to somewhat volatile interest charges
whereby expected changes in future interest rates lead to
adjustments in the current period.
Lessor
accounting
Whereas for the lessee there will
be a single accounting model for all leases, lessors will still be
required to classify leases and adopt different accounting models
depending on the classification.
While the exposure draft does not
use the terms ‘finance lease’ and ‘operating lease’, the
classification is based on similar criteria to that in current
lease standards.
Where the lessor has retained
significant risks or benefits relating to the underlying asset (for
example, operating leases), it would adopt the performance
obligation approach.
For other leases (for example,
finance leases), it would adopt the derecognition approach.
Performance obligation
approach
Under the performance obligation
approach, the lessor would continue to recognise the underlying
asset on its balance sheet as is the case for operating leases
under current lease standards.
However, in addition, the lessor
would recognise a right to receive lease payments and a lease
liability (representing the obligation to make the asset available
to the lessee). All these amounts would be presented net in the
balance sheet.
As in the case of the lessee’s
liability to make lease payments, the right to receive lease
payments and the lease liability would initially be the present
value of the expected payments (rather than the minimum lease
payments) but discounted at the rate the lessor charges the
lessee.
Interest income would be recognised
on the right to receive lease payments and the lease liability
would be released to profit on the same basis as the pattern of use
of the underlying asset by the lessee or on a straight line basis
if this cannot be determined.
The technical basis for this
approach has been the subject of much discussion and, in this
respect, it is my view that the approach is inconsistent with the
proposed accounting model for lessees and also with the proposals
in the recent exposure draft Revenue from Contracts with
Customers as to when a performance obligation is
satisfied.
The performance obligation approach
also results in the net lease assets exceeding the present value of
future cash flows during the lease term with the result that
excessive profits would be recognised in the early part of the
lease and possibly losses in the latter part.
Arguably, an impairment adjustment
is therefore required. It is also unclear why the lessor’s income
should vary with the pattern of the lessee’s use of the underlying
asset as the lessor’s obligation (to the extent there really is
one) is settled when the lessor makes the asset available to the
lessee, whether or not the lessee actually uses the asset.
As for the lessee, the lease
payments and expected lease term would be regularly reassessed and
adjustments made to the right to receive lease payments as
necessary.
These variations should be taken to
profit or loss if the lessor has satisfied the related lease
liability or give rise to an adjustment to the lease liability if
not.
Applying this requirement may be
difficult in certain circumstances – for example, where rentals
vary with tax, it is unclear as to in which period the
corresponding reduction in lease rentals represents a satisfaction
of the lease liability.
Derecognition
approach
Under the derecognition approach,
the lessor would derecognise a proportion of the underlying asset
and instead recognise a right to receive lease payments (calculated
as under the performance obligation approach). The portion of the
underlying asset retained would be shown as a residual asset.
The proportion of the underlying
asset derecognised is the carrying amount of the underlying asset
multiplied by the fair value of the right to receive lease payments
divided by the fair value of the underlying asset. A gain or loss
could arise on initial recognition.
Interest income would be recognised
on the right to receive lease payments, but no income would be
recognised on the residual asset until realised at the lease
end.
The consequence is that, if there
is a significant residual asset, losses will generally be made over
the lease term, offset by a gain at the lease end when the residual
asset is realised.
Where the residual value is
guaranteed, the lessor has effectively a financial asset and so, in
my view, it is incorrect not to allow the lessor to recognise
income thereon.
Again, the lease payments and
expected lease term would be regularly reassessed and adjustments
made to the right to receive lease payments as necessary.
Except where there is a change in
the lease term (for which the residual asset would be adjusted),
all adjustments, even those relating to future periods, would be
recognised immediately in the profit or loss.
Sale and
leasebacks
Sale and leaseback transactions
should be accounted for as a sale and a separate leaseback if it is
determined that the underlying asset has been sold.
In this case, a profit or loss
would be recognised on that sale and the lessor would account for
the leaseback using the performance obligation approach.
Otherwise the arrangement should be
accounted for as a financing. The underlying asset is treated as
having been sold if, at the end of the contract, control of the
underlying asset and all but a trivial amount of the risks and
benefits associated with the underlying asset have been transferred
to the buyer/lessor.
Transition
On adopting the new standard, the
proposal is that lessees would recognise a liability to make lease
payments at the present value of the remaining lease payments.
A right-of-use asset would also be
recognised equal to this liability plus an adjustment for any
recognised prepaid or accrued rentals, by which is presumably meant
recognised under the previous accounting standards.
Finance leases will be recognised
at the existing carrying amounts only if the lease contains no
options, contingent rentals, term option penalties or residual
value guarantees.
In practice, few finance leases
would meet this condition. As stated in the “alternative view”
included in the basis for conclusions, these requirements “will
lead to a misleading and inappropriate reduction in profit of a
lessee on transition and increase profit growth in subsequent
periods”.
Furthermore, for an existing
finance lease that has been prepaid, there will be no “recognised”
prepaid or accrued rentals and so the proposals will result in the
lessee having to write off the entire asset recognised under
current standards.
For a lessor using the performance
obligation approach, the lessor would recognise a right to receive
lease payments at the present value of the remaining lease payments
and a lease liability of the same amount. It would also reinstate
the underlying asset at depreciated cost.
Again, as pointed out in the
alternative view, this will have the opposite effect to the lessee
accounting and also distort the profit trends of lessors.
Furthermore, curiously, no
adjustment is suggested for prepaid and accrued rentals and so, for
a fully prepaid lease, the lessor would just reinstate the
underlying asset and subsequently have depreciation charges with no
lease income.
For a lessor using the
derecognition approach, the lessor would recognise a right to
receive lease payments as above and a residual asset at its fair
value at the date of initial application.
Overall
comments
While I support bringing all leases
on to the balance sheet of lessees, in many areas the Boards have
gone for a ‘quick fix’ rather than properly thought through
proposals, with a consequence that the proposals will both be
difficult to implement and produce misleading and inappropriate
results.
It is also difficult to see how the
proposed lessor accounting can be considered to be an improvement
on current lessor accounting.
David Maxwell is director of
Classic Technology Limited, a leasing consultancy
