Jacqueline Mills looks at the positives and negatives of the second lease accounting exposure draft

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) released their revised proposals for accounting for leases in a new Exposure Draft (ED) in June this year.

Apart from two IASB and three FASB members voting against the proposals, there are no major surprises in the revised ED, which reflects the decisions taken during the 30-month re-deliberation process following the 2010 ED.

The IASB has decided to stick to its Right of Use model, capitalising all leases. Yet it has still failed to explain why leases are different to other types of executory (service) contracts.

It argues that it’s the delivery of a physical asset to the lessee that makes the difference, but it’s unclear to many as to why this should be the discriminative factor between leases and other types of contractual commitments, such as mobile phone subscriptions, utility services or even employment contracts.

Nevertheless, a number of changes to the initial ED have been made.

Steps in the right direction

There are those that go in the right direction like the Boards’ revision of the definition of a lease which aims to capture those contracts where the lessee effectively controls an identified asset.

If the lessor has what the Boards are referring to as a "substantive right" (i.e. an economically feasible right) to substitute the asset, the contract would not qualify as a lease.

Additionally, the Boards have taken measures to simplify the horrendously complex way of dealing with optional periods and contingent rentals first proposed in 2010.

Lease payments under optional periods need now only be recognised if the lessee is deemed to have a "significant economic incentive" to exercise the option.

Lease payments varying with changes in a rate or index need to be recognised, but payments that depend on performance measures (like lessee sales) or usage of the asset, need only be taken into account if they represent "in-substance fixed payments".

In short, the Boards have tried to lower the recognition thresholds for options and contingent rentals compared to the first ED.

Their objective has been to arrive at a situation that more closely captures the true liability of the lessee, while still building-in safeguards to avoid structuring.

These are undoubtedly positive developments, but it remains to be seen whether concepts like "significant economic incentive" or "in-substance fixed payments" will be interpreted consistently and turn out to be workable.

European lessees have been invited by the European Financial Reporting Advisory Group (EFRAG), the body in charge of advising the European Commission on the adoption of IFRS into EU law, to look into these matters in a field-testing exercise.

On the lessor side, our battle for accretion of the residual asset under the de-recognition model has been won and proportionate sales profit recognition for manufacturer and dealer lessors confirmed.

While the practicability and cost of implementing the proposals remains a huge concern, the above simplifications show that the
Boards have tried to address the issues raised by constituents in response to the first ED.

Property bombshell

If they had left the changes at that, it may well have been that we would truly be approaching the end of the lease accounting saga by now.

Towards the end of the re-deliberation process, however, the Boards dropped a bombshell.

As a concession to property lessees, who don’t view property rental contracts as financing transactions, the Boards (under the FASB’s lead) decided to reintroduce classification into the model, with different accounting treatments for different leases.

The classification principle is based on the extent to which the lessee consumes the benefits inherent in the leased asset during the lease.

The new ED translates this into differentiating between equipment (Type A leases) and property leases (Type B leases).

For Type A leases, the treatment remains equivalent to what was set out in the initial ED, and results in a front-loaded P&L for equipment lessees.

For Type B leases however, lessees recognise an asset and a liability, which remain equal over the lease term, with the recognition of a single lease expense (where interest and amortisation are not separated). Type B lessors continue to use operating lease accounting, retaining the leased assets on their books.

The approach, which is being billed as a "pragmatic solution" is impossible to reconcile with the premises of the Right of Use model which implies that all leases should be treated in the same way, and as financing transactions.

This is a point of view that many constituents share and will undoubtedly be one of the issues at the centre of the debate over the coming months.

EFRAG has issued its draft comment letter stating that the Boards should put the Right of Use model on hold while they figure out its conceptual basis.

In the meantime, it recommends retaining IAS 17 with improved disclosures.

On our side, Leaseurope has come to a similar conclusion. After more than six years of re-deliberations and endless tweaks to a difficult model, we are of the opinion that the Right of Use model is simply unworkable in practice and will be an immense source of cost for preparers without providing the diverse user community with better information.

Leaseurope will therefore be recommending to the IASB that it retains IAS17 with disclosures that are designed to provide users of accounts with the flexibility they need to assess lessee accounts depending on their analysis perspective.

Jacqueline Mills is director of asset finance and research at Leaseurope