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CPD technical article
FASB and IASB are working together on a common standard for lease accounting, which will remove the distinction between finance and operating leases. Graham Holt reports
This article was first published in the June 2010 edition of Accounting and Business magazine.
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The basic lease accounting model has not changed for many years and has been the subject of significant criticism. The major criticism is that the rules which determine lease classification may result in similar transactions reported very differently, leading to lack of comparability and significant amounts of off balance-sheet finance not being recognised.
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are working to develop a common standard for lease accounting, and they expect to release an exposure draft in 2010.
For lessees, as outlined in their joint discussion paper (issued in March 2009), the boards believe that all lease contracts should be treated in a manner similar to the treatment of finance leases. A single conceptual model for the recognition and measurement of all lease contracts is proposed by removing the existing requirement for lessees to classify leases as finance or operating leases.
It is argued that the right obtained by the lessee in a lease contract is the right to use the leased asset during the lease term, and that this right meets the definition of an asset. The lessee incurs an obligation to pay rentals in a lease contract, and that this obligation meets the definition of a liability.
A lessee would recognise in its statement of financial position an asset representing its 'right to use' the leased item for the lease term and a corresponding liability for its obligation to pay rentals. Under this approach, all leases would be accounted for in a similar manner, and the classifications of finance and operating leases would be eliminated.
The boards believe the right-of-use model is the most consistent with their conceptual frameworks and increases the transparency of lease accounting. As leases are a form of financing, the obligations recognised under the right-of-use approach would be consistent with how businesses reflect other financing arrangements.
Measuring leases
Leases initially would be measured at cost - the present value of the lease payments, including initial direct costs incurred by the lessee. Present values would be calculated using the lessee's incremental borrowing rate as the discount rate. If the rate implicit in the lease is determinable, this rate can be used.
Lessees would not have to determine the lessor's implicit rate, which is more likely to be identifiable in leases of plant and equipment, particularly when it also may be purchased outright. For other types of lease, including property leases with rents based on cost per square metre, the lessee rarely knows the implicit rate.
The lease asset will be subsequently measured at amortised cost. The expense recorded would be presented as amortisation expense rather than rent expense.
The lessee's obligation would subsequently be measured at amortised cost using the effective interest rate method under which payments would be allocated between principal and interest over the lease term.
As a result, the interest expense would be higher in the early years of a lease compared with the current straight-line treatment for rent expense. These changes will affect accounting ratios, which may in turn affect loan covenants, credit ratings and other external measures of financial strength.
Currently, any optional lease periods are considered as part of the lease term, if at lease inception it is 'reasonably certain' (IAS 17, Leases) the lessee will exercise the right to renew the lease for the optional periods. Under the right-of-use model, lessees would be required to estimate the ultimate lease term and periodically reassess that estimate. A lease's term would be re-examined only if changes in facts and circumstances indicate that a revision may be needed.
Lease term
The lease term is defined as the longest possible term more likely than not to occur; for example, a lease with a non-cancellable six-year term and two one-year renewal options. Clearly, the minimum contractual term of six years is more likely than not to occur, but the lessee would also need to consider whether the seven- or eight-year terms available as a result of the renewal options are more likely than not to occur. The longest of those would be used to account for the lease.
Lessees would be required to estimate and reassess other optional or variable elements, such as contingent rentals, and residual value guarantees at each reporting date using current facts and circumstances, and adjust the lease obligation as appropriate. As a result, the amounts to be recognised are expected to be more than the amounts recognised currently for a finance lease.
The requirements to reassess these elements requires significantly more effort than the current model, under which lease accounting is set at initial recognition and revisited only if there is a modification or extension of the lease. As a result the administrative effort required may be greater and it may be necessary to invest in information systems that capture and catalogue relevant information and support reassessing lease terms.
The accounting model under consideration for lessees would affect virtually every company, but would have the greatest impact on lessees of significant large-value items, such as property and manufacturing equipment.
The changes to lessee accounting could significantly impact lessors' businesses because some lessees may decide to buy rather than lease if operating leases are eliminated.
Although a final standard is not expected until 2011, it is important the entities should immediately consider the implications of the changes being considered, particularly if long-term leases and contracts are being currently negotiated. Companies should start anticipating the potential impact of all leased assets being brought on to the Statement of Financial Position.
The proposals would have implications for gearing and similar ratios. Entities need to consider existing and new leases that have terms that might straddle the application date of any new standard.
The aim is to have symmetrical accounting for the lessee and lessor in a lease arrangement. The boards have tentatively decided to use the performance obligation model for lessor accounting. Under this model, the underlying leased asset continues to be accounted for as an economic resource of the lessor and remains on the lessor's statement of financial position.
The lessor recognises a lease receivable, representing the right to receive rental payments from the lessee, with a corresponding performance obligation, representing the obligation to permit the lessee to use the leased asset. The lessor's lease receivable would be measured similarly to the lessee's obligation, except the lessor would be required to use the interest rate implicit in the lease as the discount rate.
Subsequent measurement of the lessor's receivable would be at amortised cost using the effective interest method. The performance obligation would decrease as the lessor permits the lessee to use the item over the lease term.
The boards have not yet concluded over how the performance obligation is satisfied and revenue is recognised. At the November 2009 meeting, the boards recommended that the revenue should be recognised in a systematic and rational manner as the performance obligation is satisfied. This could be based on time, usage, or other measure that the economic benefit derived from the leased asset is provided to the lessee.
Similar to the lessee impact, the right-of-use model would affect the timing of income statement recognition for lessors. Interest income under the effective interest method would be higher in a lease's early years compared with the current straight-line recognition of an operating lease's rental income.
Sale and leaseback
In the April 2010 meeting, the boards discussed sale and leaseback transactions. They agreed that the most appropriate test to apply is whether the transaction represents the sale of the underlying asset. This is to be determined by assessing whether control has been transferred, and all but a trivial amount of the risks and rewards associated with the underlying asset have transferred to the buyer.
The boards then deliberated when a gain or loss arising on a sale and leaseback transaction should be deferred. The boards unanimously agreed that as long as the sale and leaseback transaction results in a sale, and both the sale and leaseback are at fair value, gains or losses arising from the transaction should not be deferred.
The majority of Board members also tentatively agreed that where either the sale or the leaseback is not established at fair value, the assets, liabilities, gains and losses should be adjusted to reflect current market rentals.
The boards are adopting a simplified approach to transition from the existing standard reflecting the reality that, for many long-term leases, the information needed to retrospectively adopt the new standard may no longer be available.
The boards considered providing an option to adopt retrospectively, recognising that the asset and obligation are equal only at inception, but rejected that in favour of a single transition approach, which is to measure all leases at the present value of lease payments, discounted using the lessee's incremental borrowing rate at the date of transition.
Depending on the number of leases, the inception dates, and the records available, analysing the information could take considerable time. Starting the process early will ensure that implementation of the future standard is orderly and well controlled.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School
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