IFRS Exposure Draft on Leases – Sectoral Impact

The
International Accounting Standards Board (IASB) and the U.S. Financial
Accounting Standards Board (FASB) released a joint revised exposure draft on
lease accounting on 16th May 2013 (the ED). This ED proposes fundamental
changes to lease accounting which would bring most leases on the balance sheet
for lessees. Recognising leases on the balance sheet is a long stated goal of
the standard setters. These proposals would achieve that goal.

In addition to recognising most leases on the balance sheet for lessees, the
proposals would also introduce new lease classification tests resulting in a
‘dual model’ for both lessees and lessors. This would preserve straight-line
expense recognition for most leases of property, i.e. land and/or buildings,
similar to operating leases today. However, there would be recognition of
interest and amortisation expense for most other leases, similar to finance
leases today – i.e. lease expense would not be recognised on a straight-line
basis.

The previous article of this series discussed the proposals of the ED in
detail. To recap, the significant changes introduced by the ED include the
following:

• The biggest change proposed is the introduction of dual lease accounting
models – and a new lease classification test to assess whether a lease is a
Type A lease or a Type B lease. This does away with the concept of operating
and finance leases. The classification criteria would be based on the nature of
the underlying asset and the extent to which the asset is consumed over the
lease term.

The proposed lease classification tests are fundamentally different from the
current ‘risks and rewards’ approach in IAS 17. Also, they perform a different
role, for example, for lessees, the outcome of the classification tests would
no longer determine whether a lease is recognised on the balance sheet, but
instead, would affect the profile of lease expense recognised over the lease
term.

• The ED proposes to bring on the balance sheet of the lessee, a lease
liability and a right-to-use (ROU) asset for both Type A and Type B leases.
Lease expenses in a type A lease comprise of amortisation of the ROU asset and
interest accretion to lease liability (a finance expense). The lease expense
would be front loaded over the lease term. Whereas, the lease expense will be
straight lined over the lease term in the case of Type B with both the components
i.e amortisation and accretion to lease liability to be presented as an
operating expense.

• The ED now proposes to include within its ambit the concept contained in
IFRIC 4 Determining whether an arrangement contains a lease. A lease would
exist when both of the following conditions are met: fulfillment of a contract
depends on the use of an identifiable asset; and the contract conveys the right
to control the use of the identifiable asset for a period of time in exchange
for consideration. While at the first glance, the proposal appears to be
similar to IFRIC 4, there are examples and clarifications in the ED with regard
to the portion of assets, control, direction to use, derivation of benefits and
substitution of assets which may lead to different conclusions about whether or
not a lease exists.

• The ED requires a reassessment of the lease payment and consequently a
computation of the new carrying value for its lease liability when there is a
change in assessment of lease term, economic incentive to exercise purchase
option, residual value guarantees and an index or rate used to determine lease
payments during the reporting period.

• The ED introduces new requirements from the lessor perspective as well. A
concept of ‘residual asset’, representing the interest of the lessor in the
underlying asset at the end of the lease term, has been introduced. The lessor
recognises a lease receivable for Type A leases by de-recognising the
underlying asset. There are specific rules around computation and recognition
of profit/loss on such de-recognition.

The above propositions will have far reaching impacts not only on the
accounting policies of companies, but also on their business strategies,
processes and systems. Significant impact will be felt on account of the
additional effort involved in reviewing and identifying lease arrangements and
extracting lease data, new requirements for estimation and judgment, balance
sheet volatility on account of reassessment, and communication of the changes
in lease accounting to the stakeholders. The foremost financial impact across
sectors will be the recording of new asset and liability which will impact the
key financial metrics such as financial ratios, debt covenants, etc. A summary
that highlights the key impact that the ED may have on certain specific sectors
is given below:

Aviation:

The airline operators deploy aircrafts taken on operating and finance leases.
The ED will require recognition of most of the operating leases on the balance
sheet. Considering the high value of the underlying asset, this will
significantly impact the debt to be recorded on balance sheet. The p r o p o s
a l will also impact the income statement profile for many leases, accelerating
e x p e n s e recognition compared to current operating lease treatment.

Example –
Company A enters into a 4-year lease contract for an aircraft which has a
total economic life of 20 years. The lease does not contain any renewal,
purchase, or termination options. The lease payments of Rs. 2,000,000 per year
are made at the end of the period, their present value is calculated at Rs.
6,339,731 using a discount rate of 10%. The fair value of the aircraft is Rs.
35,000,000 at the date of inception of the lease.

This lease would be classified as a Type A lease since it is not property and
the lease term is considered more than an insignificant part of the total
economic life (20%) and the present value of lease payments is more than
insignificant relative to the fair value of the aircraft (18%).

This lease would have been classified as an operating lease under the existing
principles of IAS 17, and Rs. 2,000,000 would be the annual lease cost to be
accounted by the airline operator. However, the Type A classification will lead
to much different accounting under the ED proposals.

The lessee would recognise a lease liability and a ROU asset of Rs. 6,339,731. In year 1, the amortisation expense would be Rs. 1,584,933 (6,339,731/4) and interest expense of Rs. 633,973 (6,339,731*10%). In year 2, the amortisation expense would be Rs. 1,584,933 and interest expense of Rs. 497,370 [(6,339,731+633,973-2,000,000)*10%]. The cash outflow of Rs. 2,000,000 will be reduced from the lease liability. Thus, under the Type A model, the lessee would see a front loading of the lease expense.

Generally, lease payments for aircrafts are denominated in USD or EUR considering the concentration of suppliers of aircraft in the countries with USD and EUR as the functional currency. The requirement of reassessment of lease liability will significantly impact the reporting entities which do not have USD or EUR as their functional currency. The foreign currency lease liability recorded on Type A leases (erstwhile operating leases) will need to be restated and the effect taken to profit and loss account. This will have a significant impact on Indian companies, given the depreciation of the Indian Rupee.

The new judgments to be made with regard to classification of leases with regard to ‘insignificant’ portion of the economic useful life of the asset and present value of lease payment in relation to the fair value of the asset may risk different interpretations. This is further complicated with the existence of second-hand aircrafts in the market.

The ED does not discuss whether a lessee should identify components of the ROU asset as would be required for an item of property, plant and equipment. If the componentisation principles are to be applied to the aircrafts, there will be additional efforts involved.

Infrastructure:

While at first glance the proposals of the ED appear similar to that contained in IFRIC 4, different conclusions may be reached in the assessment of whether an arrangement contains a lease. For e.g. some power purchase agreements that are identified as leases under IFRIC 4 may not be leases under these proposals. This is because ED’s approach to control has a greater focus on the purchasers’ ability to direct the use of the underlying asset than IFRIC 4. Accordingly, an agreement under which an entity agrees to purchase all of the electricity from a power plant but does not control the operations of the power plant might be a lease under IFRIC 4 but not under ED.

Retail

One of the critical success factors of the companies in this industry is to have retail spaces throughout the country to increase the customer reach. In India many retail companies enter into long term lease arrangements (3-9 years) to ensure business continu-ity. This could have a significant impact on the balance sheets of retail companies ie., grossing up of asset and liability and in turn may impact debt covenants and ability to raise more funds

The following example illustrates the impact as discussed above:

Consider a property lease under which a retailer and landlord enter into a lease of a retail premise for a 5-year period. Assume that the lease payments are Rs. 4,120 per year (paid in arrears) and the discount rate is 4.12%. The lease agreement does not contain a renewal or purchase option.

Under the EDs’ proposed lease classification tests, this lease would be classified as a Type B lease by both Lessee and Lessor. This is because the asset is property (property is defined as land or a building, or part of a building, or both), the lease term is for less than a major part of the economic life of the underlying asset, the present value of the lease payments is less than substantially all of the fair value of the underlying asset, and the lease does not contain a purchase option.

Lessee would recognize a ROU asset and a lease liability for its obligation to make future lease payments. Lessee would initially measure the lease liability and ROU asset at the present value of Rs. 4,120 per year over 5 years discounted at 4.12% (Rs. 18, 280). The following table summarises the amounts arising in lessee’s balance sheet and profit and loss account.

It is important to note that amortization and interest would be combined as a single lease expense in the profit and loss account.

In this example, the ROU asset would be amortized each period by the straight-line lease expense amount minus interest on the lease liability for the period.

In this simple fact pattern, the ROU asset would equal the lease liability throughout the lease term because the lease payments are constant through-out the lease term. If a lease contains variable lease payments that are based on an index or rate, rent escalations, or a rent-free period, then the calculation of the amortization of the ROU asset each period increases in complexity and the ROU asset will not equal the lease liability after lease commencement.

Certain retail companies have arrangements for sub-contracting warehousing, distribution and re-packaging of goods on an exclusive basis. These arrangements mostly qualify as lease arrangements following the guidance in IFRIC 4 and particularly because of the complete off-take of the services/goods from the sub-contractor by the retailer. Considering the proposals of ED, such arrangements may not qualify as a lease because the retailer may not have ability to direct the use of the underlying assets as envisaged in the ED.

Banking and leasing businesses

The new proposal, for a lessor, will result in the de-recognition of underlying assets given on operating lease by leasing companies and recognition of residual asset and lease receivable, representing the interest of the lessor in the underlying asset at the end of the lease term. The new principles of computation and recognition of profit on commencement of leases will need to be applied. There will also be a significant change in the profile of lease income to be recognised. Further, the lease income will now have a component of finance income (being accretion of interest on residual asset and lease receivable). This will significantly impact the EBITDA of companies. Application of the principles of the proposal in practice will pose a significant challenge with IT systems as well.

While it is not yet known how convergence with IFRS in India interplay with the RBI’s capital adequacy framework, a key consideration of the new proposal’s impact on the financial services sector is likely to be in the area of regulatory supervision. As all leases would be brought onto the balance sheet in a grossed-up manner, the increase in liabilities could have significant adverse implications on the capital adequacy requirement, thereby reducing the amount of capital available for business.

Lending entities would need to determine the impact on debt covenants of their clients, as service coverage and leverage ratios as well as net worth calculations may be affected. It will also affect their own decisions of whether to lease or purchase assets, as well as the same decisions made by clients to whom they provide lease financing.

While the ED proposes significant changes, the local tax and regulatory regulations may or may not factor in the principles specified in the ED proposals. This will possibly result in different accounting policies being followed for tax computations. All the proposals in the ED will have a consequential impact on the deferred taxes to be recognised.

The proposals of the ED are complex and create a far reaching fundamental difference from the existing principles. While accounting professionals are getting their arms around the proposals, it will be a significant challenge to educate the users of the financial statements in terms of communicating the change in accounting policies and explaining the volatility and complexities that it brings from both an operational, as well as financial standpoint.

Given that India has not yet converged with IFRS, it will be important to watch out for the position that standard setters and regulators take in India for implementation of the new leases standard (i.e., will Ind AS be based on the old lease principles of IAS 17 or the new standard that may be issued pursuant to the ED).