On 16th May 2013, the IASB issued an exposure draft (ED) on Leases. This is the second exposure draft issued after much internal and external deliberation by the IASB.
The leases project is one of the joint projects between the FASB and IASB which has been a focus area for the boards. The ED proposes fundamental changes to the existing lease accounting and is aimed to bring most leases on balance sheet for lessees. The first exposure draft was issued in September 2010 and since then, there have been various IASB meetings and public consultations. The second exposure draft is open for comments until September 2013. It introduces a dual-model approach for lease accounting, which would have a significant impact on the classification of leases, as well as the pattern and presentation of lease expense and income.
In this article, we will discuss some of the fundamental changes that are proposed in the Leases exposure draft.
Identification of leases
The ED defines a lease as “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”. An entity would determine whether a contract contains or is a lease by assessing whether:
(a) fulfillment of the contract depends on the use of an identified asset; and
(b) the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.
A contract conveys the right to control the use of an identified asset if the customer has both the ability to direct the use and receive the benefits from use of the identified asset throughout the term of This definition encompasses the embedded leases concept currently under IFRIC 4. Hence arrangements which are not structured as leases but include an identified asset where the customer can direct the use and receive benefits will be considered leases. However, the ED puts a greater focus on the customer’s ability to direct the use of the underlying asset which means that contracts in which the customer uses substantially all of the output of an asset, but does not control its operations may not fall under the lease definition.
Lease term
The determination of the lease term is based on the non-cancellable period of the lease, together with any optional renewal periods which the lessee has a significant economic incentive to exercise and periods covered by a termination option, if the lessee has a significant economic incentive not to terminate. The proposals include many factors for an entity to consider which are contract-based, asset-based, entitybased and market-based such as the amount of lease payments in the secondary period, location of the asset, financial consequences of termination, market rentals, etc for determination of the lease term. Again, there are no bright lines for the term ‘significant economic incentive’.
These proposals are a significant change as the lease term is a crucial estimate in determining the classification and accounting for the lease.
Classification – Type A and Type B leases
The ED identifies two types of leases – Type A and Type B. These are in some ways akin to current finance lease and operating lease models under IAS 17 Leases. The classification criteria would be based on the nature of the underlying asset and the extent to which the asset is consumed by the lessee over the lease term.
If the underlying asset is not property (i.e. not land and/or a building), it is classified as a Type A lease, unless the lease term is for an insignificant part of the total economic life of the underlying asset or the present value of the lease payments is insignificant relative to the fair value of the underlying asset. An underlying asset that is property (i.e. land and/or a building), is classified as a Type B lease, unless the lease term is for the major part of the remaining economic life of the underlying asset or the present value of the lease payments accounts for substantially all of the fair value of the underlying asset.
However, in all cases, if the lessee has a significant economic incentive to exercise an option within the lease to purchase the underlying asset, then the lease is classified as a Type A lease.
The terms ‘insignificant’, ‘major part’ and ‘significant economic incentive’ are not defined in the ED and there are no explicit bright lines or threshold percentages to make this assessment.
In effect, most leases other than property would be Type A leases and most leases of property would be Type B leases unless the above presumptions are rebutted.
Example
Company A enters into a 2-year lease contract for an item of equipment which has a total economic life of 10 years. The lease does not contain any renewal, purchase, or termination options. The lease payments of Rs. 1000 per year are made at the end of the period, their present value is calculated at Rs. 1,735 using a discount rate of 10%. The fair value of the equipment is Rs. 5,500 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 equipment (31.5%).
This lease would have been classified as an operating lease under the existing principles of IAS 17. However, the Type A classification will lead to much different accounting under the ED proposals.
Accounting by lessee
In a Type A lease, the lessee would recognise a lease liability, initially measured at the present value of future lease payments, and also a right-of-use (ROU) asset measured at the amount of initial measurement of lease liability plus any initial direct costs and payments made at or before the commencement date less any lease incentives received. Subsequently, the lessee would measure the lease liability at amortised cost using the effective interest rate method and the ROU asset at cost less accumulated amortisation – generally on a straightline basis. The lessee would present amortisation of the ROU asset and interest expense on the lease liability as separate expenses on the statement of profit or loss. The ROU asset will be presented under property, plant and equipment as a separate category (bifurcated further between Type A and Type B leases residual assets).
Continuing the example above, the lessee would have recognised a lease liability and a ROU asset of Rs. 1,735. In year 1, the amortisation expense would be Rs. 867 (1735/2) and interest expense of Rs. 174 (1735*10%). In year 2, the amortisation expense would be Rs. 867 and interest expense of Rs. 91 ((1735+174- 1000)*10%). The cash outflow of Rs. 1000 will be reduced from the lease liability. Thus, under the Type A model, the lessee would see a front loading of the lease expense.
In a Type B lease, the lessee would follow the approach for Type A leases for initial measurement. Subsequently, the lessee would calculate amortisation of the ROU asset as a balancing figure, such that the total lease cost would be recognised on a straight-line basis over the lease term and would be presented as total lease cost (amortisation plus interest expense) as a single line item in the income statement. Hence, considering the example above, under the Type B model, in year 1, the lessee would record a total expense of 1000 split between interest expense of Rs. 174 and ROU amortisation of Rs. 826. This will effectively result in a straight-line recognition of the lease expense over the lease period.
Accounting by lessor
In a type A lease, on commencement, the lessor would derecognise the underlying asset and recognise a lease receivable, representing its right to receive lease payments as well as a residual asset, representing its interest in the underlying asset at the end of the lease term. The total profit i.e. difference between the fair value of the asset and the carrying amount of the asset (if any) will be divided between upfront profit and unearned profit. Upfront profit will be recognised at the lease commencement and is calculated as total profit multiplied to the proportion that the present value of the lease payments divided by the fair value of the underlying asset.
The lease receivable would initially be measured at the present value of future lease payments. The lessor would measure the lease receivable at amortised cost using the effective interest rate method. In addition, the lease receivable will be tested for impairment under IAS 39 Financial Instruments: Recognition and Measurement. The lessor would also be required to re measure the lease receivable to reflect any changes to the lease payments or to the discount rate. Such re measurement may be triggered due to a change in lease term, lessee having or no longer having a significant economic incentive to exercise purchase option, etc .
The residual asset would be measured at the present value of the amount that the lessor expects to derive from the underlying asset at the end of the lease term, discounted at the rate that the lessor charges the lessee adjusted for the present value of expected variable lease payments. In the balance sheet, the residual asset is presented as net residual asset after reducing the unearned profit. Subsequently the residual asset will be accreted with interest over the lease period. Also, this residual asset is subject to impairment provisions under IAS 36.
This accounting under Type A leases for the lessor is much more complex than the existing finance lease accounting model.
Continuing the example above, consider the following additional facts: the carrying amount of the equipment in lessor’s books is Rs. 5,000 on the inception of the lease. The lessor estimates that the future value of the equipment at the end of the lease term would be Rs 4,555 (the present value using 10% discount rate would be Rs. 3,765). The following entry would be recorded in the lessor’s books at commencement:
Lease receivable Dr. 1,735
Gross residual asset Dr. 3,765*
Equipment Cr. 5,000
Unearned profit Cr. 342
(500-158)
Gain on lease of equipment Cr. 158
((5500-5000)*(1735/5500))
*Rs. 3423 (3765-342) is the net residual asset to be presented in the balance sheet.
In Year 1, lessor would receive a cash flow of Rs. 1000 of which Rs. 174 (1735*10%) would be recorded as interest income and Rs. 826 would be reduced from the lease receivable. Also, the lessor will book interest income on accretion of the residual asset Rs. 375 (3765 x10%).
For Type B leases, the lessor would follow an accounting model similar to that of an operating lease per existing IAS 17 and would continue to recognise the underlying asset in its balance sheet and recognise the lease income on a straight line basis over the lease term. However, there are proposed additional disclosures requirements for lessors’ of Type B leases compared to current GAAP.
Exemption for Short-term leases
The ED gives the option to entities to elect not to apply the new accounting model to short-term leases. A short-term lease is a lease that has a maximum possible term under the contract including any renewal options of less than 12 months and does not contain any purchase options for the lessee to buy the underlying asset. Under this option, lessees and lessors would only recognise lease expense/income on a straight line basis.
Impact
The new proposals will have a significant impact on the future of lease accounting. Entities will need to reexamine lease identification and classification as per new proposals. Moreover, recognising new assets and liabilities will impact key financial performance metrics. Management will need to make new estimates and judgments. Some of these estimates and judgments need to be reassessed at each balance sheet date giving rise to volatility in the balance sheet. The new proposals may also impact the way lease contracts are structured. This ED does not propose an effective date but it is unlikely to be effective before 1st January 2017.
