Lease Accounting- Significant changes that can impact your business
In August 2010, International Accounting Standard Board (IASB) and US Financial Accounting Standard Board (FASB) issued an Exposure Draft (ED) on Leases. The proposed ED will result in fundamental change in lease accounting from the current International Financial Reporting Standards (IFRSs) covered under IAS 17: Leases.
- Proposed requirements will significantly change lease accounting and is expected to impact almost all entities
- Proposed requirements will replace; IAS 17 Leases, IFRIC 4 Determining whether an Arrangement contains a Lease, SIC 15 Operating Leases - Incentives, SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease
- Use of ‘right-of-use’ model for all leases and elimination of ‘risks and rewards’ model
- Introduction of single lease accounting model
- All assets and liabilities arising under lease contracts are recognised in the statement of financial position while eliminating the off-balance sheet lease accounting
- Management should plan to evaluate the impact on financial reporting function and business implications including tax consequences
- The comment period ended on 15 December 2010 and Boards expect to issue the final standard in June 2011. The effective date is yet to be determined but expected to be in 2014
What do we need to know
Leases play a vital role in the operations of many entities and contain provisions that range from simple to complex. The accounting for leases under existing IFRS depends on the classification of a lease into either operating lease or finance lease. Classification as an operating lease results in the lessee not recording any assets or liabilities in the statement of financial position (balance sheet) under existing IFRS. This results in many users having to adjust the financial statements to estimate the effects of lessees’ operating leases for the purpose of investment analysis.
Definition of a lease
The draft IFRS proposes to define a lease as ‘a contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for consideration’.
Changes to lessee accounting
Existing IFRS classify leases into two categories as finance leases and operating leases. At present, lease payments arising from operating leases are accounted for by recognising them as an expense in the period in which they occur. The draft IFRS requires lessees to recognise an asset representing its right to use the leased asset for the lease term (the ‘right-of-use’ asset) and a liability to make lease payments in the statement of financial position. The lessee would amortise the right-of-use asset over the expected lease term or the useful life of the asset if shorter.
Lessee shall recognise interest expense on the liability, amortisation of right-of-use asset, revaluation gains/losses, any changes in the liability to make payments and any impairment losses of right-of-use asset in the statement of comprehensive income.
At the inception of the lease, a lessee shall measure the liability to make lease payments at the present value of the lease payments, discounted using the lessee’s incremental borrowing rate while the right-of-use asset at the amount of the liability, plus any initial direct costs incurred by the lessee. After the date of commencement of the lease, a lessee shall measure the liability to make lease payments at amortised cost using the effective interest method and the right-of-use asset at amortised cost. Lessee shall reassess the carrying amount of the liability after the date of commencement of the lease.
For lessees, the statement of financial position will be grossed up to report a leased asset and lease liability. In addition, straight-line rent expense will be replaced by amortisation of the leased asset and interest expense on the lease liability. Hence, as illustrated below, the total expense will be front-loaded compared to the current practice.
- Illustration on the changes in lessee accounting
- A lease contract to pay annual lease payment of AED 3,000 each, over a period of three years. The present value of lease payments discounted at incremental borrowing rate is AED 7,500.
- As per current IFRS, AED 3,000 annual lease payment is recognised in the profit or loss while proposed IFRS requires recognising a right-of-use asset of AED 7,500 together with corresponding liability of AED 7,500 at the commencement of the lease.
- The impact on the profit or loss is analysed in the below table (amounts in AED).
Illustration on the changes in lessee accounting
|Existing IFRS||Proposed IFRS|
|Lease expense||Amortisation||Interest||Total expense|
Changes to lessor accounting
The proposed approach to lessor accounting would differ significantly from existing IFRS. According to the proposed IFRS, Lessor would recognise an asset representing its right to receive lease payments and, depending on its exposure to risks or benefits associated with the underlying asset, would either:
(i) recognise a lease liability while continuing to recognise the underlying asset (‘performance obligation approach’); or
(ii) derecognise the rights in the underlying asset that it transfers to the lessee and continue to recognise a residual asset representing its rights to the underlying asset at the end of the lease term (‘de-recognition approach’).
A lessor shall not change the accounting approach after the date of inception of the lease.
If a lessor retains exposure to significant risks or benefits associated with the underlying asset, the lessor would continue to recognise the underlying asset and in addition recognise a right to receive lease payments and a lease liability.
If a lessor does not retain exposure to significant risks or benefits associated with the underlying asset, the lease would be accounted for in a way similar to the existing accounting for finance leases. The pattern of income recognition will also be similar to the pattern of revenue recognition currently required for manufacturer/dealer lessors.
Under both approaches, at each reporting date lessor shall assess whether the right to receive lease payments is impaired and shall recognise any impairment loss in profit or loss.
Although the proposed changes may be less fundamental for leases currently classified as finance leases, they would result in significant changes in the measurement of the assets and liabilities arising from those leases due to the adjustments required for options and contingent rentals. In addition, the pattern of income and expense recognition in profit or loss will change significantly.
Accounting for short-term leases
The draft IFRS proposes that a lessee or a lessor may apply simplified requirements to short-term leases, for which the maximum possible lease term, including options to renew or extend, is twelve months or less:
Lessee: At the date of inception of a lease, a lessee may elect on a ‘lease-by-lease basis’ to measure, both at initial measurement and subsequently, (i) the liability to make lease payments at the undiscounted amount of the lease payments and (ii) the rightof- use asset at the undiscounted amount of lease payments plus initial direct costs.
Such lessees would recognise lease payments in profit or loss over the lease term.
Lessor: At the date of inception of a lease, a lessor may elect on a lease-by-lease basis not to recognise assets and liabilities arising from a short-term lease in the statement of financial position, nor derecognise any portion of the underlying asset. Such lessors would continue to recognise the underlying asset in accordance with other IFRSs and would recognise lease payments in profit or loss over the lease term.
An entity shall recognise and measure all outstanding contracts within the scope of the draft IFRS as of the date of initial application using a simplified retrospective approach as described in the draft IFRS.
The proposed IFRS results a significant change from existing accounting treatment for leases. The proposed changes affect the financial reporting function over leases while having significant impact on financial position, financial results, tax consequences, leverage and capital ratios, cash flows and EBITA etc. The management shall assess the impact on these proposed changes over the business operations, even though the effective date of these changes is expected to be in 2014.