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Steven Brice
 

European Views on the New Leasing Exposure Draft

The IASB and the FASB have entered into a joint project on leasing, but early views suggest standard setters listen carefully to both lessee’s and lessor’s views before finalizing the proposed accounting requirements.

October 25, 2010
by Steven Brice

The aim of the International Accounting Standards Board (IASB)/Financial Accounting Standards Board (FASB) joint project on leasing is to develop a new single approach to lease accounting that would ensure that all assets and liabilities arising under lease contracts are recognized in the statement of financial position (balance sheet).

The current status of the project is that in August 2010 the IASB, jointly with the FASB, published an exposure draft “Leases” with a comment deadline of December 15, 2010. Following up on the significant interest and concern that was raised when the discussion paper was issued, the exposure draft is now being scrutinized with only marginally less controversy in Europe.

Current Accounting Framework

The current International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (U.S. GAAP) leasing accounting standard has two lease categories:

  • Finance leases (referred to as capital leases under U.S. GAAP) and
  • Operating leases.

Categorization is largely based on the balance of a number of indicators (or bright-lines) included in the standard. If a lease is classified as a finance lease, assets and liabilities are shown on the lessee’s balance sheet. However, for an operating lease, the lessee does not show any assets or liabilities on the balance sheet. The lessee simply accounts for the lease payments as an expense over the lease term.

The problems that arise from the distinction in the accounting standards between finance leases and operating leases is one of the main criticisms of the current approach. For example:

  • Having two vastly different accounting models for leases that may represent economically similar transactions makes it hard for investors to compare different entities;
  • The current accounting model also provides opportunities to structure transactions to achieve a particular accounting outcome; and
  • The operating lease accounting model generally results in understated assets and liabilities for the lessee.

Exposure Draft Key Proposals — Lessee Accounting

The Boards are proposing a “right-of-use” accounting model in which the lessee would record an asset representing the right to use the leased asset and a liability to make lease payments. As such the classifications of financing and operating leases will essentially disappear and all lease contracts will now be recorded on the balance sheet.

The assets and liabilities are proposed to be recorded initially at the present value of the lease payments; and subsequently measured using a cost-based method.

Early European Views on Lessee Accounting Proposals in the Exposure Draft

While there appears to be “general” acceptance of the single right-of-use accounting model for lessees, there are still concerns about the complexity of the model proposed. The IASB received over 300 responses to the discussion paper, which only covered lessee accounting. Of those responses, the majority stressed the need for the standard setters to simplify their initial proposals considerably.

The complexity arises inter-alia because instead of lessees deciding whether a lease is a finance lease or an operating lease, firms will now be faced with a series of judgement calls as recognition of the right of use asset is based on a probability weighted average of the cash flows for a reasonable number of outcomes.

To determine the initial recognition of the right-of-use asset, the following will be required all leases:

  • The lease term instead of using the minimum lease term, the proposal must identify the expected lease term that would include options to extend or terminate.
  • The cash-flows these are proposed to include all payments due over the expected lease term including contingent payments and residual value guarantees.
  • When the above are determined, they are then discounted, using the lessee’s incremental borrowing rate. This is another controversial point, as it will mean that the more risk-inherent in a business, the lower the resultant value of the right-of-use asset. A point that leaves many readers bemused.

With the increased level of decision-making to be made on a lease-by-lease basis and very limited simplification for short-term leases, many European businesses have further concerns regarding the cost of implementing these plans. A number of European organizations are concerned about the costs potentially outweighing the perceived benefits.

Wider implications on gearing ratios, solvency requirements and banking covenants add to the concern especially given the long-term nature of some of the property leases in Europe.

Exposure Draft Key Proposals — Lessor Accounting

Since the implications for lessors was not considered in any detail at the discussion paper stage, the implications of the proposed new rules are only now being considered for the first time. For lessor’s, the proposed accounting model is certainly more complex.

It begins with the question “Is there a transfer of significant risks or benefits of the underlying asset?”

If it is judged that the significant risks and benefits of the underlying asset have been transferred, then the tangible asset is derecognized and new assets are created reflecting:

  • The residual value of the tangible asset that the lessor still has and
  • A receivable for the right to receive lease payments.

A gain or loss on disposal of the tangible asset representing the difference between lease income (present value of lease payments to be received) and lease expense (the portion of the underlying asset that is derecognized) may arise that is recorded in the income statement. A lessor shall classify lease income as revenue and lease expense as cost of sales if that income and expense arise in the course of a lessor’s ordinary activities.

However, if it is judged that the significant risks and benefits of the underlying asset have not been transferred, then a performance obligation approach is followed. This approach results in the tangible asset still being retained on the balance sheet of the lessor, but in addition a receivable reflecting the right to receive lease payments would be recognized and a liability to permit the lessee to use the underlying asset (a lease liability) is recorded.

Early European Views on Lessor Accounting Proposals in the Exposure Draft

The lessor accounting model is seemingly an area of larger concern with confusion and consternation being aroused even on the fundamentals of the proposed model, which is considered by many to be contradictory to what is being suggested for lessees. Lessees are proposed to have one accounting model to cover all situations and will always recognize a right-of-use asset. However, lessors will have to use one of two accounting models, which will result in either continued recognition of the asset or the derecognition of the asset. The identification of the appropriate model will be based on the potentially difficult decision as to whether to significant risks and benefits of the underlying asset have been transferred to the lessor or not.

Anxiety is specifically raised over the performance obligation model, which results in the recognition of two assets (being the entire value of their leased assets together with receivables for their rights to receive rental payments) and one liability on the balance sheet. Many reporters are concerned that this accounting will provide distorted information to the market.

Conclusion

The proposals made in the exposure draft will result in significant changes to lease accounting. Ultimately the key implication of the exposure draft is that there will be an increase in assets and liabilities being recognized on the balance sheet as well as a lot of work to assess current lease arrangements. Limited exemptions from retrospective applications will mean that the leasing industry will incur significant costs.

Leasing is a multi-billion dollar industry and the IASB and FASB will need to listen carefully to the views of the respondents to the exposure draft to ensure we get a leasing standard that is acceptable in practice for both lessees and lessors and also meet the standard setters’ objective to show a complete and understandable picture of an entity’s leasing activities.

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Steven Brice is a technical partner in the financial reporting advisory group for Mazars UK and provides his views on international convergence of GAAP and whether progress is really being made in light of recent developments. For U.S. IFRS, you can contact Remi Forgeas, CPA, who is an audit and assurance partner.

* The views expressed in this article are the author’s own and do not necessarily reflect the views of the AICPA or AICPA CPA Insider™.