The IASB’s proposed new approach to lease accounting by lessees

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30 May 2012

This article gives an overview of the status of the IASB’s project on leases, which is part of the IASB’s and FASB’s programme of improvement and convergence. It discusses the potential impact of the proposed rules on the financial statements of lessees. This article considers the proposals for amending the treatment of leases in the financial statements of lessees; the Boards also have plans to make significant changes to accounting by lessors.

IFRSs and US GAAP currently split leases into two categories: finance leases (i.e. capital leases under US GAAP) and operating leases. Only the assets and liabilities arising from finance leases are recognised in the balance sheet. With operating leases, the lessee simply recognises lease payments as an expense in the income statement over the lease term, normally on a straight-line basis.

The background to the lease project is that a number of problems were identified with existing rules, in particular:

• The traditional treatment of operating leases by lessees conflicts with the IASB’s Conceptual Framework document; all leases generate assets and liabilities that meet the fundamental recognition and measurement criteria;
• Users of financial statements often have to adjust the balance sheet when attempting to assess the effect of assets and liabilities resulting from operating lease contracts; and
• The difference in the accounting treatment between operating and finance leases also provides opportunities to structure transactions so as to achieve a particular lease classification and consequently a particular effect on the financial statements.

In view of these weaknesses, the lease project was initiated. In August 2010 the IASB, jointly with the FASB, published an Exposure Draft that proposed new accounting models for lessees (and lessors). The Exposure Draft was open for comment until December 2010. In January 2011, the Boards began their redeliberations on the proposals. In July 2011, they decided to re-expose revised proposals since decisions taken during the redeliberations were sufficiently different from those published in the original Exposure Draft; in particular the Boards had developed a new approach to lessor accounting, the so-called ‘receivable and residual’ model and had tried to simplify some complex proposed estimations required for lessee accounting. The second Exposure Draft on leases is expected to be published in the second half of 2012.

The IASB intends to pursue a right-of-use model in the financial statements of lessees. This means that the lessee would have to recognise a right-of-use asset representing its right to use the underlying asset during the lease term. At the same time, the lessee would have to recognise a liability to make future lease payments. Both the right-of-use asset and the liability would initially be recognised at the present value of the expected lease payments.

However, discussions continue about the subsequent measurement of the right-of-use asset and the obligation to make lease payments. One of the issues yet to be resolved is the pattern by which the asset is amortised; the Exposure Draft envisaged straight-line recognition. When this is combined with recognising finance charges on the lease liability under the effective interest rate method, the lessee’s total leasing charges would be front-loaded, with higher expenses in the early years and progressively lower expenses in later years. The Boards are currently assessing three possible new patterns of expense recognition, each of which might produce something closer to straight-line expense recognition: these are known as ‘interest-based amortisation’, ‘underlying asset’ and ‘whole contract’ approaches.

The IASB has already tentatively decided that the right-of-use asset would be evaluated for impairment according to IAS 36 and that revaluation of the right-of-use asset according to IAS 38 would be permitted under certain circumstances.

However, lessees need not apply the above approach to short-term leases. A short-term lease was defined in the Exposure Draft as a lease that, at the date of commencement, has a maximum possible term, including any options to renew or extend, of 12 months or less. If applied, this means that short-term leases would remain off balance sheet and be accounted for in a similar manner to operating leases under IAS 17, i.e. by recognition in profit or loss on a straight-line basis over the lease term. An entity would be able to choose this short-term lease treatment as a separate accounting policy election for each class of asset.

As mentioned above, the original thrust of the project on leases was to develop a new approach that would ensure that all assets and liabilities arising under lease contracts are recognised in the lessee’s balance sheet. The IASB already introduced an exception to that approach, i.e. the rule that short-term leases need not be recognised in the lessee’s balance sheet. Currently, there are ongoing discussions on lease accounting. If the new accounting model becomes mandatory, entities should consider its effect on existing debt covenants, such as interest cover and leverage.

At the moment, the final outcome of the lease project is uncertain. In the face of the emergence of a possible divide between the Boards, the IASB’s Chairman, Hans Hoogervorst, has expressed concerns that there are those who do not like the idea of reflecting lease liabilities on the balance sheet and that it may be possible to prevent the new approach to lease accounting from being part of the new standard.

The revised Exposure Draft is currently intended to be published in the second half of 2012 but no date for publication of any new standard is targeted at present, nor is there view about when a new standard would become effective.