Have your say on reform of accounting standards for leases. By Nick Topazio, financial reporting specialist, CIMA.
In March, the International Accounting Standards Board issued a discussion paper on the way ahead for lease accounting. The comment period ends on 17 July.
The paper, 'Leases – preliminary views' is the product of a joint project between the IASB and the US FASB. Not all of the preliminary views are shared by the two boards, but both are committed to thrashing out differences over the next few months, so that they can issue a joint exposure draft in 2010 and a standard by mid 2011.
But let’s not get ahead of ourselves – what is the current IASB thinking?
Single accounting model
The paper’s big ticket item is the removal of the need to distinguish between operating leases and finance leases. All leases will in future create commitments that need to be recognised on the balance sheet. The single accounting model for all leases proposes that the right obtained by the lessee in a lease is the right to use the leased asset for the term of the lease. The discussion paper considers that this right meets the definition of an asset. The lessee’s commitment to pay lease rentals is considered a liability.
Initial measurement
On entering into a lease arrangement, the lessee needs to calculate the present value of the future lease payments using its incremental borrowing rate as the discount rate. This represents the initial valuation of the liability. The asset value is initially set to equal this liability.
Lease term
Not all leases have a clearly defined end. There are often extension and/ or purchase options clouding the issue. The discussion paper proposes that the lessee assesses the most likely lease term and includes the exercise price of any purchase option based on an estimate of the most likely outcome.
Contingent rentals
Some lease arrangements - notably for retail space - contain provisions for rentals to flex based upon certain criteria such as turnover. The proposals require such contingent rentals to be included in the obligation to pay rentals based on a probability weighted estimate of the rentals.
Subsequent measurement
Subsequently, the asset would be measured at amortised cost over the shorter of the expected lease term and the economic life of the asset. Lease payments would be apportioned between an interest charge and a reduction of the outstanding obligation to make rental payments.
For instance, take a five year lease with annual payments of £50k made on the last day of the financial year. The first step is to calculate the present value of the most likely lease payments using the lessee’s incremental borrowing rate - assumed to be 10% a year.
This present value is then taken to be the initial cost and the obligation recognised. Subsequent calculations based on amortised cost principles will be as follows:
Present value of lease payments
In this example, there were assumed to be no complicating factors such as purchase options, or possible lease extensions.
If these were included, the assumptions made on initial recognition would need to be revisited at each year end, and new calculations made if assumptions changed.
Such changes would be accounted for using the ‘catch up’ approach - where the carrying amount of liability is adjusted to the present value of the revised estimated cash flows, discounted at the original effective interest rate.
Presentation
The discussion paper proposes that a ‘right of use’ asset be presented in the balance sheet based on the nature of the underlying asset, and be disclosed separately from owned assets. The obligation to pay rentals would be presented as a financial liability, although separate presentation from other financial liabilities would not be necessary.
Alternative FASB views
The US Financial Accounting Standards Board does not agree with all of the proposals. These areas are most likely to be hotly debated at future IASB/FASB meetings:
a) Degrees of probability
The FASB thinks that the lessee should include lease payments based on a most likely estimate of such rentals. The IASB proposes a probability weighted outcome
b) Subsequent adjustments
When a lessee subsequently measures and adjusts the carrying amount of the obligation, the FASB thinks that such an adjustment should be recorded against:
i. the carrying amount of the ‘right-of-use’ asset for lease term and purchase option related adjustments, and
ii. profit or loss for contingent rental related adjustments.
The IASB thinks that all such adjustments should affect the carrying value of the ‘right-of-use’ asset.
c) Changes in incremental borrowing rate
Where there are changes to the lessee’s incremental borrowing rate, the FASB does not propose to remeasure the obligation to pay rentals. The IASB proposes remeasurement but has not yet prescribed how often this should be done.
d) Presentation of financial liability
The FASB proposes that the financial liability should be disclosed separately from other financial liabilities on the balance sheet. The IASB does not require separate presentation.
Lessor accounting
There is nothing above on how to account for leases if you are a lessor rather than as lessee. Indeed there isn’t much mention of lessor accounting in the discussion paper. This is because the boards have decided to defer consideration of lessor accounting and concentrate on developing an improved lessee accounting model. The timing for the development of a revised lessor accounting standard has yet to be determined.
CIMA’s perspective
CIMA has long advocated eliminating the different accounting treatments for operating and financial leases.
The Report Leadership publication Tomorrow’s reporting today identifies the inclusion of operating lease commitments with the debt structure of an entity as one of the ways in which corporate reports can be improved. We firmly support recognising material obligations associated with all forms of lease in the balance sheet.
CIMA is concerned with the intention to develop a lessee model independently from a lessor model. We believe that symmetry of accounting treatment is essential to avoid inconsistency.
Your views
Contribute your views at our consultation database, or at Nick Topazio's blog 'Whose aeroplane is this?' on CIMAsphere or contact Nick Topazio at nick.topazio@cimaglobal.com
July 2009