Friday, 17 May 2013 10:52
The long awaited second exposure draft (ED2) of the new global lease accounting standard was finally published on May 16. It contains few real surprises, due to the very public deliberation process used by the standard
setters through the long gestation period. It nevertheless throws up some key issues that will need to be addressed by the leasing industry during the comment period running for the next four months.
The two standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) - have issued almost identical versions of the proposal, consistent with the aim of a converged standard.
Most of the divergences between the two versions concern aspects of relatively minor importance, within the disclosure rules for notes to the accounts. Those mainly reflect areas of close interface with the accounting
rules for property, plant and equipment (PPE) owned by the users, where the respective accounting standards (IAS 16 within international financial reporting standards (IFRS) and Topic 630 in US GAAP) are in many respects
There are, however, some significant “alternative views” released with ED2, covering some of the major issues, where minorities on each of the Boards have expressed dissent.
P&L expensing rules
The core objective of the new standard is to require on-balance-sheet recognition by lessees of all leases capable of running for more than 12 months. However, one of the most notable parts of the release is the section of the
“Basis for Conclusions” document accompanying the main draft, addressing the most controversial lesse accounting issue that arose within the re-deliberation period after the first exposure draft (ED1) issued in 2010. This is the method for expensing leases in the profit and loss (P&L) account or income statement, where the Boards last June adopted a split model as between equipment and real estate leases.
What is proposed is described as a new lease classification system. Under current rules the split into finance and operating leases determines whether or not the asset goes on the balance sheet, and it is based on whether “substantially all of the risks and rewards of ownership” are passed to the lessee. Under the new proposals all leases – except those that cannot run for more than 12 months – will go on-balance-sheet. The new lease classification split, into what the Boards are calling Type A and Type B leases, will determine the lessee's periodic expense profile – and the dividing line will be struck in a different place.
The proposal is that most real estate leases will be Type B. These will be expensed on a straight line basis, and presented as a single rental expense, like operating leases under existing rules (although the difference of course will be that the asset will now be on-balance-sheet). Nearly all equipment leases by contrast will be Type A - expensed on a front loaded basis, like current finance or capital leases (in fact a combination of heavily front loaded finance charges, and deprecation or amortization normally on a straight line basis).
There will be some exceptions on either side. Some of the longest property leases, like for example the 99-year leases sometimes used in UK real estate, will be Type A; and a very narrow range of equipment leases - where the residual value (RV) is exceptionally high and yet the lease period can run for more than 12 months so capitalization will be required - might be Type B.
The Boards are claiming that the underlying principle of the split will be consistent for both equipment and property leases. The stated principle is that a lease should be Type A, accounted for like a financing transaction, “if the lessee consumes more than an insignificant proportion of the benefits embedded in the underlying asset”. That is an intentional moving of the goal posts compared with existing lease classification. At present, there is in effect financing type treatment only if the lessee consumes substantially all the benefits of the asset; whereas the new proposal is for financing type treatment in any case where the portion consumed is significant.
Yet the starting point for the test will be whether the lease is for equipment or real estate. If it is equipment, it will be Type A, front loaded expense, unless either the lease term is insignificant in relation to the economic life of the asset, or the present value (PV) of the lease payments is insignificant in relation to the fair vale of the asset.
For real estate, it will be Type B unless either the lease term is a significant part of the asset's economic life, or the PV of lease payments represents substantially all of the fair value of the asset.
At first sight this appears not to be consistent, in that the Boards have not moved the goal posts for real estate leases (where that PV test at “substantially all” of fair value is in fact taken from the current IAS 17 international standard) as they have for equipment leases. However, the Boards argue that this is not truly inconsistent, because in the case of a commercial property lease the economic life part of the test will relate to the life of the
building, which of course represents a part of the value of the whole property including the land value.
They say that a property lessee is not truly consuming more than an insignificant portion of the benefits embedded in the property (including the land) unless the lease term is a major part of the remaining economic life of the building; whereas of course equipment lessees are using up rapidly depreciating assets.
The equipment vs real estate split in the P&L expensing model remains highly controversial. It has already attracted criticism before ED2 was released, and seems certain to attract widespread comment in the formal