Proposed Lease Accounting Changes: Impact on Asset Finance Deals

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1 Proposed Lease Accounting Changes: Impact on Asset Finance Deals In August 2010, the International Accounting Standards Board ( IASB ) issued a proposal which, if adopted, will overhaul lease accounting for all companies reporting under IFRS. Executive Summary In Canada, publicly accountable enterprises ( PAE ), with few exceptions, will be required to apply International Financial Reporting Standards ( IFRS ) for financial periods beginning after January 1, PAEs, in particular public issuers, face a substantial challenge in preparing for the transition and reporting their first quarter for 2011 in accordance with IFRS. It is important nonetheless for IFRS adopters to be aware and plan for proposed changes to IFRS rules that are forthcoming. For instance, the financial statement presentation project proposed by the International Accounting Standards Board ( IASB ) proposes to classify items on the statement of financial position (known as the balance sheet under current Canadian GAAP) and the statement of comprehensive income by activity in the same manner as it is done on the statement of cash flows. This will significantly change the appearance of financial statements as we know them. Another equally significant change proposed to IFRS relates to the accounting for leases. The proposal for leases will end the financial reporting practice of off-balance sheet financing. Once implemented, lessees who previously entered or will enter into a lease arrangement that satisfies the current Canadian GAAP definition of an operating lease will be required to record an asset for the right to use the leased asset and a corresponding liability on their balance sheets. Such leases will be treated as capital leases, referred to as finance leases under IFRS. It is expected that lease accounting changes will be implemented in early As a result, lessees must anticipate the impact of these accounting changes. For instance, lessees may have other financing arrangements which are subject to financial covenants that include ratios tied to balance sheet position. The proposed changes will have a direct impact on the calculation of these ratios. There will also be an impact on profitability as accounting for finance leases will require the recording of both amortization of the right-of-use asset and imputed interest expense based on the estimated term of the lease. We believe that it is important for lenders and borrowers to discuss the impact of these changes on financial reporting and we are prepared to provide assistance in these discussions. Current Canadian GAAP Rules: A capital lease (referred to as a finance lease under IFRS) is distinguished from an operating lease as a transaction that transfers substantially all the risks and rewards incidental to ownership of an asset from a lessor to a lessee. Canadian GAAP sets quantitative thresholds with respect transfer of ownership, lease term and present value of lease payments which must be attained before a lease is accounted as a capital lease. Current IFRS Rules that Apply to Leases: Like Canadian GAAP, a transfer of substantially all the risks and rewards means a lease transaction must be accounted as a finance lease. However, quantitative thresholds to help classify leases do not apply. IFRS requires an approach that considers the substance of a transaction rather than the form of the contract.

2 Page 2 Accounting treatment is very similar to current Canadian GAAP: Under an operating lease, the lessor and lessee recognize the lease payments as income/expense over the lease term. The lessor recognizes the leased asset in its statement of financial position (balance sheet) and records depreciation while the lessee does not. A finance lease is recognized by the lessee at the lower of the fair value of the leased asset and the present value of the minimum lease payments. The lessor recognizes a lease receivable and the lessee recognizes the leased asset, records depreciation on the asset and a liability for future lease payments. Lessee Lessor Under Current Canadian GAAP and IFRS: Two different types of leases Operating lease 1 Finance lease No asset or liability recorded on the statement of financial position. Rent expense in P&L Disclosure of future minimum lease payments Underlying asset and lease liability recorded on the statement of financial position. Interest and depreciation expense in P&L Disclosure of future minimum lease payments Cost of equipment is included as a capital asset. Rent is treated as income and depreciation as an expense. Any initial direct costs must be amortized over the term of the lease. If risks and rewards are transferred to the Lessee (dealer and manufacturer) A lease receivable is presented on the statement of financial position based on present value. Profit or loss from "selling" the asset is recognized in P&L at the time of transaction and financing income over lease term. If risks and rewards are not transferred to the Lessee (financing) The statement of financial position will present a lease receivable and deferred financing income, based on an interest rate implicit in the lease. Financing income is recorded and presented in the P&L over the term of the lease. Proposed IFRS changes to lease accounting: The proposed model records assets (right of use) and liabilities (for lease payments) arising from all lease contracts. It is expected that the changes will be implemented starting in IFRS also allows a lessee to classify a real property interest held under an operating lease as an investment property accounted for at fair value.

3 Page 3 The right-of-use asset would originally be recorded at the present value of estimated lease payments and presented separately from other assets on the balance sheet. It would then be amortized over the life of the lease and tested for impairment. This approach requires lessees and lessors to determine, for the purpose of valuation of the estimated lease payments: the expected lease term including renewal and termination options; and the estimated contingent rentals and residual value guarantees during the term of the lease. These two elements have the effect of increasing the asset and corresponding liability recognized on the statement of financial position of the lessee. Lessee Lessor Lease Accounting Proposals under IFRS: One model for all leases In all cases: Lease results in a right-of-use asset and a liability to make lease payments that will be recorded on the statement of financial position. Amortization of right-of-use asset and imputed interest on the lease liability are recorded in the P&L. Additional information disclosed in notes to the financial statements. Applicable methods: 1) Partial derecognition method - If significant risks or benefits are transferred to Lessee: remove (derecognize) leased asset from the statement of financial position and record a right to receive lease payments. record lease revenue and possible gain on derecognition. 2) Performance obligation method - If significant risks or benefits are not transferred to Lessee : keep the leased asset on the statement of financial position and record a right to receive lease payments. record a lease liability for the transfer of right of use of asset. record lease revenue and depreciation of leased asset. 3) Short-term leases for lease terms less than one year. 4) Investment property for actively managed real property leases. Leases that are essentially financed purchases of assets, i.e. a contract providing an automatic transfer of title and a bargain purchase option at the end of the lease term, are not covered by the above rules. They are treated as a purchase and loan obligation.

4 Page 4 There are no grandfathering provisions proposed, therefore it is expected that all existing leases will be subject to the new regime. Impact on your business: The implementation of the changes to lease accounting as proposed will effectively eliminate off-balance sheet financing for entities who will adopt Canadian GAAP for publicly accountable enterprises. It will result in higher reported costs for the lessee during the first half of the lease because both amortization and imputed interest expense are recorded in the P&L. The consequences will be far reaching for debtors whose agreements do not provide for frozen GAAP provisions. 2 Financial Covenants Any financial covenants linked to a borrower's balance sheet position, such as debt to equity (leverage) and return on asset ratios, should be re-evaluated. You should consider whether any financing agreements will need to be renegotiated in order to ensure you continue to respect the financial covenants therein. Debtors can usually expect to pay additional costs or fees associated with the renegotiation of a pre-existing financing facility. For the same reasons, the impact of the new rules should be considered when negotiating financial covenants in new facilities. Similarly, the new rules will impact cost of capital calculations because it will increase interest expense that is recorded on the newly recognized lease liability. Financial Indebtedness Restrictions Debtors should be careful to verify whether the proposed changes will add leases for consideration under financial indebtedness restrictions. A financial indebtedness definition typically excludes operating leases but includes finance or capital leases. Debtors should review such definitions in their existing facilities and carefully consider the scope of such definitions going forward. Financial Statement Presentation Any lease transaction which has been structured to achieve off-balance sheet treatment for a particular party, should be re-evaluated by management. Currently companies that record rental expense for their operating leases, will present such payments as an operating activity on the statement of cash flows. Under the proposed changes the same payments will be classified as a financing activity which may not accurately reflect the nature of their business. This is particularly so for retailers where leasing is an integral part of delivering their products to consumers. IFRS adoption in Canada: The proposals for lease accounting apply to entities which report on the basis of IFRS and FASB in the U.S. Then once the proposed IFRS changes to lease accounting are adopted, they will automatically apply in all jurisdictions in which IFRS applies. The changes will be imported in to Canadian GAAP for publicly accountable enterprises (Part I) once they are implemented. and this will include Canada. At present, a similar proposal for changes to lease accounting has not been made for Canadian GAAP for private enterprise. Therefore private enterprises which do not adopt IFRS, will not likely be subject to the proposed changes for some time. 2 Under a frozen GAAP provision it is expressly stated that any financial information prepared subsequent to the conclusion of a financial facility must be reconciled with the basis of accounting used for financial information/ statements prepared at the time the financing facility was initiated. Such an arrangement normally involves the use of accounting experts to ensure that the reconciliations are properly done. This can be costly.

5 Page 5 If you are not a publicly reportable enterprise, and would like to preserve the status quo on your balance sheet, at least for the time being, it may be in your interest to apply Canadian GAAP for private enterprise rather than IFRS, for periods beginning after January 1, Conclusion: The proposals for lease accounting are a radical departure from the financial reporting standards with which Canadian businesses have become accustomed. Even though in Canada IFRS is only applicable to financial years beginning after January 1, 2011, you should gain a clear understanding of how the proposals will affect you and consider discussing the impact of these changes with your stakeholders. We encourage you to consult the public comments made regarding the proposed changes to lease accounting. They provide interesting points of view of companies which will be affected by the proposals. You can view the comments posted at the link below: