New on the Horizon: Leases

Transcription

1 IFRS New on the Horizon: Leases May 2013 kpmg.com/ifrs

2 Contents Leases on-balance sheet but at what cost? 1 1. The proposals at a glance Key facts Key impacts 3 2. Overview and effective date 4 3. When to apply the proposals Identification of a lease Scope Multiple component arrangements 9 4. Lease classification Classification tests Applying the classification tests Multiple underlying assets in a single lease component Combined leases of land and buildings Accounting models for lessees Overview Initial measurement of the lease liability Initial measurement of the ROU asset Subsequent measurement of the liability Subsequent measurement of the ROU asset Presentation Accounting models for lessors Overview Lessor accounting for Type A leases Lessor accounting for Type B leases Other lease accounting issues Sale and leaseback transactions Sub-leases Investment property Lease modifications Disclosures General disclosure objective Additional disclosures for lessees Additional disclosures for lessors Transition Lessee approach to transition Lessor approach to transition Practical expedients 54 About this publication 55 Content 55 Acknowledgements 55 Keeping you informed 55

3 New on the Horizon: Leases 1 Leases on-balance sheet but at what cost? In their revised exposure draft (ED) on Leases, the IASB and FASB (the Boards) propose fundamental changes to lease accounting which would bring most leases on-balance sheet for lessees. Bringing leases on-balance sheet is a cherished goal of the standard setters. These proposals would achieve that goal. Many lessee companies would see an increase in reported assets and liabilities, and the proposals would have significant impacts on many different lease transactions ranging from leases of big-ticket items such as manufacturing facilities and aircraft, to leases of office space and smaller items such as company cars and computers. In addition to bringing most leases on-balance sheet for lessees, the proposals would also introduce new lease classification tests resulting in a dual model for both lessees and lessors. This would preserve straight-line expense recognition for most leases of property i.e. land and/or buildings similar to operating leases today. However, there would be interest and amortisation expense recognition for most other leases, similar to finance leases today i.e. lease expense would not be recognised on a straight-line basis. The dual model for leases is inconsistent with the Boards initial objective of introducing a single lease accounting model. This is a major compromise by the Boards, designed to make the proposals more palatable when applied to leases of property. The transition to the new proposals would require all existing leases and potential lease contracts to be re-analysed. There would also be an ongoing need for increased monitoring of leases to comply with the reassessment requirements. For some particularly lessors and lessees with large existing leasing portfolios the system changes required are likely to be significant. Implementing these proposals would be a real challenge for many organisations, as they would need to identify all their leases, extract key data, make new estimates and judgements, and perform new calculations. Companies will also need to consider how these proposals would affect their organisation and business practices. The proposals would impact a company s ability to accurately predict and forecast assets and liabilities, due to the requirement to reassess certain key estimates and judgements at the end of each reporting period. Such volatility could have a significant impact on a company s compliance with debt covenants, its tax balances and its ability to pay dividends. Lessor accounting proposals involve considerable complexity, particularly for most leases of assets other than property. The Boards have made a strong case that it is time to improve lease accounting. Some will see the proposed changes as a step forward. Others will see cost, complexity and conceptual compromise. Indeed, members of both the IASB and the FASB have dissented from the proposals. Ultimately, it is not clear whether these specific proposals will satisfy financial statement users or whether this is the best way to take forward this important project. We hope that this publication will assist you in gaining a greater understanding of the revised proposals. We encourage you to join in the debate and to provide the Boards with your comments by the deadline of 13 September Wolfgang Laubach Kris Peach Ramon Jubels Brian O Donovan KPMG s global IFRS leases, investment property and service concessions leadership team KPMG International Standards Group

4 2 New on the Horizon: Leases 1. The proposals at a glance 1.1 Key facts The IASB and FASB published ED/2013/6 Leases (the ED or the proposals) on 16 May The ED proposes new dual accounting models for lessees and lessors, and new lease classification tests to determine which of the accounting models to apply. A key objective of the proposals is to ensure that lessees recognise the assets and liabilities arising from leases. Lease identification. A lease would be a contract that conveys the right to use an identifiable asset for a period of time in exchange for consideration. The criteria for identifying a lease would be based on rights to control the use of specified assets. Lease classification. Many property leases would be Type B leases with straight-line recognition of lease income/expense. Many leases of other assets would be Type A leases with front-loaded recognition of lease income/expense. Lessee accounting. Recognise a right-of-use (ROU) asset (representing the right to use the underlying asset) and a lease liability (representing the obligation to make lease payments). For Type B leases, measure the ROU asset as a balancing figure to achieve a straight-line expense profile. Lessor accounting Type A leases. Derecognise the underlying asset and recognise a lease receivable and residual asset. Lessor accounting Type B leases. Continue to recognise the underlying asset and recognise lease payments as income (similar to current operating lease accounting). Short-term leases. There would be an exemption for leases with a maximum term, including renewal options, of 12 months or less. Transition. The new standard could be applied retrospectively, or a modified retrospective approach could be followed. Effective date. The ED does not propose an effective date for the new standard. However, it seems unlikely that entities would be required to adopt the new lease requirements before the effective date of the Boards new standard on revenue recognition, which is 1 January The proposed new standard would replace IAS 17 Leases, IFRIC 4 Determining whether an Arrangement contains a Lease, SIC 15 Operating Leases Incentives and SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease. In addition, there would be significant consequential amendments to IAS 40 Investment Property. The comment deadline for the ED is 13 September The Boards plan to undertake further outreach and to hold public round-table meetings and plan an additional consultation on the effective date of this and other new standards.

5 New on the Horizon: Leases Key impacts Identifying all lease agreements and extracting lease data. All leases longer than 12 months, including all renewal options, would be recognised on-balance sheet. It may require substantial effort to identify all lease agreements and extract all relevant lease data necessary to apply the proposals. In order to apply the simplified model for short-term leases, a company would need to identify the lease and extract key lease terms. Changes in key financial metrics. Key financial metrics would be affected by the recognition of new assets and liabilities; and differences in the timing and classification of lease income/expense. This could impact debt covenants, tax balances and a company s ability to pay dividends. New estimates and judgements. The proposals introduce new estimates and judgemental thresholds that would affect the identification, classification and measurement of lease transactions. Senior staff would need to be involved in these decisions both at lease commencement and at reporting period ends as a result of the continuous reassessment requirements. Balance sheet volatility. The proposals would introduce volatility to assets and liabilities for lessees, and for lessors in Type A leases, due to the proposed requirements to reassess certain key estimates and judgements at each reporting date. This may impact a company s ability to accurately predict and forecast results. Changes in contract terms and business practices. In order to minimise the impact of the proposals, some companies may wish to reconsider certain contract terms and business practices e.g. changes in the structuring or pricing of a transaction, including lease length and renewal options. The proposals are therefore likely to affect departments beyond financial reporting including treasury, tax, legal, procurement, real estate, budgeting, sales, internal audit and IT. New systems and processes. Systems and process changes may be required to capture the data necessary to comply with the new requirements, including creating an inventory of all leases on transition. The complexity, judgement and continuous reassessment requirements may require additional resources and controls focused on monitoring lease activity throughout the life of leases. Communication with stakeholders will require careful consideration. Investors and other stakeholders will want to understand the impact of the proposals on the business. Areas of interest may include the effect of the proposals on financial results, the costs of implementation and any proposed changes to business practices.

6 4 New on the Horizon: Leases 2. Overview and effective date The following diagram illustrates how key elements of the proposals are explained throughout this publication. The corresponding section numbers are in brackets. Determine when to apply the proposals Identify the lease (3.1) Assess whether the lease is within scope (3.2) Separate the lease and non-lease component(s) and allocate consideration (3.3) Classify the lease as Type A or Type B Apply the lease classification tests (4.1 2) If the lease component covers multiple assets, determine the primary asset (4.3) Special considerations for leases of land and buildings (4.4) Apply the lease accounting models Lessee accounting Overview (5.1) Recognition and initial measurement (5.2 3) Subsequent measurement (5.4 5) Presentation (5.6) Lessor accounting Overview (6.1) Type A leases (6.2) Type B leases (6.3) Apply other guidance if relevant Sale and leaseback transactions (7.1) Sub-leases (7.2) Investment property (7.3) Lease modifications (7.4) Prepare the necessary disclosures (8) Prepare for transition (9) The ED does not propose an effective date for the new standard and does not specify whether early adoption would be permitted. However, it seems unlikely that entities would be required to adopt the new lease requirements before the effective date of the Boards new standard on revenue recognition. The Boards have decided tentatively that the new revenue standard would be effective for annual periods beginning on or after 1 January Early adoption of the revenue standard would be permitted under IFRS but not under US GAAP.

7 New on the Horizon: Leases 5 3. When to apply the proposals 3.1 Identification of a lease Basic definition ED 6 The proposals define a lease as, A contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Right to use underlying asset Lessor Underlying asset Lessee Right-of-use asset Consideration (lease rentals) ED 7 A lease would exist if both of the following conditions are met: fulfilment of the contract depends on the use of an identified asset; and the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration. Observations Lease identification is a key judgement Identifying whether an agreement is or contains a lease would be a key judgement when implementing the proposals, particularly for lessees. In effect, there is a new bright-line between leases (on-balance sheet for lessees) and service contracts (off-balance sheet for lessees). This would remain the case for as long as the basic accounting requirements for leases and executory contracts remain fundamentally different Lease definition A closer look ED 11 ED 12 Factors to consider when applying the lease definition include the following. l l Portions A portion of an asset could be an identified asset if it is physically distinct. For example, a floor of a building could be an identified asset. However, a portion of the capacity of a pipeline would not be an identified asset, because it is not physically distinct unless the capacity portion comprises substantially all of the output of the asset. Control A contract would convey the right to control the use of the identified asset if the customer has the ability to direct the use of the asset and derive the benefits from its use throughout the term of the contract.

8 6 New on the Horizon: Leases ED ED 19 ED 9, BC105(b) l l l Directing the use In order to have the ability to direct the use, a customer needs to be able to make decisions about the use of the asset that most significantly affect the economic benefits to be derived from the use of the asset e.g. determining for what purpose the asset is employed and how the asset is operated. Deriving the benefits A customer would not be able to derive the benefits from use of the asset if it can only obtain those benefits in conjunction with the use of other goods or services that are not sold separately by the supplier or any other supplier, and the asset is incidental to the delivery of services because it is designed to function only with those other goods or services. Substitution A contract would not contain a lease if a supplier has a substantive right to substitute the underlying asset at any time during the term of the contract. A supplier s right to substitute an asset is substantive if the supplier can substitute an alternative asset without requiring the customer s consent and there are no economic or other barriers that would prevent the supplier from substituting an alternative asset. Observations New definition may change which arrangements are identified as leases At first glance, the basic elements of the lease definition appear similar to current requirements in IFRIC 4. However, the clarifications and examples included in the ED may lead to different conclusions about whether a lease exists in some important cases. For example, some power purchase agreements that are identified as leases under IFRIC 4 may not be leases under these proposals. This is because the ED s approach to control has a greater focus on the purchaser s ability to direct the use of the underlying asset than IFRIC 4. So an agreement under which an entity agrees to purchase all of the electricity from a power plant but does not control the operations of the power plant might be a lease under IFRIC 4 but not under the ED. In other cases, assets that are incidental to services would not be in the scope of the proposals as the customer would only be able to derive the benefits from the use of the service, which is not sold separately. For example, a season ticket for a sports stadium may identify a specific seat but would not be a lease as use of the seat is an inseparable part of the overall service being provided. The ED includes an explicit statement that a supplier s right to substitute an asset is not substantive whenever customer consent is required. Often, some form of consent will be required whenever a supplier wishes to enter a customer s premises to service or replace an asset. If the Boards intend that such routine forms of consent would mean that a supplier s right of substitution is not substantive, then this could increase the number of arrangements that are identified as leases. Applying the revised definition would require entities to revisit all of their existing agreements to assess whether they are or contain leases. This exercise would require new judgements to be made in many cases. For the proposals to be implemented consistently, entities would need to reach similar conclusions on which agreements contain leases. Greater consistency of implementation may be achieved by slight clarifications to the generally well understood requirements of IFRIC 4.

9 New on the Horizon: Leases Scope Scope, exclusions and exemptions ED 4 5, The ED proposes a number of scope exclusions, and comments on agreements that would be in the scope. Some leases are excluded from the scope of the proposals; others are subject to specific exceptions. Contracts that meet the definition of a lease Within scope In scope with exceptions Outside scope Leases of assets Long leases of land Sale and leasebacks Sub-leases In-substance purchases/ sales Leases of inventory Leases of non-core assets Leases with service components Short-term leases (less than 12 months) Leases of intangibles (for lessees) Leases of: Intangibles for lessors Natural resources and exploration Biological assets Service concession arrangements ED B12 14 ED BC If a lessee incurs costs relating to the construction or design of an underlying asset before it is available for use, then the lessee would account for those costs in accordance with applicable IFRSs. In addition, the ED proposes that a lease that is assessed to be onerous between the dates of inception and commencement would be in the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Observations Scope similar to current practice with some important differences The scope of the proposals is broadly similar to current practice, with the following key differences. Short-term leases Lessees and lessors would be able to apply a simplified approach to short-term leases (see 3.2.2). Intangible assets other than ROU assets The IASB proposes that a lessee need not apply the lease models to leases of intangible assets. Leases of intangible assets would be outside the scope of the proposals for lessors as the new revenue standard will contain guidance on licensors. The ED proposes these exemptions because the Boards believe that the accounting issues associated with leases of intangible assets are too complex to address comprehensively. The rationale for exempting leases of biological assets is that the fair value model under IAS 41 Agriculture provides relevant information to financial statement users. The ED does not seek to address whether there is a general conceptual case for exempting from the proposals leases of assets measured at fair value through profit or loss. The Boards have rejected proposals to simplify implementation by excluding leases of non-core assets, noting that IFRS does not generally distinguish between core and non-core assets. This would increase the implementation burden for some.

10 8 New on the Horizon: Leases Short-term leases ED , App A The ED proposes that entities could elect not to apply the proposed new accounting models to shortterm leases. A short-term lease would be defined as a lease that: has a maximum possible term under the contract, including any options to extend, of 12 months or less; and does not contain an option permitting the lessee to purchase the underlying asset. Example Short-term leases Scenario Lessee A leases a car from Lessor B for 12 months. The lease does not contain a renewal or purchase option. Lessee A leases a car from Lessor B for 12 months. The lease contains a renewal option for a further 6 months which A does not expect to exercise. Lessee A leases a car from Lessor B for an indefinite period. A can return the car by giving one month s notice but expects to return the car after 12 months. Lessee A leases a car from Lessor B for 15 months, which represents A s operating cycle under IAS 1 Presentation of Financial Statements. Short-term? Yes maximum possible term of 12 months No maximum possible term of 18 months (the lessee s intention is not relevant to the analysis) No maximum possible term is indefinite No maximum possible term of 15 months ED BC ED A lease in which both the lessee and the lessor must agree to extend the lease beyond the noncancellable period would meet the definition of a short-term lease if the non-cancellable period, together with any notice period, is less than 12 months. However, if only one party has the right to terminate the lease, or if the lessee has the right to extend the lease without agreement of the lessor, then the parties would be required to include optional periods in the assessment of the lease term as there are enforceable rights and obligations beyond the initial non-cancellable period. The election not to apply the proposed accounting models to short-term leases would be available by class of underlying asset and would result in the following simplified accounting approach. No lease assets or lease liabilities recognised Lessee Recognise lease payments in profit or loss over lease term, generally on a straightline basis No lease receivables and residual assets recognised Lessor Continue to recognise the underlying asset Recognise lease payments in profit or loss over lease term, generally on a straightline basis

11 New on the Horizon: Leases 9 Observations A simplified approach but substantial efforts required to identify relevant leases Without the exemption for short-term leases, the proposals would require lessees to recognise onbalance sheet many small ticket items that previously may have been clearly classified as operating leases under IAS 17. Under the exemption an entity could elect to account for such leases using a model based on current operating lease accounting. In some cases, lessees may seek to negotiate the terms of new leases to qualify for the simplified approach. Taking advantage of this exemption would still require substantial effort by entities; an entity would need to identify the lease and the key lease terms including the details of any renewal and purchase options to confirm whether the lease meets the definition of a short-term lease. 3.3 Multiple component arrangements Identifying separate lease components ED ED If a contract contains a lease, then an entity would identify each separate lease component within the contract. A right to use an asset would be a separate lease component if both of the following criteria are met: the lessee can benefit from use of the leased asset either on its own or with readily available resources i.e. goods or services that are sold or leased separately or resources that the lessee has already obtained; and the leased asset is neither dependent on, nor highly inter-related with, other underlying assets in the contract. Combined leases of land and buildings are discussed in 4.4. A single contract may contain several lease components and may also contain non-lease components. After identifying the separate lease components, lessees and lessors evaluate whether to account for the lease components separately and, if so, how to allocate the consideration as follows. When the purchase price (PP) or selling price (SP) of each component is an observable standalone price 1 When the PP/SP of one or more, but not all, components are observable stand-alone prices When no observable stand-alone prices for any of the components in the arrangement are available Note Lessee Separate and allocate based on a relative stand-alone price basis Separate and allocate using the residual method All lease Lessor Always separate and allocate using guidance in the Boards forthcoming joint revenue recognition standard i.e. on a relative selling price basis 1 An observable stand-alone price is a price that the lessor or similar supplier charges for a similar lease, good, or service component on a stand-alone basis.

12 10 New on the Horizon: Leases Example Allocation of consideration between lease and non-lease components Lessor C leases a specialised machine for two years, and provides consulting services. The machine is not sold or leased separately by C and there are no similar machines for sale or lease from other suppliers. The contract is for fixed consideration of 180,000. Lessor Because C does not sell or lease the specialised machine, or provide substantially equivalent consulting services separately, C would separate the lease and non-lease components and allocate the consideration in the contract based on estimated selling prices. C determines that it will utilise an expected cost-plus-margin approach with respect to the machine because its specialised nature precludes the use of a market-based assessment approach i.e. there are no similar machines for sale or lease to assess. C will utilise a market-based assessment approach for the services based on similar services offered in the consulting marketplace. As a result, C allocates contract consideration as follows. Estimated stand-alone Allocated Component price consideration Machine lease 160, ,000 Consulting services 40,000 36, , ,000 Lessee Lessee D does not have an observable stand-alone price for the leased machine. However, similar consulting services are sold on a stand-alone basis by alternate service providers; therefore, D is able to obtain an observable stand-alone price for the services, which is 40,000 i.e. the same as C s estimated selling price as noted above. Therefore, D would allocate 40,000 to the consulting services i.e. the observable stand-alone price and 140,000 (180,000-40,000) to the machine lease as the residual amount. Observations Agreements containing lease and service components are common Many agreements contain service and lease components. Under current IFRS, the service components are typically treated as executory contracts. When an arrangement contains a lease and a service component, IFRIC 4 requires an entity to separate the payments between the two components on the basis of their relative fair values, which is the general approach proposed in IASB s proposed revenue standard, ED/2011/6 Revenue from Contracts with Customers, for allocating the transaction price to separate performance obligations. The proposals provide an incentive for lessees to clearly identify the pricing of the lease asset and the service, as the penalty for a lessee not being able to identify the stand-alone price of at least one element is that the whole arrangement would be treated as a lease i.e. both the lease and service would be on-balance sheet.

13 New on the Horizon: Leases Lease classification 4.1 Classification tests ED The ED proposes new lease classification tests to determine whether a lease is a Type A lease or a Type B lease. The accounting models for each type of lease are discussed in Sections 5 and 6. Both lessees and lessors would apply the same lease classification tests. To classify a lease, the entity first considers the nature of the underlying asset in the lease i.e. whether the underlying asset is property (land and/or a building) or non-property. In many cases, this will determine the lease classification. No Is the underlying asset property (land and/or a building)? Yes Type A lease Type B lease The presumption that a lease of a non-property asset is a Type A lease is rebutted if: the lease term is for an insignificant part of the total economic life of the underlying asset; or the present value of the lease payments is insignificant relative to the fair value of the underlying asset at the commencement date. The presumption that a lease of property is a Type B lease is rebutted if: the lease term is for the major part of the remaining economic life of the underlying asset; or the present value of the lease payments is substantially all of the fair value of the underlying asset at the commencement date. However, in all cases, if the lessee has a significant economic incentive to exercise an option within the lease to purchase the underlying asset, then the lease is classified as a Type A lease. To assess the above criteria, an entity would be required to make initial estimates of the lease term and the present value of the expected lease payments. See 5.2 for a discussion on determining the lease payments and for a discussion on the initial determination of the lease term. Observations Fundamental changes to current lease classification The proposed lease classification tests are fundamentally different from the current risks and rewards approach in IAS 17. They also perform a different role as, for lessees, the outcome of the classification tests would no longer determine whether a lease is recognised on-balance sheet but instead, would affect the profile of lease expense recognised over the lease term (see Section 5). The new tests would be based on the extent of the lessee s consumption of the underlying asset and the nature of the underlying asset. In many cases, the outcome of the lease classification tests would be clear, with the nature of the underlying asset being the dominant consideration: most leases of assets other than property i.e. not land or a building would be Type A leases; and most leases of property i.e. land and/or a building would be Type B leases.

14 12 New on the Horizon: Leases Lessees and lessors would apply these tests only at lease commencement and when accounting for a new lease following a lease modification. Therefore, no change in lease classification would occur upon the exercise of an option, which at lease commencement the lessee did not have a significant economic interest to exercise, or change in likelihood related to a contingent feature included in the lease as these are not modifications. This may motivate lessees and lessors to design lease contracts that limit the need for future modifications and avoid changes in the original lease classification. It will also place more weight on the initial judgements made by lessees and lessors at lease commencement. An entity does not have to apply the lease classification tests if the lease qualifies as a short-term lease and the entity elects as an accounting policy not to apply the recognition and measurement proposals (see 3.2.2). 4.2 Applying the classification tests Leases of assets other than property Application of the new lease classification tests to a lease of an underlying asset other than property i.e. not land and/or a building can be illustrated as follows. Example Non-property lease classification A lessee enters into a 2-year lease for an item of manufacturing equipment that has a total economic life of 12 years at the commencement date. The lease payments are 10,000 per year; their present value is 18,500, calculated using the rate that the lessor charges the lessee in the lease. The fair value of the property at the commencement date is 60,000. This would be a Type A lease because: the underlying asset is not property; the lease term is for more than an insignificant part of the total economic life of the equipment (2 / 12 = 16.7%); and the present value of the lease payments is more than insignificant relative to the fair value of the equipment at the commencement date (18,500 / 60,000 = 30.8%). Note that this would be a Type A lease if either the second or third criteria above were met; it is not necessary to meet both criteria. Observations Many current operating leases of equipment will be Type A The lease in the example would probably be classified as an operating lease under IAS 17 but as Type A under the proposals. This is likely to be the case for many current operating leases of assets other than property, from big ticket items such as aircraft to smaller items such as cars and photocopiers. The ED does not provide bright-line quantitative thresholds on what constitutes an insignificant part of the total economic life or an insignificant amount of the fair value of the underlying asset when performing the classification test for assets other than property. Illustrative Example 12 in the ED suggests that 16.6% and 27.8% of the economic life and present value, respectively, would not be deemed to be insignificant. However, it is not clear how much lower than these percentages the outcome needs to be to satisfy the insignificant criteria.

15 New on the Horizon: Leases Leases of property ED App A The ED defines property as land or a building, or part of a building, or both. Application of the new lease classification test to a lease of property can be illustrated as follows. Example Property lease classification A lessee enters into a 10-year lease of a retail space that has a remaining economic life of 30 years at the commencement date. The lease payments are 50,000 per year; their present value is 465,000, calculated using the rate that the lessor charges the lessee in the lease. The fair value of the property at the commencement date is 650,000. The lease does not contain a purchase option. This would be a Type B lease because: the lease does not contain an option for the lessee to purchase the underlying asset; the underlying asset is property; the lease term is not for a major part of the remaining economic life of the property (10/30 = 33.3%); and the present value of the lease payments does not account for substantially all of the fair value of the property (465,000/650,000 = 71.5%). Observations Many property leases will be Type B The lease classification tests have in large part been constructed so that most property leases would be Type B, preserving the straight-line pattern of lease income/expense that is familiar from current operating lease accounting for many property leases (see Sections 5 and 6) and a version of current operating lease accounting for property lessors (see 6.3). The ED s proposals for classification of property leases are at odds with the Boards principle that lease classification should reflect the extent of consumption of the underlying asset. Property is only considered Type A when the lease comprises a major part of the remaining useful life and/or substantially all of the fair value of the underlying asset, rather than when a more than insignificant amount of the underlying asset is used. The ED does not provide bright-line quantitative thresholds on what constitutes a major part of the remaining economic life or substantially all of the fair value of the underlying asset when performing the classification test for assets of property. Illustrative Example 13 in the ED does provide some guidance, suggesting that 37.5% and 75% of the economic life and fair value, respectively, would not be deemed to meet the major part and substantially all thresholds. It is not clear how much higher these percentages could be before meeting these criteria.

16 14 New on the Horizon: Leases Property vs non-property The following example illustrates the importance of the nature of the underlying asset to the outcome of the lease classification tests. Example Underlying asset lease classification A lessee enters into a 7-year lease of an underlying asset which has a total and remaining economic life of 30 years at the commencement date. The lease payments are 60,000 per year; their present value is 390,000, calculated using the rate the lessor charges the lessee. The fair value of the asset at commencement date is 560,000. The lease does not contain a purchase option. If the underlying asset is non-property e.g. a ship or aircraft it is determined that the lease is a Type A lease because of the following factors: the lease term is for more than an insignificant part of the total economic life of the asset (7 / 30 = 23.3%); and the present value of the lease payments is more than insignificant relative to the fair value of the asset at commencement date (390,000 / 560,000 =69.6%). However, if the underlying asset is property e.g. an office building then it would be a Type B lease because: the lease term is not for a major part of the total remaining economic life of the property (23.3%); and the present value of the lease payments does not account for substantially all of the fair value of the property (69.6%) at commencement date. Observations Economically similar leases may be classified differently As shown above, economically similar arrangements i.e. having similar lease terms and lease payments would be accounted for differently under the proposals depending on whether the underlying asset is property. The proposals do not define major part or insignificant part of the economic life or substantially all or insignificant relative to for the purposes of evaluating the lease classification tests. In some cases, these thresholds would be key to lease classification. The following is a summary of the terminology used in current IAS 17 compared with the new terminology from the ED proposals. Criterion IAS 17 Non-property Property Economic life Major part Insignificant part Major part PV of lease payments Substantially all Insignificant Substantially all Exercise of purchase options Reasonably certain Significant economic incentive Significant economic incentive It is not clear whether the Boards intend the new terms to have the same meaning as the functionally similar terms in IAS 17, including when the terminology is the same. Whilst major part and substantially all appear similar to the existing criteria in IAS 17, it is the abuse of these criteria and a bright-line approach that has generated much of the concern regarding the use of leases for off-balance sheet financing.

17 New on the Horizon: Leases Multiple underlying assets in a single lease component ED 32, BC If a separate lease component includes more than one underlying asset, then the entity should determine the primary asset within the lease component. The entity would then perform the lease classification tests based on the nature of the primary asset. This would include, for example, determining whether the primary asset was property or non-property and hence which lease classification test to apply. The primary asset would be determined as being the predominant asset for which the lessee has contracted for the right of use. The purpose of any other assets may simply be to help the lessee obtain the benefits associated with the use of the primary asset. Example Primary asset ED IE5-Ex.10 A lessee enters into a lease for a turbine plant, which contains a large turbine within a building, including the land which the building is located on. The turbine is used to generate electricity. In this case, the main purpose for the lessee entering into the lease is to obtain power generated by the turbine. The building enables the lessee to obtain the benefits from use of the turbine. As such, the primary asset in this case would be the turbine and not the building or land. Accordingly, the lessee would apply the classification test based on the underlying asset as non-property (being the turbine), and use the economic life of the turbine when applying the economic life test. Observations Identifying the primary asset requires judgement Determining which of the assets is the primary asset in a lease may be difficult in practice, and in some cases, will require a significant amount of judgement. For example, consider a lease of a port, which includes: land elements e.g. an on-site rail system, storage yard and water frontage; building elements e.g. an office and a warehouse; and equipment e.g. cranes, trucks and forklifts, and spare parts. In this case, it will first be necessary to identify the separate lease components. For example, it may be the case that the trucks, forklifts and spare parts would be deemed to be separate lease components, and therefore accounted for separately. However, it is likely there would remain a lease component that covered a broad range of port assets, including land, buildings and equipment. It is not immediately clear which asset is the primary asset i.e. the predominant asset for which the lessee has contracted for the right of use. The lessee s intent may be clear it has contracted for the right to use a port. Many elements are highly inter-related and the lessee benefits from the bundle. But is the primary asset property or non-property? This determination would require a significant amount of judgement at lease commencement and would have a significant impact on the subsequent accounting. Similar to lease classification, the assessment of the primary asset is made only at lease commencement and is not reassessed unless the contract is modified. Therefore, the primary asset would not change if the lessee makes a subsequent change to its business model or use of the underlying assets. This would place more weight on the initial judgements made by lessees and lessors at lease commencement.

18 16 New on the Horizon: Leases 4.4 Combined leases of land and buildings ED 33 If a lease component contains land and a building, then an entity would use the economic life of the building when assessing whether the lease term was for the major part of the economic life of the underlying asset for the purposes of lease classification. Observations No requirement to split combined leases of land and buildings In the case of a combined lease of land and building, under IAS 17 the land and building are considered separately to determine the lease classification, with certain exceptions. In determining the classification, the minimum lease payments at inception of the lease are allocated to land and buildings in proportion to their relative fair values. Generally this results in the land being assessed as an operating lease and the building as either an operating or finance lease depending on the terms and conditions. This split would not be a requirement under the current proposals. Instead, the requirement to use the life of the building as the life of the property means that many building leases currently classified as finance leases would also meet the Type A criteria and because land and building elements would no longer be separated both the land and building would be classified as Type A.

19 New on the Horizon: Leases Accounting models for lessees 5.1 Overview ED 37 The ED proposes that lessees account for Type A and Type B leases on-balance sheet; by recognising an ROU asset and a lease liability. The differences between the two accounting models relate primarily to the subsequent measurement of the ROU asset (see 5.5) and presentation of lease expense (see 5.6). Statement of financial position Statement of profit or loss Profile of total lease expense Type A leases (non-property) ROU asset Lease liability Amortisation of ROU asset (operating expense) Interest expense on lease liability (finance expense) Front-loaded Type B leases (property) ROU asset Lease liability Lease expense (operating expense) Straight-line Observations Wide-ranging consequences for lessees The ED s focus on the ROU model for lessees is consistent with previous proposals. Headlines to the effect that all leases will become finance leases or changes to lease accounting mean that debt will soar have been commonplace for some years. The ED represents a further step towards the onbalance sheet treatment of leases by lessees. Analysts routinely adjust lessees reported financial figures to reflect commitments under leases that are currently classified as operating leases, based on amounts disclosed in accordance with IAS 17 and IFRS 7 Financial Instruments: Disclosures. Following the ED s publication, many are likely to focus on the extent to which the lease balances that would be recognised under the ED s proposals would provide useful incremental information to users. The proposed requirement to recognise additional assets, liabilities and finance expense would be likely to affect key performance ratios e.g. tangible asset ratios and debt/equity ratios and consequently the ability to satisfy debt covenants. Entities currently renegotiating debt arrangements may wish to seek flexibility in determining appropriate debt covenants, to minimise the impact of the new leases standard when it becomes effective. Recognising additional assets and liabilities might also affect the results of impairment tests of the cash-generating units that include the leases.

20 18 New on the Horizon: Leases Tax considerations are often a major factor when an entity is assessing whether to lease or buy an asset, and when a lessor is pricing a lease contract. However, like IAS 17, the ED addresses lessee and lessor accounting on a pre-tax basis. The income tax accounting for lease contracts would remain in the scope of IAS 12 Income Taxes. At present, depending on the treatment allowed by the tax authorities, complexities can arise in accounting for income taxes by lessees on finance leases in particular. Complexities can include, for example, how to apply the initial recognition exemption and whether the finance lease asset and liability should be considered to be linked for the purposes of the income tax analysis. Lessees are likely to encounter similar issues under the proposals, because the lessee would recognise an asset and liability for all leases other than some short-term leases. In addition, depending on jurisdictional tax laws, an entity may be required to assess income tax balances based on IAS 17. This would require an entity to maintain two separate sets of accounting books i.e. one for IAS 17 balances and one for the new leasing standard. 5.2 Initial measurement of the lease liability A single liability ED 38 ED 39 The ED proposes that the lessee would initially measure its lease liability at the present value of the lease payments. The lessee would recognise the obligation to make lease payments as a single liability (the lease liability). Measurement of the liability would include expectations about various possible cash flows, as follows. PV of lease payments includes expectations about: Lease term (see 5.2.3) Variable lease payments that depend on an index or rate (see 5.2.4) Purchase options (see 5.2.6) RV guarantees (see 5.2.5) Term option penalties (see 5.2.5) Discount rate (see 5.2.2)

21 New on the Horizon: Leases 19 Observations Lease liability includes items that would be recognised separately under the financial instruments standards The lessee s lease liability is a financial liability. However, this liability would be measured in accordance with the requirements of the ED, and not the requirements of the financial instruments standards. As such, common features of lease agreements e.g. renewal and purchase options would not need to be accounted for separately or, potentially, measured at fair value. However, the ED contains extensive guidance on measurement. Therefore, in some cases, the measurement of a financial liability would be different depending on whether it arises from a lease. For example, an agreement to purchase an asset on deferred payment terms in which title passes when the final payment is made may be accounted for differently depending on whether the agreement is or is not a lease Determining the discount rate ED 38(a) ED App A The ED proposes that the lessee s lease liability be measured at the present value of the lease payments, discounted using the rate that the lessor charges the lessee. If that rate cannot be readily determined, then the lessee would use its incremental borrowing rate. The ED defines the lessee s incremental borrowing rate as the rate of interest that the lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the ROU asset in a similar economic environment. Observations Lessees may not be able to estimate the rate the lessor charges Measuring the lease liability at the interest rate that the lessor charges the lessee enables the specific circumstances of a lease including the structured financing of the arrangement or tax benefits inherent within the return agreed between the lessee and the lessor to be captured in the lease accounting. However, it may be difficult for a lessee to determine the rate that the lessor charges the lessee in particular, for leases in which the underlying asset has a significant residual value at the end of the lease term. This may often be the case for leases that are currently classified as operating leases and for which the lessee has not historically performed a quantitative investment appraisal to inform its lease vs buy decision Determining the lease term ED 39 ED 25 ED 26, B5 6 The potential lease payments that would be included in the lessee s lease liability are those that arise during the lease term. The ED proposes that the lease term be defined as the non-cancellable period of the lease, together with: the periods covered by an option to extend the lease if the lessee has a significant economic incentive to exercise that option; and the periods covered by an option to terminate the lease if the lessee has a significant economic incentive not to exercise that option. In determining the lease term, the ED proposes that an entity consider the following factors.

22 20 New on the Horizon: Leases Type of factor 1 Contract-based Asset-based Entity-based Market-based Examples Amount of lease payments in any secondary period Existence and amount of any contingent payments Existence and terms of renewal options Costs associated with an obligation to return the leased asset in a specified condition or to a specified location Location of the asset Existence of significant leasehold improvements that would be lost if the lease were terminated or not extended Non-contractual relocation costs Costs associated with lost production Costs associated with sourcing an alternative item Financial consequences of a decision to extend or terminate a lease Nature of the leased asset (specialised/non-specialised; the extent to which the asset is crucial to the lessee s operations) Tax consequences of terminating or not extending the lease Statutory law and local regulations Market rentals for a comparable asset Note 1 The ED does not map the examples against the type of factor. The only practical impact of the mapping is that an entity does not subsequently reassess the lease term solely for changes in market-based factors see Example Lease term Lessee N has entered into a non-cancellable lease contract with Lessor L to lease a building. The lease term is four years, and N has the option to extend the lease by another four years at the same rental. At inception of the lease, N s expectations are as follows: Market rentals for a comparable building in the same area are expected to increase by 10% over the 8-year period covered by the lease. N is intending to stay in business in the same area for at least 10 years. The location of the building is ideal for relationships with suppliers and customers. In this example, the factors support N having a significant economic incentive to extend the lease. Therefore, for the purpose of accounting for the lease, N uses a lease term of 8 years.