Accounting Update End of the Road for Operating and Finance Leases

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1 Accounting Update End of the Road for Operating and Finance Leases November 2010 ED 202R Leases, issued in August 2010, eliminates the current distinction between operating and finance leases for accounting purposes. The ED proposes a single model that would be applied to most leases, which would effectively end off-balance sheet reporting for leases. For leases of twelve months or less, lessees and lessors would be able to apply simplified requirements. This Accounting Update focuses on the main proposals of ED 202R on lessees. ED 202R addresses the accounting treatment of leases in the accounting records of both lessees and lessors. Proposal 1 Initial Recognition A lessee would recognise an asset representing its right to use the leased asset for the lease term and a liability to make lease payments. The right-of-use asset is an intangible asset. Proposal 2 Initial Measurement At the date of inception of the lease, a lessee shall measure: (a) the liability to make lease payments at the present value of the lease payments, discounted using the lessee s incremental borrowing rate or, if it can be readily determined, the rate the lessor charges the lessee; and (b) the right-of-use asset at the amount of the liability to make lease payments, plus any initial direct costs incurred by the lessee. Proposal 3 Subsequent Recognition A lessee shall recognise the following items in the statement of comprehensive income, except to the extent that another International Financial reporting Standard (FRS) requires or permits its inclusion in the cost of an asset: (a) interest expense on the liability to make lease payments; (b) amortisation of the right-of-use asset; (c) (d) (e) if applicable, revaluation gains and losses as required by IAS 38 Intangible Assets; any changes in the liability to make lease payments resulting from reassessment of the expected amount of contingent rentals or expected payments under term option penalties and residual value guarantees relating to current or prior periods; and any impairment losses on a right-of-use asset. Page 1

2 Proposal 4 Subsequent Measurement After the date of commencement of the lease, a lessee shall measure: (a) the liability to make lease payments at amortised cost using the effective interest method; and (b) the right-of-use asset at cost less accumulated amortisation and accumulated impairment losses. Example A Entity A entered into a 3 year lease of a administration building with the following lease payments, payable at the beginning of each month: $5,000 per month for the first 12 months; $6,000 per month for the next 12 months; and $7,000 per month for the last 12 months. Entity A s incremental borrowing rate is 10% per annum. Existing AASB 117 Leases This lease is classified as an operating lease, because the lease does not transfer substantially all the risks and rewards incidental to ownership of the building to the lessee (that is, entity A). According to AASB 117 paragraph 33, the lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user s benefit. Lease payments in year 1 ($5,000 x 12 months) $60,000 Lease payments in year 2 ($6,000 x 12 months) $72,000 Lease payments in year 3 ($7,000 x 12 months) $84,000 Total lease payments over the lease term $216,000 Operating lease expense for years 1 to 3 ($216,000 / 3 years) $72,000 Journal entries for year 1 Dr Operating lease expense $60,000 Cr Bank $60,000 Dr Operating lease expense $12,000 Cr Accrual (Liability) $12,000 Journal entry for year 2 Dr Operating lease expense $72,000 Cr Bank $72,000 Journal entries for year 3 Page 2

3 Dr Operating lease expense $84,000 Cr Bank $84,000 Dr Accrual (Liability) $12,000 Cr Operating lease expense $12,000 Proposals in ED 202R According to ED 202R paragraph 10, at the date of commencement of a lease, a lessee shall recognise in the statement of financial position a right-of-use asset and a liability to make lease payments. Using the information provide in this example, the following journal should be processed at the date of commencement of this lease: Dr Right-of-use asset $185,426* Cr Lease Liability $185,426 * The net present value of $185,426 was calculated using a financial calculator. A financial calculator or excel should be used to prepare an amortisation table, using the effective interest method. Journal entries for year 1 Dr Interest expense $14,896 Dr Lease liability $45,104 Cr Bank $60,000 Dr Amortisation expense re building $61,809 # # $185,426 / 3 years = 61,809 Journal entry for year 2 Dr Interest expense $11,300 Dr Lease liability $60,700 Cr Bank $72,000 Dr Amortisation expense re building $61,809 Journal entries for year 3 Dr Interest expense $4,378 Dr Lease liability $79,622 Cr Bank $84,000 Dr Amortisation expense re building $61,809 Page 3

4 Proposal 5 Lease Term Assets and liabilities recognised by lessees would be measured on a basis that assumes the longest possible lease term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease. Example B A lessee enters into a non-cancellable lease 10 year lease with two 5 year options to renew. Based on contractual and non-contractual factors, the entity assigned the following possibilities to each of the potential lease terms: 45% probability of 10 year lease term; 35% probability of 15 year lease term; and 20% probability of 20 year lease term. There is a 20% probability of a 20 year lease term, a 55% (20% + 35%) probability of at least a 15 year lease term, and a 100% probability that the lease term will be 10 years. Therefore, the longest possible lease term more likely than not to occur is 15 years. Proposal 6 Short-term Leases At the date of inception of a lease, a lessee that has a short-term lease may elect on a lease-by-lease basis to measure, both at initial measurement and subsequently: (a) the liability to make lease payments at the undiscounted amount of the lease payments; and (b) the right-of-use asset at the undiscounted amount of lease payments plus initial direct costs. Such lessees shall recognise lease payments in profit or loss over the lease term. A short-term lease is defined as a lease that, at the date of commencement of the lease, has a maximum possible lease term including options to renew or extend, of twelve months or less. Example C On 1 January 2010, Entity A entered into a 12 month lease of an administration building with lease payments of $6,500 payable at the beginning of each month. Entity A s reporting date is 30 June. The following journal should be processed at the date of commencement of this lease (that is, 1 January 2010): Dr Right-of-use asset $78,000* Cr Lease Liability $78,000 * $6,500 x 12 months = $78,000 Journal entries during reporting period ending on 30 June 2010 Dr Lease liability $39,000 Cr Bank $39,000 Dr Amortisation expense $39,000 Page 4

5 Cr Accumulated amortisation re right-of-use asset $39,000 Journal entries during reporting period ending on 30 June 2011 Dr Lease liability $39,000 Cr Bank $39,000 Dr Amortisation expense $39,000 Cr Accumulated amortisation re right-of-use asset $39,000 Proposal 7 Investment Property An entity shall apply the resulting standard from ED 202R to investment property that it holds under a lease. However, after initial recognition, a lessee may measure a right-of-use asset in accordance with the fair value model in AASB 140 Investment Property. Proposal 8 Presentation ED 202R proposes that following commencement of a lease a lessee would present right-of-use assets in the statement of financial position as if they were tangible assets within property, plant and equipment, separately from owned assets. The liability would be presented separately from other financial liabilities. Proposal 9 Effective Date and Transition ED 202R does not propose an effective date and does not specify whether early adoption would be permitted. Lessees would apply the right-of-use model to all outstanding lease contracts at the date of initial application of the new standard (that is, the beginning of the earliest comparative period presented). The Way Forward Lessees should begin to evaluate how the proposals in ED 202R would affect their financial statements, the future structure of lease contracts, debt covenants, accounting policies, and information systems. Should you have any queries regarding the contents of this article please contact: Andrew Hoffmann David Gallery Partner Partner E: E: T: T: Page 5

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