Lease accounting. Are we there yet? The waiting game may finally be over with substantial convergence achieved and a final standard expected in 2015

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1 Lease accounting Are we there yet? Dónal Cahalan, Sean Rugers, Warren McGregor The waiting game may finally be over with substantial convergence achieved and a final standard expected in 2015 Where are we now? After the release of their second exposure draft in May 2013, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (collectively, the Boards ) are close to completing a final standard. However, they are still at odds over one significant area of difference: the income statement recognition profile for lease expense. The IASB is proposing that for all leases brought on balance sheet, interest on the lease liability and amortisation of the asset is recognised in the income statement. The FASB is proposing that a single straight line lease expense is recognised in respect of leases currently accounted for as operating leases. The income statement treatment for leases currently accounted for as finance leases will remain unchanged under both IASB and FASB models. It may surprise some readers that the Boards have met regularly since the release of the May 2013 exposure draft to discuss the concerns expressed by respondents and have tentatively achieved convergence in respect of almost all of the significant issues (see Figure 1). It has been a monumental task for the Boards, which have received over 600 formal responses to the latest exposure draft and made direct contact with over 250 investors and analysts globally. While the Boards received support for their efforts to improve lease Key highlights 1. Assets and liabilities will increase due to a significant number of operating leases being brought on to the balance sheet 2. The IASB and FASB are proposing differing income statement treatments in respect of leases presently off balance sheet 3. The IASB is proposing exemptions for short-term and small asset leases. The FASB is not presently considering an exemption for small asset leases 4. Lease liabilities (and assets) will include variable lease payments such as CPI ( Consumer Price Index ) 5. Determination of lease term will be more judgemental and may include more/less option periods depending on the nature of the asset/company 6. Definition of a lease has been refined and will impact contracts within scope of proposed standard 7. Impact on metrics such as EBITDA, debt / equity as lease liabilities increase and lease payments are treated as principal and interest 8. Lessor accounting is largely unchanged 9. A final standard is expected in 2015 and it is not expected that the standard will be re-exposed for further comment

2 accounting, including the key proposal that lessees recognise a right of use asset and lease liability for most leases, concerns were expressed by respondents about the perceived complexity of the proposals, in particular the proposed dual lessee accounting model and the expectation of increased costs of compliance. In this article, we take a closer look at the Boards re-deliberations, the tentative decisions reached and what a final standard might look like. It is not expected that this standard will be reexposed for comment. Lessor accounting We expect that current lessor accounting will remain largely unchanged. The Boards received significant support from users for retaining the current accounting by lessors and for retaining the current dividing line between finance and operating leases in IAS 17 based on risks and rewards as opposed to a property / non-property distinction as proposed in Respondents noted that the cost of changing lessor accounting outweighs the benefits (given the asset is already on balance sheet). Additionally, many constituents noted that symmetry between lessee and lessor accounting was not essential for them. For example, leases which do not transfer substantially all of the risks and rewards of ownership would be classified as Type B leases (similar to operating leases) and leases which do transfer substantially all of the risks and rewards of ownership would be classified as Type A leases (similar to finance leases). The Boards have proposed retaining the additional disclosures for lessors proposed in the 2013 exposure draft such as the nature of leases, significant assumptions and judgements, and residual risk. Additionally, to reduce costs of implementation for preparers, the Boards have decided that lessors would not be required to reassess the lease term or reassess index and ratebased variable payments after lease inception. All leases on balance sheet The IASB believes that bringing operating leases (with the exception of short-term leases and small asset leases) on balance sheet will bring accountability and transparency and provide investors with complete information about a company s assets and liabilities. In this context, the principal objective of the exposure draft is to require all leases, except short-term leases and small asset leases, to be reported on the balance sheets of lessees and, among other things, prevent operating leases from being used as a form of off balance sheet financing. Under the proposals, an asset (the right to use the leased item) and a financial liability (the obligation to make payments under the lease) will be recognised by the lessee at the start of the lease. The asset will then be amortised over the lease term and the liability will be reduced as payments are made. This is essentially the same accounting as for finance leases under the present leasing standard, except that the lease asset is identified as a right of use rather than as a fixed asset. The impact of bringing operating leases on to the balance sheet is far from trivial. New leases entered into in 2013 amounted to approximately $US880 billion worldwide. 1 Our research indicates that on balance sheet recognition of operating leases will increase reported average interest-bearing debt by 58% (see Figure 2). Retailers in particular will be affected, with reported average debt increasing by an estimated 213%. From an Australian perspective, June 2014 ASX 100 reporters 2 had AUD$136 billion in operating lease commitments not reported on balance sheet and retailers comprised AUD$60 billion of this total. 1. The 2015 Global Leasing Report, White Clarke Group, available for download at 2. PwC Internal Data 2

3 Figure 2: Impact of leases on balance sheet Industry All companies 58% Retail and Trade 213% Professional Services 158% Accommodation & Food Services Transport & Warehousing Average increase in interest-bearing debt (Global) 101% 95% Construction 68% Manufacturing 50% Financial Services 27% Source: 2010 PwC global lease capitalisation research Some respondents to the exposure draft suggested that a disclosure-only solution is preferable, where operating leases are not recognised on balance sheet but existing disclosures are enhanced. This alternative, however, is not widely supported by the IASB s Capital Markets Advisory Committee (the Committee), which provides the Boards with regular input from the international community of users of financial statements. The Committee pointed out that such a solution would require the same amount of effort and cost for preparers, but would not provide information to users in a way that helped them in their decisionmaking. In particular, a disclosure-only solution may only be sufficient for expert users and may not provide clear information to all users. Single lease model vs dual lease model for income statement recognition While the Boards are converged in respect of recognising all leases, except short-term leases, on lessees balance sheets, there remains a significant divergence regarding the resultant income statement treatment (see Figure 3). The 2013 exposure draft proposed a dual model regarding income statement recognition using a dividing line based on the nature of the leased asset (property / non-property). Under the model, for some leases amortisation and interest expense would be recognised (similar to finance leases under existing standards) and for other leases only a rental expense would be recognised (similar to operating leases under existing standards). Based on feedback received on the exposure draft, the IASB has tentatively decided to return to the single lessee model that was proposed in the initial exposure draft. That model recognises all leases, except short-term leases and small asset leases on balance sheet, with interest and amortisation recognised in the income statement. The IASB tentatively decided to support a single lease model that recognises interest and amortisation in the income statement for the following reasons: most investors and analysts have indicated that they believe a lease creates a right of use asset and a debt-like liability; the IASB has consistently taken the view that a lease is a form of financing that gives the lessee access to an asset, irrespective of the nature of the underlying asset or its remaining useful life; and a single model will be less complex to apply in practice than a dual model and will reduce structuring opportunities. One consequence of the single model is that the pattern of lease expense recognition is front-ended due to the 3

4 higher interest charge in the early period of the lease. In contrast, the FASB has tentatively decided to retain a dual model that recognises all leases, except short-term leases, on the balance sheet of lessees but, for certain leases, requires a different income statement recognition profile than under the IASB s single model approach. Although the FASB continues to support a dual income statement recognition model, it no longer supports a dividing line based on the nature of the asset, as was proposed in the 2013 exposure draft. Instead, the FASB has tentatively decided to propose a dual model with a dividing line based on whether the risks and rewards of ownership have passed from the lessor to the lessee, similar to current lease accounting. The FASB believes that because this approach is familiar to preparers and users it should reduce operational impacts on transition and be less complex on an ongoing basis than the classification model proposed in the exposure draft. The practical effect is that the pattern of lease expense will be straight line rather than front-ended. Given the current divergence between the Boards on this issue, a possible outcome may be that the Boards issue separate standards that achieve converged onbalance sheet accounting for operating leases by lessees but result in differing income statement profiles for preparers under US GAAP and IFRS. The difference in income statement treatment will primarily arise in respect of leases classified as operating leases under current accounting. Leases vs service agreements The Boards are converged in respect of the definition of a lease, which is substantively unchanged from the 2013 exposure draft. In our view, the new definition better articulates the concept of a lease. However, by bringing virtually all leases on the balance sheet, careful analysis is needed as to whether a transaction is a lease or a service agreement. Under current requirements, the accounting for operating leases and service agreements is similar (i.e. they are not recognised on balance sheet). Under the proposals, the distinction between a lease and a service agreement hinges on whether there exists a right to control the use of a specific asset. Control is to be assessed based on whether a lessee has power over the use of the asset and receives the benefits from that use. This approach has been incorporated by standard setters into recent standards, including consolidations (IFRS 10) and revenue recognition (IFRS 15). The control approach represents a substantial shift from current accounting. Companies most affected will be those that typically enter into long-dated agreements and account for them as service contracts under IFRIC 4 (rather than as leases). These companies should assess the impact of the proposals by examining the key terms of these agreements to determine whether they would fall within scope of the proposed leasing standard given the change in definition. Lease asset and liability measurement Lease assets and liabilities will be measured at the present value of future lease payments. Lease assets will also include direct costs relating to the lease. Included in the future lease payments will be index and rate-based (such as CPI) variable lease payments and insubstance fixed payments (see below for further detail). The Boards have proposed simplifications in respect of the timing and effect of any re-measurement of lease liabilities after inception; however, there remains some divergence between the Boards on the approach. Other tentative decisions Options The Boards confirmed that a similarly high threshold should be used in considering whether options to extend / terminate leases or purchase assets will be exercised. The Boards have decided to amend the term used in the 2013 exposure draft to describe the threshold as reasonably certain, as used in IAS 17, as opposed to significant economic incentive. This avoids the implication 4

5 that the threshold to be used had changed from IAS 17. Short term leases Short-term leases were defined in the 2013 exposure draft as leases with a maximum contractual term of 12 months or less (including option periods regardless of whether the options were reasonably certain to be exercised). The Boards have now tentatively decided that the definition of a short-term lease should align with the definition of lease term (i.e. the lease term is 12 months or less and only includes options which are reasonably certain to be exercised). This change narrows the population of leases that will be reported on the balance sheet compared to the 2013 Exposure Draft. Small asset leases - The IASB is proposing an exemption for leases of small assets (e.g. office furniture and laptops). The FASB is not currently considering an exemption for small asset leases. Portfolio approach In response to cost and complexity concerns, lessees are likely to be able to apply a portfolio approach for leases with similar characteristics where doing so would not result in a material difference from accounting for them on a lease by lease basis. Index linked variable lease payments The 2013 Exposure Draft proposed that the lease liability is reassessed annually for changes in an index or a rate (such as CPI) and movements are recognised in the income statement. In response to complexity and application concerns, annual reassessment will not be required for changes in an index or a rate; reassessment will only be required when there is a change in contractual cash flows or lease liability (e.g. a change in lease term). The waiting game The Boards expect to issue a final standard in the second half of 2015 based on the IASB work plan and are working hard to achieve convergence. Uncertainty over the content of the final standard and the expected long lead time for implementation may tempt some to put lease accounting at the bottom of their to-do list. While the perception remains that the Boards are a long way from completing the project, there are relatively few items left for the Boards to consider. What can I do now to prepare? We expect the principle of all leases on balance sheet other than short-term leases to be retained. The Boards have consistently reiterated their commitment to reaching a converged standard that reports virtually all leases on the balance sheets of lessees. The likely impact of the proposed changes will be significant and will affect almost every company. In particular, sale and operating leaseback transactions that focused on achieving an off balance sheet result for lessees will be significantly affected. While companies are likely to have a long implementation timetable, IFRS 15 Revenue from contracts with customers and IFRS 9 Financial instruments may be applicable at the same time. Accordingly, we recommend that companies with large lease portfolios or long dated contracts, or those considering entering into long-term contracts, begin the process of creating a lease inventory now to get a picture of the potential impact. A lease inventory will be critical in helping such companies assess the impact not only on their balance sheet, but also on any contracts, compensation plans or other instruments that rely on debt ratios. 5

6 Contact Sean Rugers Partner Paul Brunner Partner Warren McGregor Consultant Erica Birchall Director Dónal Cahalan Senior Manager Sharon Broekhuizen Senior Manager PwC. All rights reserved. "PwC" refers to PwC, a partnership formed in Australia or, as the context requires, the PwC global network or other member firms of the network, each of which is a separate and independent legal entity. 6