Adviser alert Leases Exposure Draft

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1 Adviser alert s Exposure Draft July 2013 Overview In May 2013, the International Accounting Standards Board (IASB) and US Financial Accounting Standards Board (FASB) published revised joint Exposure Drafts s (ED) that, if finalized as proposed, would significantly change the accounting for leasing arrangement by both lessees and lessors. The IASB s ED, if finalized, would replace the current standard, IAS 17 s (IAS 17), and related Interpretations. The comment period for the ED closes on September 13, Summary of the proposals Under the current requirements in IAS 17, the accounting for a lease depends upon its classification. Classification as an operating lease results in the lessee not recording any s or liabilities in the Statement of Financial Position (balance sheet). The ED proposes to remove this distinction by requiring lessees to recognize s and liabilities for the rights and obligations created by leases. We discuss the proposals in more detail below. Lessee accounting Under the proposals in the ED, a lessee will recognize in the Statement of Financial Position a right of use (ROU) and a liability to make lease payments for all leases longer than 12 months. A lease contract conveys the right to use an (the underlying ) for a period of time in exchange for consideration lease payments Lessee right-of-use Lessor Commercial implications Recognizing an ROU and a liability to make lease payments for all leases of more than 12 months will have a number of commercial implications for entities, including and performance ratios will be affected by the recognition of all leased s on the balance sheet, debt to equity ratios in particular may be affected by the increase in the lessee s reported borrowings and the effect on loan agreements and bank covenants may need to be considered, and entities subject to regulation may need to hold more capital.

2 2 Initial measurement The ROU and the liability to make lease payments are recognized at the date the underlying is made available to the lessee. The liability is initially measured as the present value of lease payments discounted using the rate charged by the lessor or, if this is not available, the lessee's incremental borrowing rate. To determine the lease payments, an entity will first have to determine the lease term. The lease term will include any optional period to extend the lease, if there is a significant economic incentive for the lessee to exercise the option. Once the lease term is calculated, the entity will then need to review the lease payments to determine those that are to be included in the initial recognition of the lease liability. The liability will include fixed payments, variable payments that depend on an index or rate, variable payments that are in substance fixed payments, and amounts expected to be paid under residual value guarantees and the exercise price of extension/termination options if there is a significant economic incentive for the lessee to exercise those options. Having determined the initial measurement of the liability, the initial measurement of the ROU is simply the value of the liability plus any initial direct costs incurred by the lessee plus any payments made to the lessor at or before the commencement of the lease less any lease incentives. Right of use (at cost) liability (present value of lease payments) Subsequent measurement The dual approach Unlike the 2010 ED, the new ED does not apply a single lessee accounting model but instead applies a dual approach for lease expenses. This dual approach determines the subsequent accounting for the recognition of the lease expense. The principle for determining which approach to apply is based on the consumption of the underlying. This reflects the IASB s view that there is a difference between a lease for which the lessee pays for consuming a significant part of the underlying during the lease term, and a lease for which the lessee merely pays for using the. The ED applies this concept in a simplified way, distinguishing between Type A and Type B leases. This determination will depend on whether or not the lease is a real estate (property) lease, on the basis that for most leases of real estate the lessee merely uses the underlying without consuming more than an insignificant part of it. By way of contrast, the ED asserts that a lessee typically consumes a significant part of any equipment or vehicle that it leases.

3 3 classification test s for equipment/ vehicles are Type A unless s for real estate are Type B unless lease term is insignificant relative to total economic life of, or present value of lease payments is insignificant relative to fair value of. lease term is a major part of the remaining life of, or present value of lease payments is substantially all of fair value of. After initial recognition, the liability for lease payments is accounted for at amortized cost subject to certain adjustments, while the ROU is recognized at cost less accumulated amortization and impairment. Classification of the lease as either Type A or Type B affects both the calculation and the presentation of the lessee's lease expense. Type A leases For Type A leases, a finance charge for the unwinding of the discount on the lease liability will be recognized separately from an amortization charge for the ROU. The unwinding of the lease liability will be measured using the effective interest method. The ROU will be amortized on a straight line basis unless another basis is more representative of the pattern in which the lessee expects to consume the ROU 's future economic benefits. As a result, the lessee's total cost for a Type A lease will be higher in the earlier years of the lease and lower in later years (so-called front loading ). Most current non-property operating leases are expected to become Type A leases. Type B leases Type B leases will result in a straight-line total lease cost in each year of the lease. The total lease cost will combine both the unwinding of the discount on the lease liability and the amortization of the ROU. The unwinding of the discount on the lease liability will be calculated using the effective interest method. The amortization of the ROU will be a balancing figure to ensure the total lease expense is recognized straight line over the lease term. Lessee accounting overview Statement of Financial Position Income Cash flow Type A Type B of equipment /vehicles of real estate Right-of-use liability Right-of-use liability Amortisation expense Interest expense Single liability lease expense on a straightline basis Principal Interest Single lease payments

4 4 Lessor accounting For practical purposes, the ED would have only a minor impact on the accounting by lessors for finance leases. Under IAS 17, lessors recognize a lease receivable and derecognize the underlying. These leases would be Type A under the proposed model and lessors would apply the receivable and residual model described below. However, the residual would be relatively small. For leases that are considered operating leases under IAS 17, the extent of change would depend on whether the underlying is property or equipment. A lessor would distinguish between most property and most equipment leases in the same way that a lessee would under the proposals. Operating leases of property would be Type B leases and the proposed lessor accounting model would be essentially unchanged. Operating leases of equipment or vehicles would typically be Type A and, for these, the changes proposed are significant. A lessor of most equipment or vehicles leases would apply the receivable and residual approach and would: a) recognize a lease receivable and a retained interest in the underlying (the residual ), and derecognize the underlying ; and b) recognize interest income on both the lease receivable and the residual over the lease term. A manufacturer or dealer lessor might also recognize profit on the lease when the underlying is made available for use by the lessee. Lessor accounting overview Statement of Financial Position Income Type A of equipment /vehicles receivable Residual Interest income and any profit on the lease Type B of real estate Continue to report being leased Rental income Exceptions The ED would permit simplified accounting for short-term leases, defined as leases where the maximum possible term (including any option periods) is 12 months or less. For such leases, an entity may elect on a class by class basis to account in essentially the same way as for operating leases in accordance with IAS 17. The ED also proposes a number of scope exceptions that are broadly in line with IAS 17's (for example, leases of intangible s and leases to explore for or use mineral resources and similar non-regenerative resources).

5 5 The link between the leasing model and IAS 40 Investment Property (IAS 40) also remains important. Under the ED A lessee would be obliged to apply IAS 40 in measuring ROU s that are investment property, and can choose IAS 40's cost or fair value model. This would change the current position under which a lessee with an operating lease interest in investment property can choose to apply IAS 40 but must use fair value if it does. A lessor that owns an investment property and leases it under a Type B lease would apply IAS 40 to the. Disclosures The proposed Standard sets out extensive numerical and narrative disclosure requirements for both lessees and lessors designed to enable users of the financial s to understand the amount, timing and uncertainty of cash flows arising from leases. Transition The ED proposes what is referred to as a modified retrospective approach. Entities applying the modified retrospective approach would use certain shortcut calculations to initially measure lease-related s and liabilities. They also would be able to use hindsight to determine the lease term or whether an existing arrangement contains a lease. Entities will adjust the of financial position at the beginning of the earliest comparative period presented, as if the entity had always applied the proposed Standard. For finance leases existing at the date of initial application, lessees and lessors will be permitted to use the existing carrying amounts of lease-related s and liabilities as the initial measurements under the proposal. Resources Exposure Draft ED/2013/6 s About Grant Thornton in Canada Grant Thornton LLP is a leading Canadian accounting and advisory firm providing audit, tax and advisory services to private and public organizations. Together with the Quebec firm Raymond Chabot Grant Thornton LLP, Grant Thornton has approximately 4,000 people in offices across Canada. Grant Thornton LLP is a Canadian member of Grant Thornton International Ltd, whose member firms operate in close to 100 countries worldwide. The information in this publication is current as of July 30, We have made every effort to ensure information in this publication is accurate as of its issue date. Nevertheless, information or views expressed herein are neither official s of position, nor should they be considered technical advice for you or your organization without consulting a professional business adviser. For more information about this topic, please contact your Grant Thornton adviser. If you do not have an adviser, please contact us. We are happy to help.