NEED TO KNOW. Leases A Project Update

NEED TO KNOW Leases A Project Update

2 LEASES - A PROJECT UPDATE TABLE OF CONTENTS Introduction 3 Existing guidance and the rationale for change 4 The IASB/FASB project to date 5 The main proposals 6 Definition of a lease 6 When would a contract contain a lease? 6 What would be the lease term? 6 What would be a significant economic incentive? 7 Scope 8 Contracts that contain lease and non-lease components 8 Lessee accounting 9 Initial recognition and measurement 9 Subsequent accounting 10 Accounting for the lease 11 Presentation 15 Lessor accounting 16 Recognition and measurement 16 Operating lease approach 19 Presentation 19 Amounts included in lease payments 20 Variable lease payments 20 Purchase options 21 Residual value guarantees 21 Term option penalties 21 Reassessment of the discount rate 22 Short term leases 22 Sale and leaseback transactions 22 Disclosure 23 Consequential amendments business combinations 24 Transition 25 Lessees 25 Lessor 25

LEASES - A PROJECT UPDATE 3 INTRODUCTION This publication sets out key proposals about the future of lease accounting, based on the most recent discussions of the IASB and the FASB during their joint project to revise the accounting requirements. If, as appears likely, the proposals are finalised on the basis of decisions taken to date, a wide range of entities will be affected. In summary: Lessees Lessees would record assets and liabilities for a wide range of leases that are currently not recognised on balance sheet For leases of items that are currently accounted for as operating leases, except for leases of real estate, the single amount currently included within operating results in the income statement will be split into operating and finance components For leases of real estate, although assets and liabilities will be recognised on balance sheet, the lease expense recognised in profit or loss will continue to be on the same basis as under IAS 17 Leases, in most cases resulting in a constant expense over the lease term. Lessors For many leases except most leases of real estate, lessors would adopt a receivable and residual approach, with the leased asset being partially derecognised and a separate lease receivable being recognised For leases of real estate, in many cases an approach similar to operating lease accounting in accordance with IAS 17 would be retained. For some entities, the effect on their financial statements will be very significant, with this extending to include not only the statement of financial position (or balance sheet) but also their comprehensive income and cash flow statements. Although a finalised accounting standard is not expected to be effective on a mandatory basis before 2015, we now know enough about the IASB s tentative decisions to have a fairly clear picture of the revised proposals. Given the extent of outreach and discussion with constituents, it appears likely that the revised exposure draft will contain many proposals that will be taken forward. Consequently, entities should start to assess the effect of the proposals on their financial statements, and in particular the consequent effect on related arrangements including: Lending agreements, including key ratios and covenants Employee remuneration arrangements, including bonus schemes linked to reported profits and share-based payments; and Investor communications. The revised exposure draft is expected to be issued before the end of 2012, with a comment period of 120 days.

4 LEASES - A PROJECT UPDATE EXISTING GUIDANCE AND THE RATIONALE FOR CHANGE The existing accounting models under both IFRS and US GAAP require lessees to classify their lease contracts as either finance (capital) leases or operating leases. Under a finance lease, a lessee recognises the leased asset on balance sheet together with a corresponding lease liability which is subsequently accounted for as a financing transaction. Under an operating lease, leased assets and related gross liabilities are not recognised, with only a lease expense being recognised in profit or loss (usually on a straight line basis over the lease term). Under IFRS, the distinction between a finance and an operating lease is based on whether the lease transfers substantially all of the risks and rewards associated with the leased asset to the lessee. Under US GAAP, although specified criteria are used to determine the classification, the result is typically the same as under IFRS although the US GAAP bright line thresholds can result in differences for some transactions. These models have been criticised for failing to meet the needs of users of financial statements, because, unless a lease is classified as a finance lease, rights and obligations that meet the definitions of assets and liabilities in the IASB and FASB conceptual frameworks are omitted from balance sheets. Transactions are frequently structured specifically to result in operating lease classification, and hence to avoid recording associated assets and liabilities. This leads to a lack of comparability and, because of the structuring of transactions to achieve a particular accounting result, to complexity. As a result, many users of financial statements adjust amounts presented in financial statements to reflect assets and liabilities arising from arrangements classified as operating leases.

LEASES - A PROJECT UPDATE 5 THE IASB/FASB PROJECT TO DATE In order to address the criticisms set out above, the IASB and the FASB (the Boards) initiated a joint project to develop a new approach to lease accounting that would result in most, if not all, assets and liabilities arising from lease contracts being recognised in an entity s statement of financial position. While the main focus was on lessee accounting, proposals were also developed for changes to lessor accounting. An exposure draft (the ED) was issued in August 2010 which set out an accounting approach based on the premise that lease contracts result in lessees obtaining the right to use an asset for a specified period (the right of use model). The proposals were controversial, and the Boards received almost 800 comment letters. In addition to publishing the ED for comment, the Boards: Initiated over 200 outreach meetings, including 7 round tables and 15 preparer workshops Prepared questionnaires that were completed by over 250 lessors and over 400 lessees Carried out targeted outreach during redeliberations with over 70 organisations. There was general support for the proposed right of use model. However, the feedback received also included many comments that the detailed approach proposed in the ED was too complex, inconsistent with the economics underlying certain transactions and, for many companies, excessively costly to implement. In particular, there were concerns about complexity of measurement, costs associated with required reassessments during lease terms, accounting for multi element contracts (contracts which contain lease and non-lease components) and the proposed lessor accounting model. During their redeliberations, the Boards have made significant changes to the proposals set out in the ED. Consequently, as noted above, the proposals will be re-exposed in order to provide interested parties with an opportunity to comment on revisions that the Boards have proposed. BDO comment The Boards have addressed many of the concerns raised by constituents in response to the original proposals, and this has resulted in simplifications being made to the proposed model which would assist in making them more straightforward to implement. We welcome these developments. However, the proposals that we expect to be re-exposed for comment also include what some might regard as a compromise for leases of real estate. While we believe that the proposals would continue to bring a significant improvement to the quality of financial reporting, the extent of this improvement in accounting for leases of real estate would be more limited. The revised proposals for lessor accounting are also complex, and we anticipate that there may be calls for further simplification of the model in responses to the revised exposure draft.

6 LEASES - A PROJECT UPDATE THE MAIN PROPOSALS The main objective of the project has been maintained, which is that for most leases with a term of one year or more lessees will record assets and liabilities. There will be two approaches to be followed to determine the amounts to be recorded in profit or loss; one will result in a higher overall charge in the early periods of a lease due to the effect of finance charges on the lease liability which will decline as the obligation declines over the lease term, while the other will normally result in an overall constant charge to profit or loss over the lease term. The model to be followed will depend on the extent of consumption of the leased asset over the lease term. For lessors, there will also be two approaches which will be based on the same classification criteria used by lessees. One approach will result in the recording of the sale of part or all of the leased asset, while the other will result in accounting that is similar to current guidance for operating leases. BDO comment We believe that clear application guidance will need to be included in the revised proposals, in particular in respect of the new concept of the extent of consumption of the leased asset, as the accounting result under each of the two approaches may be significantly different. DEFINITION OF A LEASE When would a contract contain a lease? An entity would determine whether a contract contains a lease on the basis of the substance of the contract, by assessing whether the fulfilment of the contract depends on the use of a specified asset (an asset that is explicitly or implicitly identifiable) and whether the contract conveys the right to control the use of that specified asset for a period of time. A right to control the use of an asset is conveyed if the lessee has the ability to direct the use, and receive the benefit from that use throughout the lease term. The requirement for the arrangement to cover a specified asset is an important distinction, as it means that it would be necessary to be able specifically to identify the asset (for example, an item of plant and machinery or a building). A physically distinct portion of a larger asset could also be a specified asset (for example, the first floor of a building, floors 10 to 15 of a 20 storey building or an indentified 100 square metre area of a 1,000 square metre commercial space). However, if a portion of an asset cannot be specifically identified (for example, a specified proportion of the capacity of a pipeline or of a fibre optic cable network) that portion is not a specified asset. What would be the lease term? The lease term would be the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with the effect of any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.

LEASES - A PROJECT UPDATE 7 What would be a significant economic incentive? In assessing whether there is a significant economic incentive to exercise an extension or termination option, a lessee and a lessor would consider contract-based terms (terms that are included in the lease contract), asset-based factors (for example significant leasehold improvements made by the lessee that might have material value when a lease extension option is due to be exercised and would be lost if the lessee exercised the termination option) and entity-based factors (for example management intent). All these factors would be considered together and the existence of only one factor would not necessarily, by itself, signify a significant economic incentive to exercise an option. The lease term would be reassessed only when there is a significant change in relevant factors, meaning that the lessee would either now have, or no longer have, a significant economic incentive to exercise an option. The thresholds for evaluating a lessee s economic incentive to exercise options to extend or terminate a lease and options to purchase the underlying asset would be the same for both initial and subsequent assessment. However, changes in market rental rates after lease commencement would not be included in the analysis. BDO comment The Boards decision to exclude future changes in market rental rates from the analysis when reassessing whether there is a significant economic incentive to exercise options to extend or terminate a lease might initially seem odd. However, this was in response to comments received by the Boards that, if changes in market rental rates were included in the analysis, this could result in excessive complexity in financial reporting. This is because the effect could be excessive volatility in the carrying amounts of assets and liabilities, as part or all of the arrangements subsequently fell within or moved outside the recognition threshold. What is not yet entirely clear from the Boards discussion is the linkage between market rental rates and management intent, as the latter would be taken into account. The IASB Staff included the following example to support the decision to exclude changes in market rental rates (IASB Board paper, May 2011): Lessee A has a 10-year lease for its corporate headquarters in a large metropolitan area with annual payments of CU150,000. The lease has a 5-year renewal option at the same annual payment of CU150,000. During the 10 years, the following occurs to annual market rates for the lease of comparative real estate: (a) At the end of year 3, there is an increase in demand. The annual market rate increases to CU300,000. (b) At the end of year 6, a local recession drives the annual market rate to CU50,000 per year. (c) At the end of year 8, because of tax incentives instituted by the local jurisdiction to stimulate the economy, an increase in demand results in the market rate increasing to CU320,000 per year. (d) At the end of year 10, the market rate is still CU320,000. However, Lessee A has decided that it has changed its business model to lower costs by decentralizing its management. It now estimates that it needs a much smaller space for its corporate headquarters and does not exercise the option to extend the lease term. The example does illustrate that, if market rental rates were to be taken into account it would be possible for the assessment of whether the extension option would be exercised to change on a number of occasions. This would result in the five year extension period being included or excluded from the lease asset and liability at various points. However, it does not clearly address the potential for management to decide to relocate, and also exercise the lease extension option with the intention of subletting the existing premises at a profit.

8 LEASES - A PROJECT UPDATE SCOPE The proposed scope means that the new requirements would apply to all leases (including subleases) except for: Leases for the right to explore for or use minerals, oil, natural gas and similar non-regenerative resources Leases of biological assets Leases of service concession arrangements within the scope of IFRIC 12 Service Concession Arrangements Short term leases (these are leases with a maximum possible term, including any options to renew, of 12 months or less). This means that leases of noncore assets (that is, assets not related to an entity s main business activities), and long term leases of land, would be within the scope of the proposals. In addition, there is no scope exclusion for assets that are often treated as inventory, such as non-depreciating spare parts, operating materials, and supplies, if these are associated with the leasing of another underlying asset. This may represent a significant further change for some entities. Although not specifically within the scope of the proposals, intangible assets are noted as not being required to be accounted for in accordance with the leases standard. This means that it would appear that an entity will have an option to apply the new requirements to leases of intangibles. It is not yet clear whether the approach adopted would need to be applied to all leased intangibles, or whether an entity would have a choice on an individual leased asset basis. CONTRACTS THAT CONTAIN LEASE AND NON-LEASE COMPONENTS For contracts that contain lease and non-lease components, the proposals would require each component to be identified and accounted for separately. A lessee would allocate payments due under the overall contract as follows: If the purchase price of each component is observable, the lessee would allocate the payments on the basis of the relative purchase prices of individual components. If the purchase price of one or more, but not all, of the components is observable, the lessee would allocate the payments on the basis of a residual method. If there are no observable purchase prices, the lessee would account for all the payments required by the contract as a lease. Application guidance is to be included in the proposals, to assist lessees in determining what is meant by an observable price. This will take account of guidance that is planned to be included in other projects, in particular for revenue recognition. A lessor would allocate payments to be received in accordance with the guidance on revenue recognition.

LEASES - A PROJECT UPDATE 9 LESSEE ACCOUNTING Initial recognition and measurement At the date of commencement of a lease, a lessee would recognise and measure a right-of-use asset and a liability to make lease payments. The date of commencement of a lease is the date on which the lessor makes the underlying asset available for use by the lessee. The date of commencement of a lease may be different from the date of inception of the lease, which is the earlier of the date of the lease agreement and the date of commitment by the lessor and lessee to the principal terms of the lease; this can be earlier than the commencement date. In the 2010 ED, the IASB made a distinction between the recognition date (commencement of lease) and the date on which the lease assets and liabilities would be measured, which was the date of inception of the lease. This was similar to existing guidance in IAS 17. This approach was eliminated during redeliberations by the boards. Application guidance is to be included to cover costs incurred, and lease payments made, by lessees after the date of inception of a lease but before its commencement date. In addition, a lease might meet the definition of an onerous contract between its date of inception and date of commencement, meaning that the costs of the lease are greater than the economic benefits to be received from the use of the leased asset. In those cases, it would be accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets until the date of commencement. A lessee would measure its obligation 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. The lessee s incremental borrowing rate is the rate of interest that, at the date of inception of the lease, the lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to purchase a similar underlying asset. The right-of-use asset is measured at the amount of the obligation to make lease payments, plus any initial direct costs incurred by the lessee. Initial direct costs are those costs that are directly attributable to negotiating and arranging a lease, that would not have been incurred had the lease transaction not been entered into. Any lease incentives provided by the lessor to the lessee would be deducted from the initial measurement of the right-ofuse asset. Where a right-of-use asset is amortised on a straight line basis to a nil residual value, the accounting result for the incentive will be the same as under current guidance in SIC-15 Operating Leases Incentives, but it will be different where amortisation is not on a straight line basis.

10 LEASES - A PROJECT UPDATE Subsequent accounting The subsequent accounting would depend on the nature of the underlying asset. There would be two types of leases, with the classification being based on the extent of consumption of the leased asset during the lease term. Determining the type of lease The two proposed types of leases are: The finance approach (or the interest and amortisation approach, or accelerated expense approach) The straight line approach. While this would appear similar to the current finance vs operating lease distinction, the distinction between the two types of lease under the proposals would be different. The underlying principle in distinguishing between the approaches would be based on whether the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term. If it does then the transaction would be looked at as a financing transaction and the income statement would reflect a pattern of financing income or expense. The principle would be applied using a practical expedient based on the nature of the underlying asset, such that leases of property (including land and/or a building or part of a building) would be accounted for using the straight line approach unless: The lease term is for the major part of the economic life of the underlying asset; or The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset. Leases of assets other than property would be accounted for using the finance approach (accelerated expense) unless: The lease term is an insignificant portion of the economic life of the underlying asset; or The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset. During an IASB webcast in July 2012, the Staff presented a slide with the following examples: Truck (4 years) 3 Vessel (20 years) 1 Vessel (5 years) 1 More than Insignificant Car (3 years) 4 Commercial property (30 years) 1 Insignificant Commercial property (10 years) 1 Aeroplane (8 years) 2 Assumed economic life: 1. 40 years 2. 25 years 3. 10 years 4. 6 years BDO comment It would appear that most leases (except for leases of real estate) would be regarded as being for more than an insignificant portion of the underlying asset and would therefore be accounted for under the finance approach. For example, the slide indicates that, if a the lease term of a vessel is five years and the assumed economic life 40 years, the staff believes that there is need for further judgment since this might suggest that the lessee consumes more than an insignificant portion of the underlying asset over the lease term.

LEASES - A PROJECT UPDATE 11 Accounting for the lease Under both the finance and straight line approaches, the lessee would measure the liability to make lease payments at amortised cost using the effective interest method and the right-of-use asset at amortised cost (subject to impairment), unless it was to be revalued. The difference between the two approaches is the way in which the right-of-use asset would be measured after initial recognition, and the associated effect on the income statement. Under the finance approach, the right-of-use asset would be amortised on the same basis that the lessee would apply to the underlying asset (and therefore in a way that reflects the pattern of consumption of the expected future economic benefits of the right-of-use asset). The lease liability would be accounted for using the effective interest method (that is, in the same way as a conventional loan). Interest and amortisation expenses would be recognised separately in the income statement. BDO comment Assuming the right-of-use asset was amortised on a straight line basis, the effect would be that the overall income statement charge would be greater in the early periods of a lease in comparison with later periods, due to the larger interest expense. This front loading would be increased if the right-of-use asset was amortised on a reducing balance basis. In addition, the amortisation expense will be included within operating results, with the interest expense being included within finance charges. Assuming the arrangement would be accounted for as an operating lease under IAS 17, in addition to the front loading of the combined amortisation and finance charge, the finance element will be eliminated from operating results. Entities will need to consider carefully the effect on their reported results, and the associated effect on aspects such as bank covenants, employee remuneration arrangements linked to reported results (including share-based payments), and on key metrics that they report to the markets and other users of their financial statements. Under the straight-line approach the amortisation of the right-of-use asset is measured each period as a balancing figure such that the total lease expense would be recognised on a straight-line basis, regardless of the timing of lease. In addition, and in contrast to the finance approach, the two components of the lease expense would be recognised as one single amount to be charged to operating results in the income statement. A lessee may have a significant economic incentive to exercise a purchase option. In such cases, because the lessee would be assumed to acquire the underlying asset, the right-of-use asset that is recognised by the lessee would be amortised over the whole economic life of the underlying asset rather than over the lease term. The following examples illustrate the difference between the finance and straight line approaches.

12 LEASES - A PROJECT UPDATE Example 1 illustration with equal lease payments in each period A lease contains the following key terms: Lease term: 6 years Lease payments: Annual payments, made at the end of each year, of CU75 Lessee incremental borrowing rate: 4%. The effect on the lessee s statements of financial position and comprehensive income is as follows: Periods 0 1 2 3 4 5 6 Total expenses FINANCE APPROACH Balance sheet Right-of-use assets 393 (1) 328 (5) 262 197 131 66 0 Liability to make lease payments 393 (1) 334 (4) 272 208 141 72 0 Income statement Interest on lease obligation (2) 16 13 11 8 6 3 Amortisation expense (3) 65.5 65.5 65.5 65.5 65.5 65.5 393 Total lease expense 82 79 76 74 71 68 450 STRAIGHT-LINE APPROACH Balance sheet Right-of-use assets 393 (1) 334 272 208 141 72 0 Liability to make lease payments 393 (1) 334 (4) 272 208 141 72 0 Income statement Total lease expense 75 (6) 75 75 75 75 75 450 Total lease expense by approach Finance Approach 82 79 76 74 71 68 450 Straight-line approach 75 75 75 75 75 75 450 (1) The present value of the lease payments discounted by the incremental borrowing rate. (2) The present value of the liability to make lease payments at beginning of the period multiplied by the incremental interest rate. (3) In the finance approach the right-of-use asset s amortisation expense is calculated by dividing the right-of-use asset carrying amount on commencement of the lease by the lease term of six years. (4) The present value of the liability to make lease payments at beginning of the period less the principal part of each lease payment 393-(75-16)=334. (5) 393-65.5=328. (6) Accretion of interest on the liability of 16 plus amortisation of the right-of-use asset at a balancing figure amount of 59 (which is also used as the principal part of the lease payment) to give a total charge of 75.

LEASES - A PROJECT UPDATE 13 Example 2 - uneven lease payments A lease contains the following key terms: Lease term: 6 years Lessee incremental borrowing rate: 4% Lease payments: annually, made at the end of each year. Periods Lease payment 1 37.5 2 52.5 3 67.5 4 82.5 5 97.5 6 112.5 The effect on the lessee s statements of financial position comprehensive income is as follows: Periods 0 1 2 3 4 5 6 Total expenses FINANCE APPROACH Balance sheet Right-of-use assets 384 (1) 320 (5) 256 192 128 64 0 Liability to make lease payments 384 (1) 362 (4) 324 269 198 108 0 Income statement Interest on lease obligation (2) 15 14 13 11 8 4 Amortisation expense (3) 64 64 64 64 64 64 Total lease expense 79 78 77 75 72 68 450 STRAIGHT-LINE APPROACH Balance sheet Right-of-use assets 384 (1) 325 (7) 264 202 138 71 0 Liability to make lease payments 384 (1) 362 (4) 324 269 198 108 0 Income statement Accretion interest (included in total lease expense below) (6) 15 14 13 11 8 4 Total lease expense 75 75 75 75 75 75 450 Total lease expense by approach Finance Approach 79 79 77 75 72 68 450 Straight-line approach 75 75 75 75 75 75 450 (1) The present value of the lease payments discounted by the incremental borrowing rate. (2) The present value of the liability to make lease payments at beginning of the period multiplied by the incremental interest rate. (3) In the finance approach the right-of-use asset s amortisation expense is calculated by dividing the right-of-use asset carrying amount on commencement of the lease by the lease term of six years. (4) The present value of the liability to make lease payments at beginning of the period less the principal part of each lease payment 384-(37.5-15)=362. (5) 384-64=320. (6) The right-of-use asset amortisation charge is a balancing number so that the total expense (including accretion of interest on the liability) will be 75 in each period. (7) Difference between the accreted interest and the lease payment (384-(75-15)).

14 LEASES - A PROJECT UPDATE The proposals would require a lessee to reassess the carrying amount of each of its lease obligations if facts or circumstances indicated that there had been a significant change in them since the previous reporting period. Changes in obligations could arise as a result of reassessments of the lease term, of variable lease payments linked to an index or a rate, of a reassessment of whether a purchase option will be exercised, and of other amounts that may become payable (for example, under residual value guarantees). Changes in lease payments that are due to a reassessment in the lease term would result in a lessee adjusting its obligation to make lease payments and its right-of-use asset, as these relate to future periods. Some leases include a clause under which the lessee guarantees the amount of the residual value of the leased asset at the end of the lease term. Amounts expected to be payable under a residual value guarantee on the commencement date are included in the lease liability and right-of-use asset. Changes in lease payments after the commencement date that are due to a reassessment of amounts payable under residual value guarantees would change the obligation to make lease payments and be recognised: a) In net income to the extent that those changes relate to current or prior periods and; b) As an adjustment to the right-of-use asset to the extent those changes relate to future periods. The allocation between (a) and (b) would reflect the pattern in which the economic benefits of the right-of-use asset would be consumed or have been consumed. If that pattern cannot be reliably determined the changes would be allocated to future periods in their entirety. Amounts expected to be payable under residual value guarantees are reassessed only when events or circumstances indicate that there has been a significant change in the expected amount. This is intended to reduce the frequency with which lessees need to reassess amounts payable, and hence the carrying amounts of related lease liabilities and right-of-use assets. The IASB has retained the option in the 2010 ED, such that a lessee is permitted to measure a right-of-use asset at its revalued amount, less any amortisation and impairment losses. The requirements are consistent with those set out in IAS 16 Property, Plant and Equipment, in that all assets in that class of property, plant and equipment would be required to be revalued. This links to the right-of-use assets being presented within the category of property, plant and equipment to which the underlying asset would be allocated if it was owned by the lessee. Although the proposals would require the recognition of gains and losses on the revaluation of right of use assets to be in accordance with IAS 38 Intangible Assets, which is consistent with a right-of-use asset technically being an intangible right to use another entity s asset, in practical terms there is no difference between the recognition requirements of IAS 38 and IAS 16. However, for the purposes of the revaluation itself the IAS 38 requirement for an active market to exist for an asset would not apply. IAS 36 Impairment of Assets would be applied at each reporting date to determine whether a right-of-use asset is impaired, and for the purposes of the recognition of any impairment loss. Foreign exchange differences related to the liability to make lease payments would be recognised in profit or loss, consistent with the guidance in IAS 21 The Effects of Changes in Foreign Exchange Rates.

LEASES - A PROJECT UPDATE 15 Presentation A lessee s presentation of amounts arising from leased assets would depend on whether the lease(s) are to be accounted for under the finance or straight line approaches. For those leases accounted for under the finance approach, the lessee would: 1. Present the right-of-use asset on the same basis as if the underlying asset were owned. 2. For right-of-use assets and lease liabilities included in the statement of financial position, either disclose amounts relating to leases as separate line items, or include those amounts in primary statement line items that contain other items and disclose the right-of-use assets and lease liabilities in the notes to the financial statements. If right-of-use assets and lease liabilities are not presented in separate line items in the statement of financial position, the note disclosures would be required to indicate the line item in the statement of financial position in which the right-of-use assets and lease liabilities have been included. 3. Present separately in the statement of comprehensive income, or disclose separately in the notes, (total) interest expense and the component of interest paid relating to leases. 4. Recognise interest expense and the amortisation expense associated with the right-of-use asset separately in the statement of comprehensive income. This means that combining interest expense and amortisation expense in the statement of comprehensive income, and presenting this as a single amount of lease or rent expense, would be prohibited. 5. Present lease payments in the cash flow statement in the following way: a. Lease payments relating to principal within financing activities. b. Lease payments relating to interest in accordance with IAS 7 Statement of Cash Flows. This will depend on the accounting treatment of the interest amounts; interest expense will fall within the scope of IAS 23 Borrowing Costs when determining amounts that could be capitalised, which could affect the cash flow classification. c. Variable lease payments not included in the measurement of the lease liability within operating activities. For those leases accounted for under the straight line approach, the lessee would: 1. Present the right-of-use asset on the same basis as if the underlying asset were owned. 2. Present interest expense and amortisation expense in the statement of comprehensive income as one single line item. 3. Present lease payments as operating activities in the cash flow statement.

16 LEASES - A PROJECT UPDATE LESSOR ACCOUNTING Recognition and measurement The proposals will contain two approaches to lessor accounting: The receivable and residual approach and An approach similar to operating lease accounting. The distinction between the two approaches would be based on the same criteria used for lessee accounting (the extent of consumption of the leased asset during the lease term) with the same practical expedient if the underlying asset is property (land and/or a building or part of a building). The receivable and residual approach would apply to leases under which the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term. Leases of investment property measured at fair value and short term leases would be outside the scope of the new leases standard, and the lessor would continue to recognise the underlying asset and recognise lease income over the lease term. Receivable and residual approach The lessor would apply the following approach: Initially measure a receivable for the right to receive lease payments at the present value of the lease payments, discounted using the rate the lessor charges the lessee, plus direct costs. The receivable would subsequently be measured at amortised cost using the effective interest method Initially measure the residual asset as an allocation of the carrying amount of the underlying asset. The initial measurement of the residual asset would comprise two amounts: (a) The gross residual asset, measured at the present value of the estimated residual value at the end of the lease term discounted using the rate the lessor charges the lessee; and (b) The deferred profit (that is, the element of any difference between the fair value and book value of the leased asset that relates to the retained, residual, asset), measured as the difference between the gross residual asset and the allocation of the carrying amount of the underlying asset. Subsequently measure the gross residual asset by accreting this to the estimated residual value at the end of the lease term using the rate the lessor charges the lessee. Defer recognition in profit or loss of the profit relating to the residual asset until the point at which that asset is sold or released. Present the gross residual asset and the deferred profit together as a net residual asset. Apply IAS 36 Impairment of Assets, when assessing whether the residual asset is impaired.

LEASES - A PROJECT UPDATE 17 Example A lease contains the following key terms: Lease term: 4 years Expected life of the leased asset: 10 years Lease payments: CU502, annually, made at the end of each year Interest rate charged to the lessee: 2.84% Fair value of leased asset on commencement of the lease: CU4,040 Carrying amount of the leased asset on commencement of the lease: CU3,840 Expected carrying amount of the leased asset at the end of the lease term: CU4,040*6/10=CU2,424. The effect on the lessor s statements of financial position and comprehensive income is as follows: Periods 0 1 2 3 4 Balance sheet Lease receivable 1,873 (1) 1,424 (8) 963 488 0 Gross residual asset 2,167 (2) 2,229 (7) 2,292 2,357 2,424 Deferred profit (107) (5) (107) (107) (107) (107) Net residual asset 2,060 (3) 2,121 2,185 2,250 2,317 Income statement Day 1 profit 93 (4) Interest income (6) 53 (6) 40 27 14 Accretion income 62 (7) 63 65 67 Total income 93 115 103 92 81 (1) Present value of lease payments (n=4, payment=502, I=2.84%). Subsequently measured by using the effective interest method. (2) Represents the Expected carrying amount at the end of lease term at present value discounted by the incremental interest rate. (3) Carrying amount of asset less derecognised part of asset (3,840-1,780=2,060). The part of the asset that is derecognised in the lease is calculated by multiplying the carrying amount of the asset by the ratio between the present value of the lease payment (e.g. the fair value of the derecognised part) and the all asset s fair value (3,840x1,873/4040=1,780). (4) Profit on partial derecognition is measured as the difference between the present value of lease payments (1,873) and the derecognised part of the asset (1,780). (5) Deferred profit is the difference between the gross residual asset (2,167) and the net residual asset (2,060) at lease s commencement. (6) Lease receivable at beginning of a period multiplied by the interest rate (1,873x2.84%=38). (7) Subsequently the gross residual asset is measured in a manner similar to effective interest rate. The carrying amount at beginning of the period is multiplied by (1+ interest rate) (2,167x1.0284=2,229). The accretion income is 2.84%x2,167=62. (8) Calculated by using the effective interest method (1,873x1.0284 502=1,424).

18 LEASES - A PROJECT UPDATE A lessor would apply the guidance in IAS 39 Financial Instruments: Recognition and Measurement, to assess whether the lease receivable is impaired. Changes in lease payments that are due to a reassessment in the lease term would result in an adjustment being made to the receivable and to any residual asset, the combined effect of which would be recognised in profit or loss. BDO comment The receivable and residual approach would be the most complex of the models to be applied, and there are certain aspects that may be controversial. For example, the accounting to be applied for the residual asset retained by the lessor is not simply to maintain the retained portion of the book value during the lease term, subject to impairment. Instead, the calculation is based on the following steps: 1. The expected residual value of the portion of the leased asset that has been retained by the lessor is calculated. This is based on the fair value of the asset at the commencement of the lease (in the example above this is CU4,040, a CU200 increase in comparison with the existing depreciated cost of CU3,840). 2. The expected residual value is then discounted back for the lease term, using the interest rate that the lessor charges the lessee. This gives the present value of the residual asset at the commencement of the lease (in the example above this is CU2,167). This amount will not appear in the lessor s statement of financial position, instead representing a memo amount that is required for the purposes of the overall calculation. 3. The difference between the present value of the residual asset and the existing depreciated cost that has been raecorded by the lessor is established. This difference is equal to the amount of the fair value increase (in this example, CU200) that relates to the residual asset that has not been disposed of by the lessor (in this example, CU107). The reason for this approach is to ensure that the lessor does not recognise any profit in respect of the residual asset that has not been disposed of, instead only recognising profit of the amount of the asset that relates to the lease term (in this example CU93). The operation of the calculation means that the total of the profit relating to the two components of the leased asset that are disposed of and retained (CU93 and CU107) will always equal the difference between the fair value and existing book value of the asset at the lease commencement date (CU200). 4. The accretion of the revalued residual asset (step 2 above) is then added each period to the carrying amount of the recognised residual asset (in the example above, this is CU2,060 at commencement of the lease). The difference between the gross and net residual asset (in the example above, CU107 which is the fair value uplift that relates the portion of the asset that is not covered by the lease), remains the same throughout the lease term. It does not initially seem clear why the residual asset recognised by the lessor is accreted each year using the amount that is calculated on the basis of the revalued amount of the asset. However, the approach appears consistent with the whole asset approach that is required to be applied for the purposes of sale and leaseback transactions. The overall approach would seem to be that the whole of the leased asset is derecognised, with the retained portion then being recognised at the discounted amount of its expected depreciated fair value at the end of the lease. This amount is then reduced to the extent of the portion of the difference between the existing carrying amount of the leased asset, and its fair value, at the commencement date of the lease that relates to the residual asset that the lessor has retained. Although, from a conceptual perspective, this would seem largely to be an appropriate approach it is complex. Some might also question why the recognised (net) residual asset is accreted using amounts calculated on the basis of the revalued amount of the asset. This is because a portion of the accretion then represents part of the revaluation (because the accretion is based on the revalued amount and not the lower existing carrying amount). Under the leases proposals, this would be recognised in profit or loss as finance income, but under IAS 16 any revaluation credit would be recorded in Other Comprehensive Income. Others may have concerns about the accretion of a non-financial asset, as accretion is normally applied only to financial assets and liabilities. It might be suggested that a more straightforward approach would be to measure the residual asset on the same basis as it was measured before the commencement date of the lease (that is, for the example above, depreciated cost meaning that the lessor would measure the residual asset at CU2,060 throughout the lease term (unless it was impaired). This approach might also simplify the accounting for leased assets that have previously been revalued, with amounts recorded in Other Comprehensive Income, as it would appear that under the IASB s proposed model there would be a further adjustment to reallocate a proportion of the gain recorded in OCI. It will be interesting to see comments received by the Boards, and their associated redeliberations once the comment period has closed.

LEASES - A PROJECT UPDATE 19 Operating lease approach The proposed model is similar to the current operating lease model. A lessor would not recognise a lease receivable and would continue to recognise the underlying asset. Lease payments receivable would be recognised as income on a straight line basis or another systematic basis, if more representative of pattern of earning rentals. The differences between the two approaches can be summarised as follows: Residual and receivables approach Operating lease approach Statement of financial position 1. Receivables - right to receive lease payment (present value plus direct costs) 2. Residual asset - The IASB tentatively decided that revaluation of the residual asset should be prohibited Leased (ROU) asset - measured at fair value or cost Income statement Profit on transfer of ROU (presentation based on business model) Interest income on both the lease receivable and the residual asset Rental income-straight-line basis or another systematic basis Depreciation or fair vale changes Presentation A lessor that applied the residual and receivable approach would include the following information: In its statement of financial position, present: The lease receivable and the residual asset separately on the face of the statement, adding to a total for lease assets; or The lease receivable and residual asset as one amount for lease assets, with those two components being disclosed in the notes. In its statement of comprehensive income: Present the accretion of the residual asset as interest income Present the amortisation of initial direct costs as an offset to interest income Present lease income and lease expense in either separate line items or net as a single line item, on the basis of which best reflects the lessor s business model Separately identify income and expense either by separate presentation in the statement of comprehensive income or by disclosure in the notes to the financial statements If disclosed and not presented, notes should reference the line item where income is presented. In its cash flow statement, classify cash inflows from leases within operating activities.

20 LEASES - A PROJECT UPDATE AMOUNTS INCLUDED IN LEASE PAYMENTS Variable lease payments Variable lease payments are payments that arise under the contractual terms of a lease because of changes in facts or circumstances occurring after the date of inception of the lease, other than the passage of time. For example, increases in lease payments might be linked to a benchmark interest rate, and some retail property lease payments are linked to the value of the lessee s sales that are made from the leased property. Some variable lease payments would not be included in the measurement of the right-of-use asset, the lessee s lease liability and the lessor s receivable. However, the following variable lease payments would be included: 1. Lease payments that are in-substance fixed lease payments, but are structured as variable lease payments in form. 2. Lease payments that depend on an index or a rate (for example, a lease where future increases in lease payments are linked to a benchmark interest rate). These would be included in the lessee s liability to make lease payments and the lessor s right to receive lease payments in the following way: Lease payments that depend on an index or a rate would be initially measured using the index or rate that exists at commencement of the lease. Lease payments that depend on an index or a rate would be reassessed using the index or rate that exists at the end of each reporting period. Lessees would reflect changes in the measurement of lease payments that depend on an index or a rate in net income to the extent that those changes relate to the current reporting period and as an adjustment to the right-of-use asset to the extent that those changes relate to future reporting periods. Lessors would recognise changes in the receivable due to reassessments of variable lease payments that depend on an index or a rate immediately in profit or loss. The proposals are expected to include guidance for the subsequent measurement of a lessor s residual asset, in circumstances where a lease contract includes variable lease payments that are excluded from the lease receivable at the lease commencement date: If the rate the lessor charges the lessee does not reflect an expectation of variable lease payments, the lessor would not make any adjustments to the residual asset with respect to variable lease payments. This is because the amounts allocated to the portion of the leased asset that is derecognised on lease commencement, and therefore the amount allocated to the residual asset, will not be affected by any estimates of future variable lease payments. The effect of variable lease payments would be reflected in net profit or loss for the period. If the rate the lessor charges the lessee does reflect an expectation of variable lease payments, the lessor would adjust the residual asset on the basis of the variable lease payments that are actually received in each reporting period. This would be achieved by recognising a portion of the cost of the residual asset as an expense when variable lease payments are recognised in profit or loss. BDO comment It might not seem entirely clear why a distinction is made between the two scenarios set out above. However, the rationale for this adjustment is that when a lessor does expect to receive variable lease payments, the base amount (excluding any variable amount) that the lessor charges is less than the expected actual lease income. As a consequence, because the lease income used for the purposes of the lessor s accounting will exclude variable receipts, a smaller amount is allocated to the portion of the leased asset disposed of, with the residual asset carrying amount being correspondingly higher. The adjustment to the residual asset for variable lease payments actually received therefore acts as a true up of the residual asset carrying value for each reporting period. Because no adjustment is made to the residual asset on commencement of the lease to reflect expected variable lease income, no adjustment would be made to the residual asset for any difference between actual variable lease payments and the amounts that the lessor expected to receive at the lease commencement date.

LEASES - A PROJECT UPDATE 21 Purchase options Lessees (lessors) would include the exercise price of a purchase option (including bargain purchase options) in the measurement of the lessee s liability to make lease payments (the lessor s right to receive lease payments), if the lessee had a significant economic incentive to exercise the purchase option (see the section covering lease term above). Residual value guarantees Amounts expected to be payable under residual value guarantees would be included in lease payments, except for amounts payable under guarantees provided by an unrelated third party. Lessors would not recognise amounts expected to be received under a residual value guarantee until the end of the lease. However, the lessor would consider those guarantees when determining whether the residual asset is impaired. For lessees, as noted above, changes in lease payments that are due to a reassessment of residual value guarantees would change the obligation to make lease payments and be recognised: a) In net income to the extent that those changes relate to current or prior periods b) As an adjustment to the right-of-use asset to the extent those changes relate to future periods. Term option penalties The accounting for term option penalties would be consistent with the accounting for options to extend or terminate a lease. That is, if a lessee would be required to pay a penalty if it does not renew the lease and the renewal period has not been included in the lease term, then that penalty would be included in the recognised lease payments.

22 LEASES - A PROJECT UPDATE REASSESSMENT OF THE DISCOUNT RATE The discount rate would not be reassessed if there was no change in the lease payments. The discount rate would be reassessed when the changes below were not reflected in the initial measurement of the discount rate: 1. When there is a change in lease payments that is due to a change in the assessment of whether the lessee has a significant economic incentive to exercise an option to extend a lease or to purchase the underlying asset. 2. When there is a change in lease payments that is due to the exercise of an option that the lessee did not have a significant economic incentive to exercise. The revised discount rate would be the spot rate at the reassessment date (that is, the rate that would be applied to a new lease that was entered into on that date), which would then be applied to the remaining lease payments (for example, the remaining payments due in the initial lease plus the payments due during the extension period or upon exercise of a purchase option). SHORT TERM LEASES A short-term lease is a lease that, at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less. Cancellable leases would meet the definition of short-term leases if the initial noncancellable period, together with any notice period, is less than one year. A lessee would not be required (but would be permitted) to recognise lease assets and liabilities arising from short term leases. For those leases, assuming the lessee did not elect to recognise assets and liabilities arising from them, lease payments would be recognised in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis was more representative of the time pattern in which use is derived from the underlying asset. It is not yet clear whether the option to recognise lease assets and liabilities arising from short term leases would need to be applied to all of those leases, or whether an entity could choose which of its short term leases to capitalise. A lessor would be permitted to elect, as an accounting policy for a class of underlying asset(s), to account for all short-term leases by not recognising lease assets or lease liabilities and by recognising lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis was more representative of the time pattern in which use is derived from the underlying asset. This would result in an accounting approach which would be similar to operating lessor accounting in accordance with IAS 17. SALE AND LEASEBACK TRANSACTIONS The first step would be to determine whether a sale had occurred, which would be assessed using the control criteria set out in the revenue recognition project. If no sale had taken place, then the entire transaction would be accounted for as a financing arrangement. When a sale of an asset has occurred and then the asset is leased back, the transaction would be accounted for as a sale and then a leaseback. If the consideration was at fair value, the gains and losses arising from the transaction would be recognised when the sale occurred. If the amount of consideration was not fair value, the assets, liabilities, gains and losses recognised would be adjusted to reflect current market rentals. The seller/lessee would adopt the whole asset approach in a sale and leaseback transaction. This means that in a sale and leaseback transaction, the seller/lessee sells the entire underlying asset and leases back a right-of-use asset relating to the underlying asset.

LEASES - A PROJECT UPDATE 23 DISCLOSURE The main disclosure requirements for lessees would include: A reconciliation of opening and closing balance of right-of-use assets (both finance and straight line), disaggregated by class of underlying asset A reconciliation of the opening and closing balance of lease liabilities (both finance and straight line), including interest and unwinding of discount A maturity analysis of the undiscounted cash flows that are included in the lease liability Information about the principal terms of any significant lease not yet commenced Expenses recognised in the period for variable lease payments that were not included in the lease liability Qualitative information related to short-term lease arrangements that would result in a material change to expenses in the next reporting period as compared to the current period. The main disclosure requirements for lessors would include: A table of all lease related income items recognised in the reporting period disaggregated into (a) Profit, recognised at lease commencement (split into revenue and cost of sales if that is how the lessor has presented the amounts in the statement of comprehensive income) (b) Interest income on the lease receivable (c) Interest income on the residual asset (d) Variable lease income (e) Short-term lease income. A qualitative description of purchase options in leasing arrangements (including the extent to which the entity is subject to such agreements). A reconciliation of the opening and closing balance of the lease receivable and residual assets. A maturity analysis of the undiscounted cash flows those are included in the right to receive lease payments (at least the undiscounted cash flows to be received in each of the first five years after the reporting date and a total of the amounts for the years thereafter). The analysis should reconcile to the right to receive lease payments. Information about the basis and terms on which variable lease payments are determined. Information about the existence and terms of options, including for renewal and termination. The main disclosure requirements for lessors of investment property would include: A maturity analysis of the undiscounted future non-cancellable lease payments (at least the undiscounted cash flows to be received in each of the first five years after the reporting date and a total of the amounts for years thereafter). Minimum contractual lease income and variable lease payment income within the table of lease income. The cost and carrying amount of property on lease or held for leasing by major classes of property according to nature or function, and the amount of accumulated depreciation in total. Information about leases that are not within the scope of the receivable and residual approach, including the basis on which variable lease payments are determined, the existence and terms of options (including renewal and termination) and any restrictions imposed by lease arrangements.

24 LEASES - A PROJECT UPDATE CONSEQUENTIAL AMENDMENTS BUSINESS COMBINATIONS If the acquiree is a lessee, the acquirer would recognise and measure a liability to make lease payments at the present value of future lease payments as if the lease contract is a new lease at the acquisition date and a right-of-use asset equal to the liability to make lease payments, adjusted for any off-market terms in the lease contract. If the acquiree is a lessor and the receivable and residual approach is used for an asset, the acquirer would recognise and measure a receivable at the present value of future lease payments at the acquisition date and a residual asset as the difference between that present value and the fair value of the underlying asset at the acquisition date. If the acquiree is a lessor of investment property- the acquirer should apply the guidance in IFRS 3 Business Combinations that relates to acquired operating leases. If the acquiree has short-term leases then the acquirer would not recognise separate assets or liabilities related to the lease contract at the acquisition date. BDO comment It appears that, in contrast to an entity that enters into short term leases, that the acquirer would not have the option of recognising assets and liabilities arising from short term leases.

LEASES - A PROJECT UPDATE 25 TRANSITION The transitional requirements would apply at the beginning of the earliest comparative period presented. Lessees The lease was accounted for as Finance lease Operating lease Operating or finance Transition No adjustments to carrying amounts. Reclassify lease assets and lease liabilities as right-of-use assets and liabilities to make lease payments. Recognise liabilities measured at the present value of the remaining lease payments, discounted using the lessee s incremental borrowing rate as of the effective date for each portfolio of leases with reasonably similar characteristics. Recognise right-of-use assets equal to the proportion of the liability to make lease payments at lease commencement calculated on the basis of the remaining lease payments. For the straight-line approach, measure the rightof-use asset at the same amount as the liability to make lease payments. Record to retained earnings any difference between the liabilities and the right-of-use assets at transition. When lease payments are uneven over the lease term, a lessee would adjust the right-of-use asset by the amount of any recognised prepaid or accrued lease payments. Lessor The lease was accounted for as Finance lease Operating lease Operating or finance Transition No adjustments to carrying amounts. Recognise a receivable, measured at the present value of the remaining lease payments, discounted using the rate charged in the lease determined at the date of commencement of the lease, subject to any adjustments required to reflect impairment. Recognise a residual asset consistent with the initial measurement of the residual asset under the receivable and residual approach, using information available at the beginning of the earliest comparative period presented. Derecognise the underlying asset. When lease payments are uneven over the lease term, adjust the cost basis in the underlying asset that is derecognised presented by the amount of any recognised prepaid or accrued lease payments.

26 LEASES - A PROJECT UPDATE The proposals also include a number of reliefs that can be taken advantage of on transition: Lessors and lessees are not required to evaluate Initial direct costs for contracts that began before the effective date. If an entity elects this relief it should disclose this. Hindsight may be used in comparative reporting periods, including the determination of whether or not a contract is or contains a lease. If an entity elects to use any of the reliefs, disclosure of this is required. Although transition disclosures would be required to be consistent with those required by IAS 8 Accounting Policies, Changes in Estimates and Errors, disclosure would not be required of the effect of the change on income from continuing operations, net income, any other affected financial statement line items or any affected earnings per share amounts for the current and any prior periods. However, all of the disclosures required by IAS 8 could be included if an entity wished to do so.

LEASES - A PROJECT UPDATE 27

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