InsightsThe future of Irish GAAP
Preparing for change
A proposed new model
The scale of the leasing industry and perceived weaknesses in lease accounting have led to it receiving focused attention in recent years from the two major standard-setters, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). Below are perspectives on a revised Exposure Draft (ED) outlining a new proposed accounting model.
The global leasing industry has grown substantially in recent years, with the World Leasing Yearbook reporting 20% growth on international markets in 2012. Ireland is a major centre for cross-border leasing, particularly aircraft leases, with many of the international leasing companies having established operations here.
The scale of the leasing industry and perceived weaknesses in lease accounting have led to it receiving focused attention in recent years from the two major standard-setters, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB).
The IASB and the FASB have worked together to develop a proposed new lease accounting model and have been successful in reaching conclusions which are nearly identical for both, one of the more successful projects undertaken in their programme of convergence of accounting standards. In May 2013 they published for public comment a revised Exposure Draft (ED) outlining a new proposed accounting model. The ED revises proposals made in an earlier ED issued in August 2010
A new model - why?
The current lease accounting model classifies leases between operating leases and finance leases. The 'substance over form' principle underlies the accounting distinction and may be quite obscure in some cases requiring focus on a number of criteria for classification, including transfer of ownership at end of lease, renewal options, proportion of estimated useful life and proportion of fair market value.
The major difference between the two lease classes is that finance leases are recorded on the balance sheet, while operating leases are off - balance sheet.
The arguments as to whether lease accounting needs to change turn on two different views. The first view is that leasing is a form of hidden leveraging that should not be allowed to remain off balance sheet, a big issue both conceptually and economically. The second view is that the economics of leasing may not really be that clear cut and current operating leases could possibly be considered as similar to simple service, or executory-type, contracts.
Many are concerned that current lease accounting is subject to easy manipulation that can result in questionable outcomes. At present, the hidden leverage that may arise from the off-balance sheet accounting for operating leases can only be "guessed" by applying arbitrary multiples to basic disclosures in financial statements. This is not satisfactory to those that hold that view, given the scale involved. It is estimated that $1.5 trillion of leasing activity would be brought onto the balance sheets of US companies alone.
What is being proposed?
The ED published in May sets out proposals which would significantly affect the accounting for lease contracts by both lessors and lessees.
The main changes from current lease accounting are as follows:
Off balance sheet treatment would be eliminated for operating leases, other than short-term leases
Classification of leases as property or non-property would determine the manner in which the lease expense is recognised each period, which will require detailed analysis of leases and lease payments.
The nature of the underlying leased asset will dictate whether the asset is derecognised and the pattern of income recognition.
The 2013 ED defines a lease as a 'contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration'. Short-term leases, for 12 months or less, would continue to be eligible for the current operating lease accounting model.
For lessees, the two-track system proposed would recognise the costs and cash flows of most property leases evenly over the term of the lease, while the costs of most non-property leases would be front loaded, being higher in early years of a lease and lower in later years. This is in response to concerns expressed by constituents about proposals made in the 2010 ED. Property leases are referred to as Type B leases in the ED, with non-property leases referred to as Type A.
Continuing with a dividing line between Type A and Type B leases is likely to be of concern to some, as a main objective of the standard-setters when initiating the project was to remove the 'bright line' between finance and operating leases, and have one consistent approach to all leases.
The proposals addresses leases with variable lease term with the determining factor being whether there is a significant economic incentive to exercise an option to increase or otherwise change the lease term. Accounting for variable lease payments is also considered in the ED proposals, with treatment depending on the nature of the payments
Challenges of implementation
The proposals would require management to exercise significant judgement in some areas including identifying a lease, determining the lease term and measuring assets and liabilities. Clear and unambiguous accounting policy disclosures will be essential, including dealing with the question of what falls within the definition of a lease under the proposals, and what constitutes a 'right of use'.
Some other practical issues that may need to be considered are:
Development of the proposals has taken quite some time and commitment of resources by both the IASB and the FASB. The standard-setters are intending to publish a final standard in 2014 with implementation in 2017.
However, there may still be a way to go as the proposals are likely to generate significant further debate. While many may support the balance sheet recognition of the majority of leases, concerns may be expected about the separate classification between Type A and Type B leases with the consequent differences in cost and cash flow measurement and recognition. While for some these may be practical steps, others may see it as a blurring of conceptual coherence and a practical issue with consistent application which may risk continuing manipulation to achieve desired results.
While implementation of the standard may not be until 2017, companies with substantial leasing arrangements would be well advised to examine the proposals and develop a model to help them understand and consider the impact on the financial statements and financial metrics. Those that prepare well will be in a stronger position to keep investors and other stakeholders well informed of any major changes.