The key outcomes from the deliberation process between the global accountancy associations the IASB and FASB on their proposals on leases is given by EY’s Patrick O’Driscoll who is a senior manager in EY’s aviation leasing practice. His guide to all the important decision informs lessors on what they should expect in 2015. While the Boards reiterated their commitment to putting most leases on the balance sheets of lessees and to reaching a converged solution, recent discussion of how to simplify lessee accounting highlighted the differences may be difficult to resolve, he says.
Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) are looking for ways to simplify their 2013 proposal on leases in response to feedback from constituents that the accounting would have been too complex and costly to apply.
While the Boards reiterated their commitment to putting most leases on the balance sheets of lessees and to reaching a converged solution, recent discussion of how to simplify lessee accounting highlighted differences between the Boards that may be difficult to resolve.
The Boards reached certain tentative decisions on a short-term lease exception as well as other ways to simplify their May 2013 exposure draft (the ED). In relation to lessee accounting, the IASB supported a single on-balance sheet model for lessee accounting while the FASB supported a dual on-balance sheet model. Despite this fundamental difference, the Boards reiterated their commitment to seek a converged solution indicating that there may be some way to go on this.
Most significantly, the Boards also indicated that they do not intend to significantly change lessor accounting. Instead, they supported retaining a dual classification model. This article intends to discuss some of the significant decisions made over the course of the redeliberation process to date.
The Boards decided to limit changes to the lessor accounting model, classifying leases using today’s IFRS approach. The bright line principles for lease term, as a percentage of useful life (75%) or the PV of future lease payments as a percentage of NBV (90%) currently present in US GAAP would no longer apply.
Therefore, the key underlying principle would continue to be whether the risks and rewards of ownership have transferred to the lessee. A lease will be classified as either a type A or type B lease. A type A lease is similar to today’s finance lease under IAS 17 (sales-type or direct finance leases under ASC 840). Under a type A lease, the lessor will recognise the net investment and will derecognise the underlying asset. Type B, on the other hand, is similar to today’s operating leases. Table 1 explains the classification criteria.
Definition of a short term lease
The Boards have agreed on the definition of a ‘short term lease’ as a lease with a lease term of 12 months or less. There will be an exemption from applying the new model for any short term leases.
Lessee accounting model
The divergence referred to above arises on leases that are not classified as short term. The IASB categorises all other leases as type A whereas the FASB will have a dual lease classification with both type A and type B leases using the same criteria as the lessor accounting model above. The Board decision here could result in different accounting treatment for similar transactions should the commitment to continue to seek ways to converge not materialise.
Table 2 identifies the lessee accounting for lessees under both types of leases. So effectively under IFRS all leases with be accounted for by lessees in a manner similar to how a finance lease liability is currently as accounted for under IAS 17.
The Boards confirmed that a high threshold should be used to determine the lease term for leases with options to extend or terminate the lease (as well as an option to purchase a leased asset). However, they decided to change the term used to describe the threshold to “reasonably certain,” which is used in IAS 17. The Boards also said that “reasonably certain” means the same thing as “reasonably assured” in ASC 840. In doing so, the Boards agreed not to use the new term they had proposed (i.e., significant economic incentive) to avoid implying that practice should change.
The Boards also decided that lessees would be required to reassess the lease term upon the occurrence of significant events or changes in circumstances that are within the lessee’s control (i.e., market-based factors would be excluded). The Boards expect that such events would occur infrequently. Finally, the Boards decided that lessors would determine the lease term at the commencement date in the same manner as lessees but, unlike lessees, would not reassess the lease term.
The Boards decided that the rate the lessor charges the lessee would be defined as “the rate implicit in the lease.” This is similar to the current definition in IAS 17 Leases and ASC 840 Leases. The lessor’s initial direct costs would be included in the lease receivable for Type A leases. Importantly, both lessees and lessors would use the revised definition of the “rate implicit in the lease” when accounting for leases. Lessees would still be permitted to use their incremental borrowing rate when the rate implicit in the lease is not readily determinable.
The Boards have decided that a lease modification would be a separate new lease (lessee and lessor) if the modification grants the lessee an additional right-of-use and the additional right-of-use is priced commensurate with the terms that could be obtained in a standalone lease agreement.
For a lease modification that does not result in a separate new lease, lessees would generally remeasure the existing lease liability and right-of-use asset without affecting profit or loss. However, for a modification that decreases the scope of a lease (e.g., reducing the square footage of leased space, shortening a lease term), lessees would remeasure the lease liability and recognise a proportionate reduction (e.g., the proportion of the change in the lease liability to the pre-modification lease liability) to the right-of-use asset. Any difference between those adjustments would be recognised in profit or loss.
For lessors, the Boards decided a modification that is not a separate new lease, would be accounted for, as follows:
• A modification to a Type B lease (generally an operating lease today) would be, in effect, a new lease, the lease payments for which would be equal to the remaining lease payments of the modified lease, adjusted for any prepaid or accrued rent from the original lease.
• A modification to a Type A lease (generally a finance lease today) would be accounted for in accordance with IFRS 9 Financial Instruments or ASC 310 Receivables.
Subleases and the effect on LILO arrangements
The Boards have decided that a head lease sublease will be accounted for as two separate lease contracts. Therefore, the current LILO structure will become more complex. Lease income will continue to be booked as is, most commonly on a straight-line basis, whereas the lease expense will now be calculated using the interest method and therefore will no longer be straight-lined.
Sale and leaseback transactions
Consistent with their 2013 proposal, the Boards decided that a seller-lessee would use the definition of a sale in the new joint revenue recognition standard (IFRS 15 Revenue from Contracts with Customers) to determine whether a sale has occurred in a sale and leaseback transaction. That is, a seller-lessee would assess whether the buyer-lessor has gained control of the underlying asset. The Boards also confirmed their earlier decision that the presence of a leaseback, in and of itself, would not preclude a sale. However, each Board decided that different circumstances would preclude a sale. The FASB decided that a sale and a purchase would not occur when a leaseback involves a Type A lease from the seller-lessee’s perspective. The FASB believes that its Type A lease is effectively a financed purchase of the underlying asset. Therefore, it would be inappropriate for a seller-lessee to account for the sale of an underlying asset that it concurrently repurchases. The IASB did not discuss this issue because it is pursuing a single lessee accounting model (with an exemption for leases of small assets).
Consistent with the new revenue recognition standard, the IASB decided that a sale and a purchase would not occur if the seller-lessee has a substantive option to repurchase the underlying asset because the buyer-lessor would not obtain control of that asset. The presence of a non-substantive repurchase option (e.g., an option that is exercisable only at the end of the underlying asset’s economic life) would not preclude sale accounting.
Accounting for the sale
The Boards decided that when the buyer-lessor obtains control of the underlying asset in a sale and leaseback transaction (i.e., Type B leasebacks only in the FASB’s proposal), the buyer-lessor would recognise the purchase of the asset based on other standards and account for the leaseback under the proposed lessor accounting. The Boards decided that the seller-lessee would do each of the following:
• Derecognise the underlying asset
• Recognise a lease liability and right-of-use asset for the leaseback (subject to the IASB’s exemption for leases of small assets and the joint exemption for short-term leases)
• Recognise a loss (if any) immediately (adjusted for off-market terms)
The Boards reached different decisions on how the seller-lessee would recognise a gain,if any, on the sale (adjusted for off-market terms). The FASB determined that the seller-lessee would recognise the full gain immediately. However, the IASB decided that the seller-lessee’s immediate gain would be limited to the portion related to the residual asset (i.e., the residual interest in the underlying asset transferred to the buyer-lessor). The remaining gain (i.e., related to the leaseback) would be recognised as a reduction to the initial measurement of the right-of-use asset, thus reflected as a reduction in the amortisation of the right-of-use asset over the term of the leaseback. Under the IASB’s approach, a seller-lessee would recognise a smaller immediate gain on a leaseback covering a large portion of the life of the underlying asset as compared to a similar transaction with a shorter leaseback of the same asset.
Accounting for the leaseback
The Boards decided that when a sale occurs, both the seller-lessee and the buyer-lessor would account for the leaseback in the same manner as any other lease (i.e., in accordance with the lessee and lessor requirements, respectively, with adjustments for any off-market terms).
Before drafting a standard, the Boards need to complete their redeliberations on the definition of a lease and address several remaining issues, including the IASB’s recognition and measurement exemption for leases of small assets, lessee disclosures, transition, effective date and consequential amendments to other standards. A standard is not expected before the third quarter of 2015.