The Exposure Draft (ED) proposes to define a lease as a "contract in which the right to use a specified asset or assets is conveyed, for a period of time, in exchange for consideration." [2]
Lease accounting is important, because of the size of the leasing industry. An example of a lease in a business scenario can be a property. There has been a large growth in the leasing industry. According to the World Leasing Yearbook 2010, leasing activity in 2008 was US$640billion [3] . This is because of tax advantage to the lessor (as in the 1970's first year capital allowances could be offset against taxable profits) and commercial advantage to the lessee.
Lease accounting is known by the International Accounting Standard as IAS 17, the US Statement of Financial Accounting Standards as SFAS 13, and the UK's Statement of Standard Accounting Practice as SSAP 21.
IAS 17 was needed because of the massive growth in the leasing industry and the growth in off-balance sheet financing. The accounting treatment of the lease transaction was seen to distort the financial reports of a company so that they did not represent a true and fair view of its commercial activities. The lease obligation would affect a company gearing and cause it to exceed its legal borrowing powers under a loan agreement. [4] Therefore, the standard was necessary to ensure consistent reporting and to prevent the accounting message from being manipulated.
Accounts are generally required to reflect commercial substance rather than their legal form. IAS 17 divides contracts into Operating or Finance lease. A Finance lease will transfer substantially all the risks and rewards of ownership of an asset to the lessee. And an Operating lease is a lease other than a finance lease. [5] A lease can be identified depending whether it is the substance of the transaction rather than the form.
IAS17 recognises leases at the fair value of the asset or the present value of the minimum lease payments if lower as an asset in the statement of financial position. The obligation to pay rentals should be included as a liability on the statement of financial position.
Throughout the years, criticisms of lease accounting have grown. The boards have been discussing lease accounting since 2006. The proposal to classify leases into finance and operating leases and to capitalize finance leases appears to be a feasible solution. Then why did these criticisms occur? The whole debate centers over the accounting policy: substance over form.
IAS 17 was issued one of main attractions of leases was the off balance sheet nature of the transactions. IAS 17 involved a substance over form approach to accounting treatment which was different compared to the traditional approach. IASC argued that there were two separate transactions taking place. In one transaction the company as borrowing funds to be repaid over a period, in the other, it was making a payment to the supplier for the use of an asset. "If information is to represent faithfully the transaction and other events that it implies to represent, it is necessary that they were accounted for and presented in accordance with their substance and economic reality and not merely their legal form." [6]
Sir David Tweedie stated that that much of the estimated annual $640bn of lease commitments was unsuccessful in appearing on the balance sheet of lessees. This meant that firms were giving an artificial impression of their liabilities and gearing. The new proposals will allow more complete financial reporting information about lease contracts which will be available to investors and others.' [7]
The current approach to lease accounting (IAS 17) is unacceptable. The approach used in IAS 17 requires leases to transfer substantially all the risks and rewards of ownership of the leased item to the lessee. This is the known as the finance leases. Those do not are known as the operating lease. IAS 17 argues that finance leases must be capitalised in the lessee's accounts.
Applying this model requires considerable subjective judgement. It can be difficult to understand and define "substantially all the risks and rewards of ownership."The end result will be different because different accounting is applied to similar lease arrangements. Many believe that the current lease accounting is "too reliant in bright lines and subjective judgments that result in economically similar transaction being accounted for differently." [8] This shows that under IAS 17 leases were accounted in different ways, and that was not very satisfactory.
Danielle Zeyher (FASB) believed that by revising lease accounting, this would allow more transparency for investors and other users of financial information. [9] This would be a potential benefit in understanding the accounts as it will be clearer.
Zeyher explains a major problem of IAS 17 is that liabilities and assets are not being recognised on the balance sheet of lessors and lessees. This issue needs to be addressed more thoroughly.
Therefore, The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) are going to address these problems in their joint convergence project. This will be coming up with a more principle- based approach, which will be beneficial in the long run.
This is by making lease accounting more transparent and less complex, by creating situations where the same asset will be included on the balance sheet for both the lessee and lessor. [10] And it will eliminate a major category of off-balance sheet liabilities: Operating leases. [11] Operating lease disclosure do not provide financial statement users with adequate information to determine the amount if related assets and liabilities. [12] Only Finance leases, which are a small minority of the contracts, are reported on the firm's books. Therefore, accounting boards wants to end this distinction between the two classes. [13]
It will also affect how rent expense is reported on the income statement because part of rent payment will be recognized as interest expense and the right-of-use asset will be depreciated, moving the expense out of the current definition of EBITDA. [14]
They have proposed the following plans;
The ED proposes that a new standard on lease accounting for lessees and lessors would replace IAS 17 Leases, IFRIC 4 Determining whether an Arrangement Contains a Lease, SIC-15 Operating Leases - Incentives and SIC-27 evaluating the Substance of Transactions Involving the Legal Form of a Lease [15] .it will create a lease obligation liability and a corresponding right-of-use asset on the balance sheet. [16]
The new proposal will mean that lessees would no longer be permitted to treat leases as "off-balance sheet" financings but instead would be required to recognize an asset and liability for all leases within the scope of the proposals. [17]
The Lessee would need to apply the right-of-use model to all outstanding lease contracts at the date of the initial application of the new standard. For leases that are current classified as operating leases, rent expense would be replace with amortization expense and interest expense. [18] The lessee would recognize a "right-of-use" asset representing its right-to-use the underlying asset, and a liability representing its obligation to pay lease rentals over the lease term. It will measure its liability of the lease at the present value of the estimated future lease payments. The lessee would measure its right-to-use asset under either a cost model or revaluation model. An active market would not be required in order to apply a revaluation model. [19]
Lessors would apply one of the two methods. The performance obligation approach or derecognition approach. If the lessor wants to retain the risks and benefits associated with the underlying asset, then it would need to apply the performance obligation approach. Otherwise it would use the derecognition approach.
Applying the Performance obligation model the lessor would need to continue to recognize its interest in the underlying asset and, at start of the lease. The lessor would measure the lease asset at the present value of the future lease payments. The liability would be amortized based on the pattern-of-use of the underlying asset by the lessee. If the lessor cannot determine this pattern reliably, then it would use the straight line method. [20]
By applying the Derecognition approach, the lessor would recognize an asset representing its right to receive lease payments from the lessee, derecognize a portion of the underlying asset representing the lessee's rights, and reclassify the remaining portion as a residual asset representing its right to the underlying asset at the end of the lease term. The asset would be measured the same way as the performance obligation approach. It would be measured by allocating the original carrying amount of the underlying asset. [21]
There will be specific accounting and disclosure requirements for sale and leaseback transactions. The accounting would depend on whether the sale meets the conditions for a sale as proposed in the ED. If the sale criteria are not met, then the seller/lessee would account for the transaction as a financing arrangement under IAS 39. If the sale criteria are met, then the proposed accounting for the lease generally would follow the requirements as proposed in the accounting models for lessees and lessors, except that a purchaser/lessor would be required to apply the performance obligation approach. [22]
There will be significant affect for deferred tax consequences associated by adopting the proposal. For example, Pickering suggests that in the UK, IAS 17 treated tax in a different manner. As in the early years, it made deals look like they were in losses, when they were profitable under the UK GAAP. He also explains that IAS 17 is persuading that firms should use straight line depreciation for operating leases. However, this will not be successful because assets depreciate in different ways.
Lessees will need to consider the tax laws because of the temporary differences. A lessee that concludes there is a temporary difference will need to consider whether the initial recognition exemption applies.
The new rules could result in a direct hit to profits and make accounts harder to understand. [23] Lease rentals are accounted on an accruals basis, and it will become more difficult to account for these leases. This will make it harder for accounts to be prepared in a consistent way and hard to compare.
Changes will affect firms that have large operating leases and expensive assets, such as aircraft. Others that would be affected are, those with leased assets in the mining, construction and transport sectors as well as entities with leased buildings, including head offices and retail premises. [24]
There will also be a significant impact on cost. For example redesign and re-evaluation of exiting procedures for negotiating, administering, recording and reporting leases in the financial statements. [25] The IASB is aware that they need to acknowledge the impact of costs on changing accounting requirements. They need to ensure that they balance any costs against the benefits of an enhanced transparency in financial reporting. However, IASB's July 2006 paper recommends that a latest accounting model for leases would not inevitably be more costly than existing models. [26] Kenneth Bentsen, president of the US Equipment Leasing and Finance Association, said "if the proposed changes do not reflect an appropriate balancing of costs and benefits, they would result in an unwarranted increase in cost of capital" [27]
The international standard setter also accepts that business decisions will be affected. There will need to be internal controls to ensure that accounts are complying with the proposed accounting rules and expanded disclosure requirements. IASB's July 2006 paper states that the recent accounting model will modify the balance between the different means for financing. This will mean there will be winners and losers. There will be a significant impact for the losers, as they will have a big cost impact. [28]
After the proposed standards, the accounts would need to be monitored regularly to ensure compliance.
Successful evaluation of leases under the proposed standard may require a very different set of skills than those necessary for evaluating leases under the present standard. The process will require more business knowledge and professional judgement.
Some see the proposals as providing a clearer picture of an entity's assets and payment obligations. Others see the changes as adding complexity without adequate benefit for reporting. [29] Zeyher states that, "at the end of the day, we want to make sure the accounting properly reflects the economics. Better and more transparent information enables investors, creditors and other users of the financial statements to make better informed decisions. Potentially, people will lease because it's economically feasible to lease, as opposed to because of the accounting. [30] " there are opportunities as well as possible risks, but in the long run the benefits will outweigh the costs.
It is advised that companies should prepare for significant changes in accounting for lease agreements.
