‘Leases’ is perhaps not the most significant figure on a balance sheet, but following the enactment of the proposed changes currently on the drawing board, the amounts that you may be required to recognise on your balance sheet may well run into millions, as our advisory experience with the proposed changes already shows.
Lease classification will now be driven by the extent of consumption of the underlying asset by the lessee
Leases are currently accounted for in accordance with International Accounting Standard 17 – Leases. That standard has often been criticised mainly on two counts. First, it is contended that the standard is old (it was last revised in 2003) and may be inappropriate in addressing certain complexities and arrangements prevalent in today’s lease contracts.
Secondly, most stakeholders argue that the standard’s major weakness lies in the off-balance sheet ‘accounting’ for certain operating leases by lessees.
Classification of leases under the current standard is reflective of the extent to which the lessee assumes the risks and rewards incidental to ownership of the underlying asset. If the lease transfers substantially all these risks and rewards, it would be classified as a finance lease. It is otherwise classified as an operating lease. Under a finance lease, a lessee would recognise the underlying asset on its balance sheet, as it would recognise the liability to make lease payments to the lessor. A lessee merely recognises lease payments as an expense in profit or loss if the nature of the lease is an operating one.
The International Accounting Standards Board and the US Financial Accounting Standards Board initiated a joint project to develop a new approach to lease accounting that would ensure that assets and liabilities arising under leases are recognised in the balance sheet. The first set of proposals was published by the IASB in August 2010 and revised proposals are expected by June. Nevertheless, an analysis of the IASB’s re-deliberations to date provides an accurate forecast of what the final proposals are likely to entail.
These proposals are likely to result in changes to some aspects of lease accounting. Lease classification will now be driven by the extent of consumption of the underlying asset by the lessee. Lessee accounting will be affected once these proposals are issued as final and lessees will be required to recognise a right-of-use asset and a liability for all leases entered into. There will be more complex treatment of certain leases, in particular for those leases in which the lessee will consume more than an insignificant portion of the underlying asset over the lease term.
The new lease classification test will be based on the extent of consumption of the underlying asset. This assessment must be made at lease commencement and subsequently in the event of a modification to the lease arrangements.
Where the lessee is to consume an insignificant portion of the underlying asset over the lease term, such as the lease of real estate under which the lessee consumes an insignificant portion of the property when compared to its economic life, the lease would be accounted for by both parties.
The lessee recognises a right-of-use asset and a corresponding liability. The amortisation of the asset and the liability, hence the recognition of the expense in profit or loss, would not exceed the lease expense (lease payments) for a given period. This method of amortisation is referred to as the straight-line model as it spreads the total lease expense on a straight-line basis over the lease term.
The lessor, on the other hand, retains the underlying asset on its balance sheet and recognises lease income on a straight-line basis, similar to the current operating lease model in IAS 17.
On the other hand, where the lessee is to consume more than an insignificant portion of the underlying asset over the lease term, such as the lease of machinery for a major part of its economic life, the lease would be accounted for by both parties as well.
In this case, the lessee recognises a right-of-use asset and a corresponding liability. Under this model, the asset and the liability are amortised separately. Interest on the outstanding liability is recognised in profit or loss in line with current practices, while the right-of-use asset is depreciated in line with the lessee’s policy in that regard.
This method results in a front-loading of the lease expense in the earlier periods of the lease term, and a diminishing charge to profit or loss as the end of the lease term approaches.
The lessor would recognise two assets on its balance sheet: a receivable representing its right to receive lease payments from the lessee, and a residual asset (which remains on the balance sheet after the lessor derecognises the portion of the underlying asset which will be consumed by the lessee). The lessor may recognise an upfront profit or loss on the commencement of the lease, and interest income on the receivable over the lease term.
These changes may have a significant impact on lessees’ and lessors’ balance sheets. The magnitude of the impact depends on the current classification under the extant standard, and the accounting (or off-balance sheet) treatment emanating from IAS 17.
As the effective date of these proposals (once final) is a couple of years away, one can afford to plan for any required changes in good time before going live.
The standard is expected to result in the increased use of judgements and estimates which will have a direct impact on the classification of leases and the measurement of the resulting assets and liabilities. These and other recent and forthcoming changes to other standards will be discussed at an IFRS conference KPMG plans to hold on June 21.
Jonathan Dingli is on the accounting advisory services team at KPMG in Malta.