Issue Likely accounting requirement
What is the lease term? The lease term is to be defined as the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with 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. This means that the lease term will include optional renewal periods that are more likely than not to be exercised.
What is the required
discount rate? The lessee would use the rate the lessor charges the lessee when that rate is available, otherwise the lessee is to use its incremental borrowing rate. 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.
How are initial direct costs to be accounted for?
Initial direct costs are defined as recoverable costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made. Lessees and lessors should capitalise initial direct costs by adding them to the carrying amount of the right-of-use asset and the right to receive lease payments, respectively.
What if there are variable lease
payments that depend on an index or a rate?
Some leases have variable components; for example, across time a lease payment might partly be based on the rate of inflation. The boards discussed the measurement of lease payments that depend on an index or a rate included in the lessee’s liability to make lease payments and the lessor’s right to receive lease payments and decided that:
1. Lease payments that depend on an index or a rate should be initially
measured using the index or rate that exists at the date of commencement of the lease.
2. Lease payments that depend on an index or a rate should be reassessed using the index or rate that exists at the end of each reporting period.
3. Lessees should reflect changes in the measurement of lease payments that depend on an index or a rate (a) in net income to the extent that those changes relate to the current reporting period and (b) as an adjustment to the right-of-use asset to the extent that those changes relate to future reporting periods.
4. Lessors should recognise changes in the right to receive lease payments due to reassessments of variable lease payments that depend on an index or a rate immediately in profit or loss.
Residual value
guarantees Lease payments should include residual value guarantees in the measurement of the lessee’s liability to make lease payments and the lessor’s right to receive lease payments.
Purchase option Lease payments should include the exercise price of a purchase option (including bargain purchase options) in the measurement of the lessee’s liability to make lease payments and the lessor’s right to receive lease payments, if the lessee has a significant economic incentive to exercise the purchase option. This represents a departure from the exposure draft released in 2010, which proposed that the exercise price of a purchase option is not a lease payment and therefore should be excluded from a lessee’s lease liability and a lessor’s lease receivable.
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available in early 2012 and might not accurately reflect the requirements that might ultimately be included in the new standard—it does nevertheless indicate that significant changes are likely when a revised account- ing standard is eventually issued. How reporting entities will respond to these changes will be interesting. Clearly, many more leases, which we have traditionally referred to as operating leases, will have to be included in the statement of financial position. The removal of the requirement that a lease must transfer the risks and rewards of ownership to the lessee before an asset and liability are recognised will have obvious implications for reporting entities’ assets and liabilities, and therefore for their gearing ratios and so forth. Accounting for leases has been in the work-in-progress tray for standard-setters for a long time. Vivian Beattie and Alan Goodacre studied the impact of the suggested changes to lease accounting in the UK in the 1990s. They dis- cuss the potential impact of this in an article in the Financial Times in 1997, reproduced in Financial Accounting in the News 10.2.
More detail of the study reported in Financial Accounting in the News 10.2 can be found in Beattie et al. (1998), though the results were extended to include 300 UK companies. Consistent with the results reported in Financial Accounting in the News 10.2, they found that capitalising operating leases had a significant impact on the magnitude of six out of nine key accounting ratios. The affected ratios were: profit margin, return on assets, asset turnover and three measures of gearing. They concluded that the unrecorded long-term liability repre- sented 39 per cent of reported long-term debt, while the unrecorded asset represented 6 per cent of total assets. The adjustments changed the ranking of the companies in respect of company performance, suggesting that the proposed changes have relevance for stakeholders.
Table 10.1 Expectations about the contents of the future leasing standard (Continued)
Issue Likely accounting requirement
Amortisation of
right-of-use asset If it is determined that the lessee has a significant economic incentive to exercise a purchase option, the right-of-use asset recognised by the lessee should be amortised over the economic life of the underlying asset, otherwise the right-of-use asset should be amortised over the lease term.
Lessor recognition of a residual asset
At the end of the lease term the lessor might have rights to a residual asset if the lease term is not for the life of the underlying asset. Where a residual asset will exist:
1. The lessor would recognise a right to receive lease payments and a residual asset at the date of the commencement of the lease.
2. The lessor would initially measure the right to receive lease payments at the sum of the present value of the lease payments, discounted using the rate that the lessor charges the lessee.
3. The lessor would initially measure the residual asset as an allocation of the carrying amount of the underlying asset and would subsequently measure the residual asset by accreting it over the lease term using the rate that the lessor charges the lessee. The increase in the value of the residual asset across time (which in part would be due to the effects of discounting) would be included in profit or loss as interest income.
Are there exclusions for
short-term leases? Initially there were to be no exceptions for short-term leases; however, this has now changed. A short-term lease is defined as 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.
The boards decided that, for short-term leases, a lessee need not recognise lease assets or lease liabilities. For those leases, the lessee should recognise lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset.
For those excluded leases, a lessor should continue to recognise and depreciate the underlying asset and recognise lease income over the lease term on a systematic basis.
Standard-setters in the UK, US, Australia and New Zealand, together with the International Accounting Standards Committee, have recently taken the unusual step of publishing a joint discussion paper, Accounting for Leases: A New Approach, which pro- poses that all leases be capitalised.
If adopted, this would mean that leases currently classified as operating leases would have the asset (and related lia- bility) recorded on the balance sheet of the lessee. To estimate the impact that this is likely to have on the balance sheets of UK companies and, in particular, on performance ratios, we used a method of constructive capitalisation. Results for 1994 for a large random sample of 232 listed companies showed that operating leases represent a major source of long-term debt-type financing in the UK. On aver- age, the unrecorded lease liability per company was £51m, of which £8m would be classified as short-term debt and £43m as long-term debt. The latter represented 39 per cent of reported long-term debt before capitalisation.
There was wide variation in the importance of operating leases across broad sectors, with the greatest impact in the services sector; this had an average long-term lease liabil- ity of £88m, representing 69 per cent of long-term debt. The smallest impact was observed in the mineral extraction sec- tor with an average long-term lease liability of £5m (just 3 per cent of long-term debt).
Capitalisation had a significant impact on six of nine perfor- mance ratios investigated (profit margin, return on assets, asset turnover and three measures of gearing). For exam- ple, the net debt to equity gearing ratio, often favoured by company management, would change from a mean of 20 per cent to a staggering 72 per cent following capitalisation,
while the profit margin would increase from 8.8 per cent to 9.8 per cent on average. What is more, the ranking of com- panies, both across the broad sectors and even within sec- tors, would change significantly as a result of differential use of operating leases by companies; again the services sector would be most affected.
These findings suggest that a policy change requiring oper- ating lease capitalisation is likely to have serious economic consequences. Significant changes in the magnitude of key accounting ratios and a major shift in company perfor- mance rankings imply that interested parties’ decisions and company cash flows are likely to be affected.
The off-balance sheet attraction of leasing finance would be drastically reduced, which would tip the balance towards pur- chasing. Alternatively, to lessen the impact of such a policy, company management could elect for shorter lease terms so that the lease asset and liability required to be capitalised would be smaller. Apparently, this has already caused some concern to lessors in the property sector as it would have a detrimental effect on the valuation of leased properties. The good news for affected parties is that the proposal is only at the discussion stage and the UK Accounting Standards Board has a very busy programme ahead of it before it gets to leasing.
Further, the supporting logic for including operating leased 'assets' on the balance sheet is not without its problems; its wholesale adoption would extend to human assets as well as capital assets (since employees are also leased assets). Partial adoption is therefore more likely.
Source: Extract from Financial Times. © THE FINANCIAL TIMES LIMITED 2012