The Hindu Business Line : Paradigm shift in lease accounting

International Financial Reporting Standards (IFRS) requires capitalisation of finance leases by lessees, whereas operating leases are treated as rental arrangements and kept outside the balance-sheet. Indian GAAP (Generally Accepted Accounting Principles) is similar to IFRS and, like IFRS, requires the ‘risks and rewards of ownership’ model to distinguish between a finance lease and an operating lease.

The criteria

Essentially, there are five primary criteria and three secondary criteria to assist in making the decision on whether risks and rewards of ownership have transferred. If these are transferred by the lease arrangement, the asset gets reflected in the balance-sheet of the lessee; if not, the asset remains in the balance-sheet of the lessor.

US GAAP also follows a similar risks and rewards approach, except that it is more rule driven. For example, the criterion under IFRS (and Indian GAAP), relating to lease term being for a major part of the economic useful life of the asset is interpreted as 75 per cent under US GAAP. Similarly, the criterion under IFRS (and Indian GAAP), relating to present value of minimum lease payments amounting to substantially the fair value of the asset is interpreted as 90 per cent under US GAAP.

The risks and rewards approach is an ‘all or none’ approach to capitalisation of leases. It suffers from the drawback that very similar lease arrangements could receive significantly different accounting treatments. Experience suggests that through innovative lease structuring, it is possible to avoid capitalisation of leases, thereby diminishing the effectiveness and basic objective of the lease standard.

Lacking in transparency

How different is a lease with a term of 74 per cent of economic useful life and present value of minimum lease payments amounting to 89 per cent of fair value from a lease with a term of 75 per cent of economic useful life and present value of minimum lease payments amounting to 90 per cent of fair value. Yet there is every chance that the former gets classified as an operating lease and the latter a finance lease, which makes application of the risk and rewards approach lack substance and transparency.

The existing standards under IFRS (as well as Indian GAAP) and US GAAP result in the omission from the balance-sheet, of leasing obligations under operating leases that appear to meet the definition of a liability. Similarly, rights to economic benefits under operating leases that appear to meet the definition of an asset are also excluded. This is a major criticism against the risks and rewards of ownership approach as it results in an override of the definition of an asset and a liability in the underlying framework of IFRS and US GAAP.

Joint project

Considering the above issues, the IASB and FASB decided to undertake a comprehensive joint project to improve lease accounting. Another reason for the joint project was that though IFRS and US standards follow the same basic risks and rewards of ownership approach, yet there were several minor differences between the two standards that require to be eliminated.

The paradigm shift the two Boards are considering is the use of a ‘rights and obligations’ model as opposed to the ‘risks and rewards’ model. Under the former, the lessee recognises an asset for the right to use the leased item over the lease term and the obligation for the lease payments. The lessor recognises an asset for the right to receive payments over the lease term and derecognises a portion of the asset subject to the lease so that the residual interest in the asset remains in the financial statements.

The paradigm shift has significant consequences. In the case of a lessee, the arbitrary classification between a finance lease and an operating lease becomes irrelevant and all leases, whether finance or operating, are reflected in the balance sheet of the lessee using the ‘rights and obligations’ model.

In summary, the Boards have agreed that:

the distinction between an operating lease and a finance lease would be done away with;

irrespective of whether the arrangement is a finance lease or an operating lease, the lessee would recognise all rights and obligations conveyed by the lease arrangement at inception of the lease; and

the lessor would report separately a financial asset for the recoverable from the lessee and the residual interest in the leased asset.

The IASB and FASB had several rounds of discussion on the joint project, but progress has been slow. For a complex accounting standard, such as leasing, and that too with a complete paradigm change, it is likely that it would take several years before a new global standard on leasing takes birth.

(The author is Partner, Ernst & Young Pvt. Ltd. The views are personal.)