A new bargain on leases

Yogesh Sharma | Updated on August 18, 2013

Leasing is a common business transaction that most companies undertake. Under IFRS (International Financial Reporting Standards) and Indian GAAP (generally accepted accounting principles), the current accounting for leases generally follows the classification of the lease as ‘operating’ or ‘finance’. The accounting for an operating lease is straightforward while it is slightly complicated for finance lease, as it involves balance sheet effects based on complex mathematical calculations. Well, it is going to get more complicated as lease accounting is proposed to be changed and operating leases will be accounted similar to finance leases.

In 2006, the IASB (International Accounting Standards Board) — the IFRS standard-setting body, and its US counterpart — the FASB jointly undertook to improve accounting for leases. The IASB recently issued the exposure draft of the new IFRS standard.

Here, lessees shall recognise on the balance sheet all leases exceeding 12 months — it’s what the exposure draft calls the ‘right of use’ model. The lessee shall recognise lease liabilities with corresponding right-of-use assets.

Lessees thereafter shall recognise and measure the expense based on the classification of lease. But the classification is no longer determined as operating or finance. The exposure draft proposes a new classification largely based on the nature of the underlying asset, and whether the asset is consumed or not by the lessees during the lease term, and accordingly,

most leases of equipment or vehicles would be classified as Type A; and

most leases of property would be classified as Type B.

For Type A leases, the lessees will recognise expense comprising the amortisation of the right-of-use asset and interest on the lease liability, and the total expense will vary from period to period. For Type B leases, the lessees will recognise expense comprising the lease payments, and the total expense will be the same for each period.

Thus, for lessees, while the balance sheet effect will change for all leases, the profit or loss impact for Type A leases will be similar to the current accounting for finance leases, while for Type B leases it will be similar to the current accounting for operating leases. This is a fundamental change, as the current operating lease accounting will be restricted to most property leases in future.

Let us consider the example of a two-year lease of IT equipment for $100 a year. Assuming operating lease classification under current guidance, the lessee will not recognise any asset and will simply expense the lease rental over the lease term. However, under the proposed accounting, the lessee has to recognise a right-to-use asset and lease liability of $173.55 (assuming a discount of 10 per cent) as the current value of lease payments. Subsequently, the lessee shall recognise interest expense of $17.36 and the amortisation of right-to-use asset of $86.78, the total expense being $104.13 in the first year. The total expense in the second year will be $95.87. This clearly illustrates the difference in accounting from the changes proposed.

For lessors, too, the classification between most property and most equipment leases shall be similar. Type A leases will be accounted similar to current accounting for finance leases — that is, the lessor will

recognise a lease receivable and a retained interest in the underlying asset, and derecognise the underlying asset; and

recognise interest income on both the lease receivable and the residual asset over the lease term.

Type B leases will be accounted similar to current accounting for operating leases — that is, the lessor will continue to report the asset being leased, and would recognise income for the lease payments on a straight-line basis.

These changes will have far-reaching effects, much beyond accounting. It will change the way key financial ratios are evaluated and financial performance is measured. It will also have a bearing on the critical covenants in financing arrangements. The changes to lease accounting will also impact how such contracts are priced and negotiated, and the ‘lease or buy’ decisions. Thus they would not only significantly affect the balance sheet of companies, but also change the way businesses are financed and operated.

The exposure draft is available on the IASB Web site for public comments until September 13, 2013; the final standard is expected to be effective in 2017, with a retrospective application date of January 1, 2016. The impact may not be immediate for Indian companies reporting under Indian GAAP and not IFRS. However, given that Indian GAAP will eventually be converged with IFRS, and that most leasing arrangements are negotiated for long terms, companies should at the earliest evaluate the terms of the proposals and their effect on the balance sheet.

The author is Partner, Assurance, Grant Thornton India LLP

Published on August 18, 2013

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