The past week has brought mixed news on the outlook for the planned new global lease accounting standard. Most importantly:
• It now seems clear that the standard, requiring wholesale capitalization of leased assets on the lessee's balance sheet, will at last be finalized this year, although probably not for at least six months yet; and
• the possibility of a major exception for small ticket leases has now disappeared; but
• in many jurisdictions, the SMEs who comprise the great majority of lessees may not have to apply any of the new rules for almost seven years yet; and
• the rules for applying capitalization to leases already running at the future adoption dates of the new rules will be easier than proposed earlier.
At this near-final stage of the project, the two standard setting bodies have been deliberating separately on the various issues. They cover areas where there is likely to be divergence between the two versions of a largely converged standard, in international financial reporting standards (IFRS) as determined by the International Accounting Standards Board (IASB), and in US GAAP as determined by the US Financial Accounting Standards Board (FASB).
The latest decisions last week were taken by the IASB, and will therefore affect a large number of jurisdictions including the European Union where listed companies are required to follow IFRS.
Small ticket exception
The IASB has confirmed its initial tentative decision in March last year to specify only a limited exception to the lessee capitalization rule for the most low-value leased assets. This will apply to leases of assets which, when the asset is new, would have a capital value of less than $5,000. The exception will not apply where the asset is “dependant on, or highly interrelated with, other leased assets”.
Application guidance to be issued with the standard is likely to suggest that among typical leased assets only office furniture and mobile phones, and not motor vehicles or multifunction copier machines, would fall within this asset size exemption. It will be specified that the $5,000 level is determined at the date when the standard is to be issued, thus implying that it should keep pace with any subsequent general price inflation in the US dollar.
Some further work remains to be done on the drafting of this guidance. IASB members were concerned that the small assets exception, at an absolute value unrelated to the size of the lessee entity, will be appropriately distinguished from the “materiality” condition that will apply as in all accounting standards and which does take account of the overall scale of the reporting entity's activities.
Because of the materiality rule, sizeable lessee companies will be able to avoid capitalizing some leases where the asset values would be above the $5,000 level of the specific small asset exception.
It now seems certain that FASB will adhere to its own earlier tentative decision to have no specific small assets exception. During an outreach exercise on this conducted by both Boards within the past year, among lessees, lessors and other interested parties, FASB's Investor Advisory Committee opposed the idea of any such exception, even though that body had earlier expressed opposition to the whole project for new lease accounting rules.
US GAAP nevertheless embodies a general materiality rule in the same way as IFRS, so this will be relevant to some small ticket leases for sizeable lessees.
The effective date of the new standard still remains to be decided. The most likely general effective date – i.e. the date from which it will apply to all accounting periods ending on or after the date – now looks likely to be either January 1 2018 or a year later.
However, for most lessees in IFRS jurisdictions, which are not listed companies, the effective date now looks likely to be much later. This results from another IASB decision last week on future reviews of the separate IFRS SMEs accounting standard. This is a simplified standard, which omits some other general IFRS rules although it includes the full terms of the current IAS 17 leasing rules.
The extent to which companies can use IFRS SMEs may be limited by local company law provisions. Subject to these, the IASB itself permits its use by all unlisted companies. In most IFRS jurisdictions, all such companies can use it – although not all make this election, and the choice between full IFRS and IFRS SMEs must be made consistently across all the accounting rules.
Some months ago the IASB finalized a revised edition of IFRS SMEs effective from January 2016. Since the new leasing standard was not then finalized, this edition will still incorporate IAS 17. The Board has now decided on the programme for subsequent updates of IFRS SMEs. Its public commitment will be for update intervals of “not more frequently than approximately three years”. The Board's working target, however, will be for updates of only once every six years.
The only firm decision is that IFRS SMEs will still incorporate IAS 17 rather than the new leasing standard for the foreseeable future. It does seem likely that the first IFRS SMEs update after the new leasing standard is finalized will make the transition to the new rules. However, it now looks as though that will not become effective until perhaps January 2022.
Transition rules for operating leases
Although the main effective date of the new standard is not yet agreed, the IASB has now agreed most of the IFRS rules for applying the new standard to pre-existing leases which will still be running at the “dates of initial application” (DIAs) of the new standard. For some companies, the DIA will be the same as the effective date.
However, in many jurisdictions public listed companies are required under local law to provide comparative figures on the new basis for one or more years before any new accounting standard becomes effective, alongside their main accounts for those periods on the old basis, to illustrate the effects of the changes of rules.
The most difficult transition issue has always been lessee accounting for currently off-balance-sheet operating leases. It is particularly challenging in IFRS since, following last year's failure of the two Boards to converge on the new profit and loss account treatment of today's operating leases, the IASB (though not FASB) will be requiring a move to finance lease type expensing for these leases.
The Boards have never been receptive to the idea of non-retrospective treatment for all running leases, as urged by many equipment leasing industry bodies. This is perhaps partly because the standard applies to real estate leases where pre-existing contracts will run for a great many years after the change. However, the IASB has now agreed significant changes, calculated to ease the cost of transition for lessees, to the “modified retrospective approach” (MRA) proposed in the 2013 exposure draft.
Under the new MRA proposal, there would firstly be an exemption from retrospection for those leases terminating within 12 months after the DIA. Where leases have continuation options, termination periods for this purpose would be determined on the same basis as for the agreed “short term lease” exemption, which will allow leases not to be capitalized where their whole term is for less than 12 months – i.e. according to whether the lease is more likely than not to end before the relevant date. For these exempted early terminating leases, costs will have to be disclosed together with those of the short term leases, in notes to the accounts.
A further agreed concession under MRA, described as “cumulative catch-up”, will be of particular benefit to those required to produce two years of comparative figures for periods between the DIA and the effective date. They will not have to restate the comparative lease expense figures. Instead they would recognize the cumulative effect of initially applying the new standard as an adjustment to the opening balance of retained earnings, in the period that includes the DIA.
For the measurement of those operating leases that do have to be accounted for under the new rules, the MRA will require the lease liability to be recognised at the present value (PV) of the remaining lease payments, discounted using the lessee's incremental borrowing rate (IBR) at the DIA. For the measurement of the “right of use” (ROU) asset, there will be a choice of two methods that can be made on a lease-by-lease basis. The lessee can either:
• measure the asset as if the new standard had always been applied, but using a current IBR based discount rate as for the liability; or
• measure the asset so as equal the liability, adjusted by the amount of any previously recognized prepaid or accrued rentals.
The first of these approaches would be the more costly to apply, while the second would result in higher subsequent amortization expense. The staff report anticipated that lessees might choose the first method for high value leases with long remaining periods, and the second for high volume, small ticket equipment leases.
For the disclosures in notes to the accounts, the MRA rules in respect of operating leases on transition will need to be further considered due to a disagreement among Board members on the solution recommended by the staff. Data on operating lease commitments, without PV discounts, already has to be disclosed under existing rules. The purpose of the transition disclosure rules will be to allow account users to distinguish any changes resulting from the new standard (as between the old disclosures and the new balance sheet numbers), from the effect of any changes in leasing activity during the reporting period that includes the DIA.
The staff had recommended disclosures on the following lines:
• the operating lease commitments that would have been reported under IAS 17 at the end of the first annual reporting period including the DIA;
• the weighted average IBR at the DIA;
• explanation of significant differences between the result of discounting the disclosed operating lease commitments under IAS 17 at the above IBR at the end of that period, and the lease liabilities recognized under the new rules at the same date; and
• the rental expense that would have been recognized under IAS 17.
Some members suggested changing this recommendation so as to apply the liabilities data to the beginning, rather than the end, of the relevant year. They accepted that in that case it might be necessary to delay the effective date to 12 months after the date that might otherwise be adopted. This will be reconsidered later.
It was agreed that lessees will have the option of a fully retrospective approach, restating all the relevant running leases under the new rules from the dates of their inception, instead of MRA. This election will not be on a lease-be-lease basis, but must be applied across the board. It seems unlikely that many lessees will opt for full retrospection.
Other transition issues
In lessor accounting, both Boards agreed last year to require few substantive changes under the new standard, so that the current distinction between finance and operating leases will continue. The IASB has now agreed that current lessor accounting can be “grandfathered” for leases running at the DIA, with no retrospective application, except in the case of sub-leases.
With sub-leases, the lease classification of each existing operating sub-lease must be reassessed by the intermediate lessor at the DIA. In accordance with a rule agreed earlier by the IASB, this reassessment will be by reference to the ROU asset in the head lease, rather than the underlying asset; and it will be based on the remaining contractual terms of the head lease and sub-lease. Where this reassessment results in a change in lease classification, the lessor must account for a new finance lease entered into at the DIA.
The IASB also agreed simplified transition rules in relation to sale and leaseback deals. For the purpose of determining whether a sale and return lease is recognized by each party (i.e. seller-lessee and buyer-lessor), rather than treating the transaction as a refinancing of the asset, the Boards have already agreed that the new standard will change the rules. However, the IASB has now agreed that there will be no reassessment of historic deals for this purpose where the lease is still running at the DIA.
The Board also agreed that in accounting by the seller-lessee, there will be no retrospective accounting specific to sale and leaseback. Each of these leases will be subject to transition rules on the same basis as for other lease of the same classification. Thus those previously accounted for as operating leases will be subject to the rules described above while accounting for finance leasebacks will be grandfathered.
On the definition of a lease, the two Boards have also previously agreed substantial changes under the new rules, in determining whether a contract comprises or includes a lease, or whether it is a pure service contract outside the scope of the leasing standard. These changes affect both the supplier (i.e. putative lessor) and the purchaser (i.e. putative lessee).
The IASB has now agreed that for transition purposes on contracts running at the DIA, there can be grandfathering of existing lease definition determinations under the IAS 17 and IFRIC 4 rules. As an alternative to applying the new rules to the running contracts, this will be an elective option; but it must be applied by each party across the board rather than lease-by-lease.