The two joint standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) – have now at last finalized all their decisions on the new lease accounting standard. It should be published shortly, in different versions for international financial reporting standards (IFRS) and for US GAAP.
The far reaching changes in lessee accounting will include the capitalization of nearly all of the presently off-balance-sheet operating leases.
However, on some key aspects the two Boards failed to achieve convergence, especially on the profit and loss (P&L) account treatment of those leases presently classified as operating leases. In IFRS these will be accounted for on the same basis as finance leases, with front-end loading of the costs; while in US GAAP they will continue to be accounted for on a straight line basis.
For public companies, the main start date of the new standard will be in around three years' time. For those subject to IFRS, it will become fully effective for annual accounting periods starting on or after January 1 2019. The corresponding main start date in US GAAP will be for “fiscal years” starting after December 15 2018, including interim periods within those years.
The new standard will apply to leases running at the start dates, though the agreed transition rules for operating leases are designed to minimize the potential disruptive effect of this retrospective application. Under national or European laws, listed companies may also have to provide either one or two years of comparative data on the new basis for the period before the main starting date, in notes to their main accounts.
Most private companies, who account for the great majority of lessees, will have significantly longer periods to adapt. The IFRS SMEs standard will continue to incorporate the current IAS 17 lease accounting standard, with operating leases remaining off-balance-sheet, for some years after 2019. IASB rules permit all unlisted companies to use IFRS SMEs, though their ability to make use of this option in some countries may be restricted by national laws.
The IASB has yet to decide that the new leasing standard ever will be incorporated into IFRS SMEs. It seems likely that it will eventually be so, but in the light of the agreed review cycle for that standard this would probably not become effective until accounting years starting from January 2022.
In US GAAP private companies will have to apply the new leasing rules a year later than public companies (i.e. for account years starting after December 15 2019); and where they produce interim figures, those will not be affected for a further 12 months.
Both Boards have decided to permit voluntary early adoption of the new standard once it is released. However, in the IASB's case this has been made subject to the new leasing rules not being applied before the provisions of the new IFRS 15 revenue recognition standard, which will have some interface with the new leasing one particularly in respect of the sale and leaseback rules.
Over the past two months the Boards have resolved some final “sweep-up” issues within the detailed rules. These emerged when their draft versions of the final standard were reviewed by outside parties over recent months.
Most of these final decisions involved either IFRS or US GAAP only, since they were in areas where there is non-convergence either in earlier related decisions on the leasing standard, or in analogous parts of other accounting rules.
Modified lease periods
However, one such issue addressed by both Boards concerned contract modifications to extend the period of a lease. Under the earlier draft it was seen that the accounting treatment of such contractual changes, normally giving rise to recognition of a new lease for the extension period, would have been sometimes inconsistent with that of lease extensions exercised as an option under the original lease.
The difference between treating such a modification as a new lease or an extension of the existing lease lies in the timing of the recognition of any resulting increase in lease assets and liabilities. If the modification were treated as an extension of the original lease, consequent balance sheet changes would be recognized at the date when the modified terms were agreed. However, if it were treated as a new lease, those changes would be recognized only from the start of the extension period, which could be much later.
Both Boards have now agreed that a contract modification extending the term should normally be accounted for as a continuation of the original lease. The alternative treatment of accounting for it as a new lease will apply only where the modification adds the right to use one or more additional underlying assets as well as extending the term.
This will apply to both the lessee's lease asset and liability, and the lessor's asset in the case of a finance lease. Lessor accounting will not be much changed under the new standard; and in the case of an operating lease lessors' balance sheet recognition will continue to be based on the underlying asset rather than the lease receivables.
Floating rate variations (IFRS)
For the IFRS version of the new standard the IASB has reconsidered lessee accounting for leases with floating finance rates based on benchmarks such as LIBOR, in circumstances where rates change from one accounting period to the next. This did not require further consideration by FASB, since that Board decided earlier not to require periodic remeasurement of lease liabilities where payments change because of changes in an index or rate.
The earlier IASB decision was for remeasurement of lease assets and liabilities where the rate has changed, but without adjusting the discount rate to be applied to the future payments (to reduce them to a present value (PV)) compared with the discount rate determined at lease inception. External reviewers pointed out that this treatment would be inconsistent with that of floating rate loan agreements under the IFRS 9 accounting standard for financial instruments, where the effective interest rate is remeasured when the future cash flows under the instrument are re-estimated.
The IASB has now decided that a lessee should update the discount rate for a floating rate lease wherever the lease payments are updated due to a change in the interest rate benchmark. While the required adjustment to the discount rate could be viewed as an additional compliance step, it will normally result in there being no significant change in the carrying amount of the lease asset or liability. For a change in either direction in the level of market interest rates would normally give rise to broadly matching changes in both the future lease rentals and the PV discount rate.
Classifying used equipment leases (US GAAP)
As agreed earlier, the classification of leases into finance and operating leases is being retained by both Boards in the case of lessor accounting where there will be little change to current rules. FASB is also retaining lease classification for lessees, because of its decision for split P&L expensing models.
The two Boards agreed to converge on the current US GAAP version of the lease classification rules, in the Topic 840 (formerly FAS 13) standard, rather than the current IFRS version in IAS 17. The new rule will therefore contain specific numerical tests that are absent from IAS 17.
In current US GAAP a lease is generally classified as a finance lease if (among other qualifying conditions) either the lease term is 75% or more of the estimated remaining economic life of the underlying asset, or the PV of the rentals is 90% or more of the asset's fair market value. However, both of those tests are dis-applied (leaving only other conditions relating to eventual transfer of title) for used assets leased in the last 25% of their useful lives – which mainly affects used equipment leases, though in principle it is also applicable to real estate leases.
At the recent final review stage, however, FASB agreed a non-convergent variation to the rules for used assets. In the new US GAAP version, the 90% PV test will not be dis-applied for used assets, but the 75% remaining life test will be dis-applied for assets leased “at or near the end” of their useful economic lives. Guidance to be issued with the standard (though not the text of the standard itself) will effectively refer back to the current rule, by indicating that one reasonable application of the new rule would be to determine that assets are near the end of their lives if in the last 25% of economic life.
However, the future IFRS version of lease classification (affecting lessor accounting only) will be in line with present rather than future US GAAP.
Other final decisions (IASB)
The Boards had not previously agreed any specific requirements (apart from those concerning usage-based lease payments) relating to a lessee's obligation to return an asset in a specified condition, or to provide for the cost of dismantling or removing the asset, at the termination of the lease. External reviewers consulted by the IASB pointed out that this was inconsistent with corresponding requirements in respect of assets owned by the reporting entity in other IFRS standards (i.e. IAS 16 on accounting for property, plant and equipment, IAS 37 on provisions and contingent liabilities and assets and IFRIC 1 on de-commissioning, restoration and similar liabilities).
The IASB has now agreed that the IFRS version of the standard will specify that where a lessee has restoration obligations associated with a lease, these should be accounted for in accordance with IAS 37. An estimate of the costs to be incurred will be recognized as a provision, and accounted for in the initial measurement of the “right of use” (ROU) asset, though not presented as lease payments. Changes in the measurement of such liabilities within the lease term will be accounted for as adjustments to the carrying value of the ROU asset, subject to this not being reduced to less than zero.
A further issue arising in the external review of the draft IFRS version of the new leasing standard concerned accounting for business mergers, in the case where the acquired company has commitments as a lessee which, prior to the merger, would not have had to be recognized on the balance sheet under the new standard. These would be either “short term leases”, i.e. with a remaining term of less than 12 months (to be exempt from capitalization under both the IFRS and US GAAP versions) or assets of very low value (which will have an additional exemption in the IFRS version).
The external review draft did not propose to require the acquirer company to recognize assets or liabilities for these leases. However, reviewers noted that this would represent a change from a current feature of IFRS 3 on accounting for business combinations. This requires the acquirer to recognize an intangible asset where the acquiree has an operating lease which (though it would be off-balance-sheet prior to the merger under current rules) has rental terms which are particularly favourable relative to market terms – and conversely to recognize a liability where such terms are onerous compared with market terms.
The IASB has nevertheless decided that the IFRS 3 merger requirement should not be retained in respect of favourable or unfavourable terms for those leases that remain off-balance-sheet under the new standard. In line with their staff recommendation, they felt that any resulting overstatement or understatement of goodwill on business acquisitions would probably not be material in the light of the likely values of these lease commitments.
Other final decisions (US GAAP)
Two of FASB's decisions in recent weeks relate to lessor accounting in “sales type” (i.e. finance) leases. Both represent divergent moves compared with the corresponding IASB decisions for the IFRS version.
FASB's review draft had proposed that initial direct costs (IDCs) incurred on these leases should be recognized up-front. However, it has now been agreed that IDCs will be deferred and recognized over the lease period in cases where the lessor recognizes no selling profit or loss on the asset – which will generally be the case for all except “captive” equipment lessors.
On lessors' balance sheet presentation of these leases, the review draft had proposed an elective option for presenting the breakdown of total assets as between lease receivables, residual values and (in the case of captives) any deferred selling profit – this breakdown being either presented on the face of the balance sheet or disclosed in notes to the accounts. However, FASB has now agreed to mandate the presentation of only the aggregated total, with the components to be disclosed in the notes.
Also in recent weeks FASB considered, but rejected, the possibility of significant easements in the new lease capitalization rule for non-public company lessees.