Following the publication last week of the new lease accounting standard IFRS 16 by the International Accounting Standards Board (IASB), the US version of the partially converged standard will be released during February by the US Financial Accounting Standards Board.
The detailed requirements in these standards bring few surprises, following the public deliberations by the Boards over the period of nearly 10 years since lease accounting came on to their agenda, and particularly since their last exposure draft of the standards in 2013.
However, the IASB has provided some revealing data and commentary in an impact assessment released with IFRS 16.
The IASB has also confirmed that in most countries covered by international financial reporting standards (IFRS) SMEs, who account for the bulk of the lessee base in terms of business numbers, may not have to worry about the new accounting rules for some years to come.
For those companies who are affected, the main features of the global new rules are:
• The currently off-balance-sheet category of operating leases, with substantial residual value (RV) asset risk held by parties other than the lessee, will in future have to be capitalized by lessees based on a “right of use” (ROU) asset and a corresponding financial liability;
• The Boards have nevertheless failed to achieve convergence on the profit and loss (P&L) account treatment of these current operating leases. Under IFRS 16 they will be aligned with current on-balance-sheet finance leases, with a front loaded expense profile comprising finance charges and depreciation. Yet in US GAAP the P&L treatment will stay as it is for operating leases – a level cost profile presented as a single rental expense;
• The lessor accounting rules will stay much as they are, after the Boards dropped earlier plans for radical changes to match the lessee side;
• Because of the above decisions, the classification of leases into finance and operating leases will be retained in lessor accounting in both IFRS and US GAAP, but removed for lessees under IFRS while staying for both parties in US GAAP.
Under the IASB's own rules, all unlisted companies using IFRS may choose to apply the simplified “IFRS for SMEs” standard, though in some jurisdictions the law may restrict that option. For the foreseeable future, IFRS for SMEs will include the current IAS 17 lease accounting rules, with operating leases still off-balance-sheet.
European Union (EU) law does not permit the use of the IFRS for SMEs standard by those EU-based companies using IFRS, but it does permit all unlisted companies to use national GAAP rules in place of IFRS. So far the national standard setters in Europe have made no move to align their GAAP rules with IFRS 16. The IASB considers that few SMEs in the EU are likely to be using IFRS currently.
Unlisted companies in IFRS jurisdictions outside Europe could be affected in future by any move to amend IFRS for SMEs to include IFRS 16. However, on the IASB's current plans for periodic reviews of IFRS for SMEs, such a change is not likely to become effective before January 2023. The IASB now says that any incorporation of IFRS 16 into IFRS for SMEs would be subject to full public consultation, and might not be judged necessary on cost/benefit grounds.
For these reasons the Board's impact statement states: “The IASB does not expect a large number of smaller companies to be affected by IFRS 16”.
SMEs and other unlisted companies in the US will be subject to the US GAAP version of the new standard. However, they will have a rather longer run-in period than listed companies; and as with all US lessees they will not face the same P&L adjustments as those subject to IFRS.
The overall impact
The overall impact of capitalizing operating leases will be considerable, especially in those commercial sectors that make most use of either equipment or real estate leases. The IASB estimates that for all listed companies reporting under either IFRS or US GAAP the discounted present value (PV) of future obligations on operating leases – equating with the balance sheet value if they had to be capitalized – is currently $2.18 trillion.
For specific lessee sectors, the IASB has estimated these PVs of operating leases as a proportion of their current total balance sheet assets. These ratios come to:
• 22.7% for airlines and 11.6% for “general transport”, the two sectors making most use of equipment leases; and
• 21.4% for retailing and 20.7% for “travel and leisure” (hotel groups etc), the two making most use of real estate leases.
Those subject to IFRS will also suffer a loss of equity from having to recognize the lease expense on a more front-loaded profile. An IASB analysis shows that assuming an evenly distributed portfolio of leases - in terms of commencement and termination dates within each accounting period - with an average lease period of 15 years (an assumption that reflects the mix of real estate and equipment leases) and a 5% average discount rate, lease liabilities under IFRS 16 would exceed lease assets by a margin of around 10%.
Giving an illustrative example for a typical airline, even assuming that 80% of its leases were already on-balance-sheet as finance leases, with total assets presently valued at some $70 billion under IAS 17, the IASB calculates that the company's equity would fall from $15.4 billion to $13.9 billion through changing to IFRS 16.
Timetable and transition
IFRS 16 will come into force for accounting periods (including half years or quarters where relevant) starting on or after January 1 2019. The US GAAP will take effect at around the same time (for periods starting on or after December 15 2018) for listed companies, and a year later for other companies.
Through variable national laws governing any changes in accounting rules, listed companies in most jurisdictions will face “dates of initial application” (DIAs) for the new leasing standard prior to the main effective date. For comparative information on the new basis will have to be disclosed in notes to the accounts, for certain periods for which the existing rules remain in force. For EU listed companies the DIA will come one year before the effective date, and for US ones it will be two years before.
The new rules must be applied retrospectively to pre-existing leases that have more than 12 months to run as at the DIA. For lessee accounting for operating leases the IASB is allowing a “modified retrospective approach” (MRA) to transition. This avoids the complexities of a fully retrospective approach, restating comparative information back to the start of all these running leases, while also avoiding having to recognize a sudden loss of equity at the time of the switch to front loaded expense on running leases.
Though the fully retrospective approach will be allowed as an option, it seems likely that most lessees will opt for MRA. Under this approach, the opening equity is adjusted in place of restating prior comparative information. The lessee will have a free choice, on a lease-by-lease basis, between measuring the ROU asset as if IFRS 16 had always applied, or measuring it at an amount equal to the current lease liability.
What is a lease?
One of the key issues in the new standard is the question of drawing the line between a service-inclusive lease, where the lease element of the customer's commitments must be recognized on-balance-sheet, and on the other hand a pure service contract that would not be regarded as including an “embedded lease” even though the use of specific equipment or property assets may be a feature of the contract.
The IASB considers that rather fewer contracts will be identified as containing a lease under IFRS 16 compared with current IFRS rules. Yet the issue becomes much more critical under the new standard. For under existing rules many “embedded leases”, if recognized as such, would qualify as operating leases where the accounting would be essentially the same for both lease and service elements.
However, in contrast with the retrospective principle that is generally applied to the new standard (see above) the new tests for identifying a lease need not be applied to leases already running at the DIA, provided they have been correctly accounted for under the previous rules.
The overall principle in IFRS 16 is that a lease must be recognized (by both parties) where fulfilment of the contract:
(a) depends on the use of an identified asset; and
(b) gives the customer the right to control the use of that asset over a period of time.
The “right to control” will be focused on the ability of each party to affect “the economic benefits to be derived from use of the asset” during the period of its use. A lease must be recognized where it is predominantly the customer (i.e. the putative lessee), and not so where it is the supplier (or putative lessor), who has that ability.
The “identified asset” test is met where the supplier does not have a “substantive right to substitute the asset” with alternative assets during the contract. For such a right to be substantive, the supplier must be able to realize a net benefit by its exercise. The lessee accounting rule specifies that where the customer cannot determine whether a supplier's substitution right is substantive, it should be assumed not to be so.
As the new standard has taken shape, the commercial sectors where there has been most concern about parties to contracts having to recognize a lease for accounting purposes include shipping (in respect of typical ship chartering arrangements) and oil and gas drilling contracts. In its final form, in shipping the guidance in the standard seems likely to require typical time charters to be treated as leases (and therefore capitalized if not within an exemption for short term leases), but not so for typical voyage charters. Oil and gas drilling contracts seem more likely to have to be accounted for as leases (with the drilling contractor as lessor and the energy producer as lessee) in the case of exploration rigs rather than extraction rigs.
Small assets exemption
IFRS 16 – although not the US GAAP version of the new standard – will allow an exemption from the capitalization rule for low value asset types. This will b e restricted to assets with a unit value when new of less than $5,000. Among assets which may in practice be leased, this concession is likely to apply only to PCs and office furniture.
This exemption will operate in addition to the materiality condition that applies to all accounting standards (in both IFRS and US GAAP), whereby specific rules can be set aside for transactions that are not material in relation to the scale of operation of the reporting entity. Some larger lessees could be able to avoid capitalizing certain leases on materiality grounds even where the contracts are not within the scope of the small assets exemption.
Sale and leaseback
IFRS 16 contains a number of rules on accounting for sale and leaseback transactions. The most important of these concerns the question of whether the parties to the deal can recognize a sale and a return lease, or alternatively whether the seller/lessee should retain the underlying asset on its balance sheet with each party accounting for the transaction as a refinancing. This rule seems likely to bring some problems in practice.
For this purpose the new leasing standard cross-refers to a separate converged standard issued by the Boards last year on the subject of revenue recognition (IFRS 15, or Topic 606 in US GAAP)., which has rules as to whether and when the sale of any asset can be recognized. Within those rules are several criteria that could count one way or the other; none on its own being conclusive, in terms of sale and leaseback versus refinancing accounting.
In a typical transaction three of these criteria in IFRS 15 would appear to work in favour recognizing a sale, in that the buyer/lessor takes legal title to the asset, the seller/lessee has a “present right to payment” for the transfer and the buyer/lessor has “accepted” the transfer of the asset.
On the other hand another IFRS 15 criterion – the fact that the seller/lessee retains possession of the asset – would in itself count against sale recognition. A further criterion - whether the buyer/lessor has assumed “significant risks and rewards of ownership of the asset”- could operate either way, depending on the extent of any unguaranteed RV in the return lease.
The IASB now states that it “expects the number of sale and leaseback transactions to decrease with the implementation of IFRS 16”. However, it suggests that this is because the arrangement will be made less attractive by accounting changes where a sale is recognized – including the fact that lessees will have to recognize ROU assets on all leasebacks, and another change restricting the amount of any gain recognized from the sale – rather than because it will necessarily become more difficult to recognize a sale.
Following the Boards' earlier deliberations the US GAAP version of the sale and leaseback rules, though otherwise being convergent with IFRS 16, will contain one additional overriding rule. Where the return lease is a capital (i.e. finance) lease, a concept that will still exist in US GAAP for both lessees and lessors, that version will not allow the sale to be recognized.