uunk henk

In my previous Asset Finance International article I concluded that “… it looks very logical … to apply IAS 16 depreciation requirements: strictly linear depreciation”.

A staff member of the International Accounting Standards Board (IASB) responded to me by pointing out some of the relevant depreciation requirements in IAS 16 in particular paragraphs 60 – 62 of IAS 16:

“These paragraphs require the depreciation method used to reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. As you discuss in your article, the Board’s intent was to depreciate the right-of-use asset on either a straight-line basis or another systematic basis if that basis is more representative of the pattern in which the lessee expects to consume the right-of-use asset’s future economic benefits.”

I am more than pleased by the IASB’s response and accept that a staff member’s views are not formally those of the Board itself. However, noting that other depreciation methods may actively be considered opens the dialogue to discuss annuity based depreciation for lessees.

Annuity based depreciation

Annuity based depreciation to me is another systematic basis in which the lessee expects to consume the right-of-use asset’s future economic benefits.

Apart from the condition “if that basis is more representative of the pattern to consume …”, there is one more stipulation to consider. A last paragraph in the section on Depreciation method in IAS 16 says: “A depreciation method that is based on revenue … is not appropriate.”

Examples are given in that paragraph plus the comment: “The price component of revenue may be affected by inflation, which has no bearing upon the way in which an asset is consumed.”

It is my opinion that the concept of annuity based depreciation is fit for application, particularly for, but not exclusive to, the current operating leases.

Measurement of IFRS 16 leases that are currently operating leases

The initial measurement of IFRS 16 leases is, without particular items like one-time direct costs, etc, equal to the current value of the future unavoidable lease payments with leased assets equalling lease liabilities.

The lease liability subsequently follows a pattern of annuity based redemption. The difficulty with the new standard starts when the leased asset is not treated in a similar way, thus, for instance, by applying a linear depreciation.

As remarked at the start of this article, this linear depreciation is not the only depreciation method allowed. However, in the January 2016 IASB brochure Investor Perspectives – A new lease of life, it is stated:  “Lease assets are then depreciated in a similar way to other assets such as property, plant and equipment. This is expected to often result in a straight-line depreciation charge over the lease term.”

Again we have to accept that staff members views are not formally those of the Board itself, even when an introduction in the brochure is provided by one of the Board members. But apart from the formal disclaimer, the IASB points at the, expected, common linear treatment, not at alternatives.

Back to initial measurement: the carrying value of a leased asset is directly impacted by the discount rate applied which in turn has a direct link to the length of the payments period and the overall economic environment, amongst others inflation.

The depreciation of a leased asset, when performed on a linear basis, has no logical context to a linear depreciation of a similar asset in own use.

Particularly not so when the contracted period of use is way off the economic lifespan of the asset - as is the case in quite a lot of current operating lease contracts.

As an example, take two floors of office space in a 20-odd floors building. The lessee would never have the option to buy and, when renting, is faced with questions like: how much of the rent amount is related to services (lift, reception and toilet areas, water supply, etc.)?

Suppose the Life Cycle Costs (LCC) for the bare premises are 480 per annum, no indexing for inflation is agreed and payments are made annually in advance.

A calculation at a 7% discount-rate would result in:

Office space10 years 10 yrs 480 is annual (I+R=)Cash flow
Rent per year: 480        
Current value of future lease
payments @
7,00%        
Remaining years   (R) Redemption (I) Interest (D) Depreciation D+I=P&L acc.
10 3.607 261,1 218,9 360,7 579,6
9 3.346 279,4 200,6 360,7 561,4
8 3.067 298,9 181,1 360,7 541,8
7 2.768 319,8 160,2 360,7 520,9
6 2.448 342,2 137,8 360,7 498,5
5 2.106 366,2 113,8 360,7 474,5
4 1.740 391,8 88,2 360,7 448,9
3 1.348 419,3 60,7 360,7 421,5
2 929 448,6 31,4 360,7 392,1
1 480 480,0 0,0 360,7 360,7
0 -        
    3.607 1.193 3.607 4.800

In case of linear depreciation, the current annual charge to the profit and loss accounts of 480 would fluctuate between 579.6 and 360.7 and show the effects of front loading of costs.

The usage of the office floors may be constant, requiring linear depreciation when owned, the calculated initial value for a leased asset is as random as one can get. In operating leases, even more so in rented real estate, there is no contractual interest rate. And therefore, the lessee has to make a choice based on alternatives, applying an incremental borrowing rate for ‘similar’ situations.

Who would ever finance two floors of bare premises, with no additional services contracted?

So what is a proper incremental borrowing rate?

Is a discount rate as function of the rate on capital employed (ROCE), say 2/3, a proper standard? And would management be interested in reducing the length of a lease for office space in return for a higher annual charge?

To show what the impact on linear depreciation is of various discounts rates (7, 8, 10 and 15%), please see below examples of depreciation amounts per length of lease:

Office space10 years 10 yrs 480 is annual (I+R=)Cash flow
Rent per year: 480        
Current value of future lease
payments @
7,00% 7,00%  8,00%  10,00%  15,00% 
Remaining years   (D) Depreciation (D) Depreciation (D) Depreciation (D) Depreciation
10 3.607 360,7 347,9 324,4 277,0
9 3.346 371,8 359,8 337,9 292,7
8 3.067 383,4 372,4 352,1 309,6
7 2.768 395,4 385,6 367,2 328,1
6 2.448 408,0 399,4 383,3 348,2
5 2.106 421,2 414,0 400,3 370,1
4 1.740 434,9 429,3 418,4 394,0
3 1.348 449,3 445,3 437,7 420,1
2 929 464,3 462,2 458,2 448,7
1 480 480,0 480,0 480,0 480,0

The above table shows that for a five-year lease at a 10% discount rate, the yearly depreciation is 400.3. The same lease for 10 years at 10% discount rate has depreciation of only 324.4.

The initial values of the above examples are very different, while annual cash out in all cases is 480 per annum: 10 years @ 7%= 3,607; 10 years @ 10%= 3,244; 5 years @ 10%= 2,001.5.

Conclusion

The debate on applying annuity based depreciation should be (re)opened.It’s not the constant usage, reflected in a constant decline of the asset value, which should prevail. It is the constant cash out, reflected in a constant charge to the profit and loss accounts, which prevails. Leasing, after all, is different from owing an asset.

A constant cash out, recorded in the profit and loss accounts for the same amount, restores the comparability between companies. Even when, artificially, the cash out is split in depreciation and interest to satisfy purists in (asset) accounting.

As a result of annuity based depreciation leased assets are equal to lease liabilities at all times. Neither investors, banks nor analysts need to worry about understanding the financial statements: transparency is ensured. Lessees will be pleased since some of the onerous effects in disclosures and tax treatment will be eliminated.

With linear depreciation impairing the faithful representation during subsequent measurement of leased assets, and with comparability of initial values so affected by the length of a lease and the discount rate applied, why not simply apply annuity based depreciation?

As a final word: the new lease standard is proof of the belief by the IASB Board that lease transactions continue to result in another type of asset than assets in own use. So, depreciation of leased assets deserves to be different from depreciation of assets in own use.

This is well possible as overall, technically, the annuity based lease depreciation fits within the current wording of IAS 16.

Henk Uunk held the position of manager financial accounting and reporting at ING Lease Holding from 2004 to 2014. He is chairman of the accounting committee of the Dutch Leasing Association (NVL) and a member of Leaseurope’s accounting and taxation committee since 1992. Uunk is a contributor to the Dutch Accounting Standards Board working group on leases and acts as a consultant to the Dutch Car Leasing Association (VNA).