The accounting treatment of foreign currency contracts is in itself a known and accepted procedure within IFRS regulations.
However, for operating leases, both existing at transition and new transactions thereafter, new and unexpected elements emerge, such as:
- the currency risks and the exchange rates to be used,
- starting moment of the foreign currency lease,
- applicable discount rate for the initial value,
- the separate reporting of leased assets.
The above elements are further elaborated below.
Currency risks and exchange rates
Under the existing IAS17 regulations, operating leases only result in an expense charged to the income statement (P&L). A company/entity can offset currency risks by generating cash-in (income) in the same foreign currency as the cash-out for the lease payment. Income items are usually recognised at the average exchange rate of the relevant period (usually month) in the Profit and Loss Accounts. So, both the periodic lease costs are booked at the average exchange rate of the period, as well as the foreign currency income in the same period. The effect is no or minimal currency risk.
Under IFRS16, the recognition on the balance sheet of 'a value' for lease transactions (concluded in foreign currencies) leads to a standardised treatment, as for any asset, expressed in the reporting currency* of the entity. Nothing changes in terms of cash flows; however, the balance sheet value (after periodic depreciation) of leased assets again** takes a different outcome from the valuation (after deduction of the lease redemption amount) of the lease obligations.
In other words: Leased assets are 'frozen' at the currency exchange rate at the inception of the lease, while the lease liabilities are calculated at the currency values of the successive subsequent reporting dates. The resulting depreciation charge of the assets in subsequent periods is a fixed amount in the reporting currency (i.e. at the exchange rate used at the inception of the lease), while the periodic repayment is recorded at the average exchange rate of the relevant period.
Starting moment of the foreign currency lease
The administrative starting moment is the next element of a foreign currency lease to look at. Under the existing rules, partial investments of foreign currency assets have to be converted at the currency exchange rate of the moment of that part of the transaction becoming final: a down payment on day 1 at the exchange rate of day 1; the delivery/payment on day 59, at the exchange rate of that day. Thus, the value of the acquired (non-monetary) asset may consist of a set of partial values.
In the case of leases, especially operating leases, which we focus on in this series of articles, the transaction only takes place (starts), if the delivery is confirmed by the recipient by signing an acceptance certificate. In this acceptance certificate, the recipient of the asset confirms that the item in question has been received in accordance with the ordered specification and is in good working order. A lease will not be established without acceptance.
If we consider the above in assessing the time of conversion of the foreign currency lease, only the exchange rate of the date of acceptance should apply. Any previous advance payments are only outstanding receivables, being pre-financings, i.e. monetary assets.
Applicable discount rate for initial value
The initial value of a leased asset is derived from the initial value of the lease liability. In a foreign currency lease transaction, there is every reason to believe that the periodic lease payments are calculated by the lessor using an interest rate appropriate to the 'foreign currency'.
On the one hand, it would be logical for a lessee also to apply a foreign currency discount rate to the contract for its foreign currency lease obligations. On the other hand, a lessee may consider, when the initial lease liability is calculated by using the incremental (marginal) interest rate, not to apply its lessee-specific interest rate in its own (functional) currency, but perhaps on the basis of the reporting currency
This may create discord in the treatment of leases
- where the implicit interest rate is used in the lease (preferred by the IASB, but actually only applicable to regular finance leases),
- where the incremental interest rate is used, with freedom of choice for the lessee as to which (foreign or non-national) discount rate to use.
Also, a follow-up question might be raised in this discussion which is all about integrity: is the entity only compensating (existing or planned) foreign currency income with lease liabilities in the same foreign currency, or is it steering the entity towards better ratios by opting for a foreign currency lease transaction that enables these secondary objectives.
This behaviour should be guided well by a management decision in this respect, making starting points clear and verifiable.
Reporting leased assets, separately from other non-monetary assets
For lessors, almost everything will remain the same as with the old IAS17 and for lessees, the current finance leases under IAS17 are already monetary liabilities, while the assets are treated as non-monetary items.
IFRS16 aligns the accounting treatment of operating leases with that of existing finance leases. The dilemma is clear: Leased assets are similar to PPE*** assets, which are non-monetary assets. Is the combined reporting together with other PPE assets on the balance sheet preferable, with further breakdowns in the notes? Or should leased assets be disclosed separately in the balance sheet because a primary (balance sheet) disclosure contributes to the understanding and transparency desired by IFRS16
* For convenience, the reporting currency and functional currency of the parent/holding company are regarded as the same. The reporting and functional currencies of foreign entities will often differ (exception: the euro area).
** ‘Again’ in the sense that for leases entered into in the entity's own reporting currency, there will also be a difference between the value of assets and liabilities, known as the front-loading of costs. This aspect of front-loading will be further shown during the topic of ‘Discount rates’, later in the series of articles.
*** PPE: Property, Plant and Equipment: Real estate, Production installations and Equipment.
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).