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Big Changes To Lease Accounting?

Published on Mon, Nov 16,2015 | 22:33, Updated at Mon, Nov 16 at 22:33Source : 

By: Vishal Seth, MD & Leader - IFRS and Financial Reporting Advisory, Protiviti India

Lease accounting has been under discussion between the global accounting bodies (IASB and FASB) for quite some time now. The two bodies have jointly been evaluating the current accounting guidance under respective accounting rules (IFRS and USGAAP respectively) and working jointly to reach a consensus with an objective to reflect the true substance of a lease transaction, particularly in the books of the lessee of leased asset/s. One of the key objectives of the joint project has been to assess whether a lessee of a leased asset should record such asset on it’s balance sheet, irrespective of the nature of the lease ie; whether it is a finance or an operating lease.

As per the recent update, it is highly likely that the new standards under IFRS and USGAAP will be rolled out by December’15. IASB has agreed to make the proposed new standard under IFRS (IFRS 16) to be effective from financial years starting on or after 1 January 2019 with early adoption permitted, if a company early adopts IFRS 15-Revenue from Contracts with Customers. FASB has not yet decided the date of the roll out.

Some provisions that would significantly impact a lessee once the new proposed standard becomes applicable, include:

Recognition of an asset on the balance sheet irrespective of finance or operating lease:

Under current accounting standards no asset has to be recognized in the books of the lessee when a lease is recognized as an operating lease. However under the proposed amendments, both bodies have agreed to classify the “Right of Use” (ROU) as an asset in the books of the lessee, with a corresponding lease liability, irrespective of whether the lease is classified as an operating or a finance lease. This is subject to exemption provided to short term lease arrangements (equal to or less than 12 months).

However, it is likely that the two bodies may differ on recognition and subsequent measurement requirements, applicable to the lessee. While USGAAP would provide separate guidance for operating and finance lease assets (Type A and Type B leases respectively), under IFRS all leases shall be classified as a Type A lease, by the lessee.

Amortisation of ROU and recognition of finance costs:

Under IFRS, once ROU is recognized, the lessee shall amortise the ROU amount over the lease term separately from the finance cost, irrespective of the lease arrangement. The asset shall be recognized based on the present value of the lease payments with a corresponding liability. In the income statement, the ROU shall be amortised over the lease term, separately from the finance cost, irrespective of the finance or operating lease classification.

However, under USGAAP, in case of a finance/capital lease (Type A lease), the ROU shall be amortised separately from the finance cost and in case of an operating lease (Type B lease), the two amounts shall not be separated but accounted for as one rental expenditure.

This would significantly be different from the current accounting practice followed by a lessee of an operating lease arrangement. Presently, a lessee under an operating lease records the lease payments in the income statement on a straight line basis and does not record any asset on the balance sheet or any finance cost in the income statement.

Some other proposed amendments…

Assessment and re-assessment of lease term

For the purpose of determining the lease term, in case the lessee has an option to extend the lease term, such extended period shall only be included if it is reasonably certain that the lessee will exercise the option. The lease term determined should be re-assessed only upon occurrence of a significant event that is within the control of the lessee.

The lessor shall not be required to re-assess the lease term.

Assessment and re-assessment of variable lease payments

The variable lease payments amount shall be included within the value of ROU asset and the lease liability only to the extent it depends on an index or a rate. Under the new proposed IFRS standard, the amount of variable lease payments shall be re-assessed only when the lessee re-measures the liability for other reasons (for example change in the lease term) and when there is a change in the cash flows resulting from the change in the reference index or rate.

Lease modifications

Detailed guidance on accounting for modification to the lease arrangements has been included to align it with the requirements under the new revenue recognition standard, IFRS 15. In case of any modification that increases or reduces the scope or the consideration, the lessee will have to adjust the ROU and the corresponding liability amount. A detailed guidance has also been provided for adjusting the impact of modification by the lessor as well.  

In addition to the above key changes, the proposed standard also provides detailed guidance/amended provisions on other aspects such as: a) costs to be incurred at the completion of the lease term to be included with ROU asset and the liability, b) deferment of profit on sale by a lessor in case there is no transfer of control, c) amended provisions on sale and lease back transactions etc.  

Closing comments
The new provisions on lease accounting may not significantly impact a lessor in a lease arrangement, except is certain situations. However, given Indian companies are transitioning to Ind-AS over the next couple of years, it would be advisable for them (particularly where they are a lessee) to assess the potential impact of the new proposed leasing standard and consider any such impact on their business model. The new standard would bring off-balance sheet assets on the books and could also impact EBITDA particularly where companies have significant operating lease expense. This could impact companies across industries but possibly more so companies in the aircraft, oil and gas, engineering and retail sectors.

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