Practical implications of the joint IASB and FASB leasing project - in detail 

Welcome to this, the second in our series of videos looking at the joint IASB and FASB leasing project.  This series of videos focuses on the potential impact of the proposals for technology companies.

In the first video we introduced the dual models and the right of use models for lessee.  We noted that lessees will recognise a right-of-use asset and lease liability at lease inception on all lease (other than short term leases).
In this second video we will look in more detail at some of the aspects of the new leasing model

Lets look at an example of the accelerated model for the lessee

This shows the individual impact of the accelerated model on one example lease of a store.

[If you have watched the first video in this series, you might be asking why we are applying the accelerated approach to a property lease – typically property leases may fall under the straight line model.  In this cases we have assuming that the lease is for all of the remaining life of the property so this is an example of when the accelerated model would apply to a property lease.  This model will apply to all other non real estate leases in scope.

The example assumes a date of transition of 1 January 2012 for a lease with 7 years remaining. Annual lease rental is approximately £400k per year.
This shows the current treatment under IAS 17 as an expense (shown in light brown) – an equal charge each period over the life of the lease.

It also shows the treatment under the accelerated model built up in stages.  The interest expense (in blue) and a right or use asset amortisation charge (in purple).   The total is the green line.  This shows the front loading of the lease total expense -- and this is greater than lease rental until 2015 where graphs cross over.

In addition, ROU asset and lease liability is approximately £2.1 million at 1 January 2012 ...and this is for just one lease!  So the impact of applying the accelerated model can be quite significant.

So we have seen that all but short term leases will result in a ROU asset and a lease liability being recognised on the balance sheet of the lessee.  We should look at how to measure the initial lease liability and the ROU asset.

The initial lease liability is the present value of the future lease payments – but which payments - It will includes expectations about lease terms, purchase options, residual value guarantees, and termination penalties.  Variable lease payments would also be included only if they are based on a rate or and index, or they are in substance fixed.  There is a higher threshold to include optional periods in assessment of lease term.

The lease liability will subsequently measured at amortised cost modified for certain reassessments.

The ROU asset would initially be measured as the sum of the present value of the estimated lease payments as before plus initial direct costs of obtaining the lease and less lease incentives.

The subsequent measurement of the ROU asset and the expense recognition is dependent upon classification (accelerated model or straight line model) as outlined in the first video.

For the accelerated model the ROU asset is amortised over shorter of lease term or economic life subject to impairment testing.  This is as we showed in the example lease earlier – this added to the interest costs will give the accelerated income statement impact.

For the straight line method the approach needs to be different – the income statement impact needs to be on a straight line basis.  To achieve this the ROU asset is considered linked to the lease liability throughout lease term, with the ROC asset subsequently measured as balancing figure to give a straight-line total lease expense recognition.

Having worked through the core accoutring concepts lets consider some of the practical difficulties technology companies will face implementing these proposals.

For technology companies the distinction between provision of a service and leasing an asset can be key.  IFRIC 4 currently give guidance on identifying embedded leases within contracts that are not in the legal form of a lease.  IFRIC 4 will be replaced with the notion of a specified asset controlled by the lessee.
Given that for all but insignificant or short term leases a right of use asset and a lease liability is recognised by the lessee the decision as to whether there is a lease or not will now drive the recognition of a lease liability.

There are likely to be practical challenges to determine variable leases payments with reference to an index and how to treat variations of lease payments – this may need reassessment over the life of the lease.

The lease liability is recorded at present value using the incremental borrowing rate as the discount rate. Companies will need to determine and monitor the incremental borrowing rates to apply to leases.

With more leases coming on balance sheet companies will need to watch for leases in foreign currencies which will be subject to foreign exchange movements – companies may need to consider hedging the exposures to foreign exchange movements and if necessary hedge accounting.

Lessees will need to recognise a right of use asset and a lease liability on the books of all but short term leases so companies will need to consider the impact on banking covenants and the ability to borrow.

The treatment of lease liabilities will also impact distributable reserves, which will need to be monitored to ensure no issues arise.

In the UK, tax legislation will initially be based on existing legislation and therefore dual tax and accounting records will need to be maintained.  This could represent a significant administrative burden for companies. 

This also highlights the need for companies to consider the extent of current systems in place to monitor leases and whether they will need to be enhanced.

That’s the end of this video looking at the proposed leasing models.  We look forward to the publication of these proposals in a revised exposure draft in the first quarter of 2013.

There is a lot for technology companies to look at; in many cases it will be necessary to consider the treatment of leases, particularly longer term leases, in advance of the application date.

Thank you for watching this video.