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Welcome to this, the first in our series of videos looking at the joint IASB and FASB’s leasing project. This series of videos focuses on the potential impact of the proposals for technology companies.
In September 2012, after many months of joint discussion, the Boards concluded their redeliberations on the lease accounting proposals which were originally published back in 2010. We can now look forward to a revised exposure draft in the first quarter of 2013, most likely with a 120-day comment period.After a long period of redeliberation, with many twists and turns, the proposals to be included in the new exposure draft are now clear, at least in outline. Central to the proposals will be the right-of-use model, under which all but short-term leases would be on-balance sheet for lessees. The goal of eliminating lease accounting as a source of off-balance sheet finance has become the project’s touchstone and in most instances, the proposals achieve that goal. However, the costs of achieving this goal include additional complexity and some conceptual compromises.The proposals will introduce new ‘dual models’ for income and expense recognition. Lessees and lessors would apply a new lease classification test, on a lease-by-lease basis, to determine which model to apply. Lease classification would depend on the extent to which the underlying asset is consumed over the lease term, and the nature of the underlying asset – whether it is real estate or other assets.In this first video we will look at an overview of the new leasing proposals.
So let’s firstly look at the definitions and proposed scope of the standard.The scope excludes all short term leases with terms less than one year. These leases will be accounted for in similar to the current treatment of operating leases.Also excluded from scope are leases of intangibles assets and certain other assets as they will continue to be accounted for in accordance with the specific guidance in existing standards for those assets.For many technology companies a key aspect will be distinguishing service contracts from contracts which may have embedded leases within them. . The definition in the new leasing standard focuses on control by the lessee of a specified asset. The proposals also include guidance on separating arrangements with both lease and non-lease components.
Within scope are all other leases and that including sub leases, guidance on sale and leaseback transactions and transactions which are in substance purchases or sales.I noted that the accounting treatment will depend on the lease classification - so let’s look at the new lease classification test that would be applied to all leases in scope of the new leasing standard.The test is to determine whether to apply ‘the accelerated model’ or the ‘straight line model’. We will look at the differences between these two models later.The test will depend on the nature of the asset – whether it is real estate or other assets and on the portion of the underlying asset that is consumed over the lease term.
For property leases, the straight line model would typically be applied. Unless the lease terms is the major part of the economic life of the asset or the present value of leases payments is substantially all of the fair value of the asset. So that is a high hurdle for property leases for the accelerated approach to be applied.For other assets the Accelerated approach would be applied. Unless the lease term is insignificant relative to the economic life of the asset or the present value of the lease payments is insignificant relative to the fair value of the asset. So a low hurdle - most leases of other assets would apply the straight line model.To recap - in many cases: leases of real estate (land and buildings) would be accounted for using the SLM; and leases of other assets (e.g. equipment) would be accounted for using the accelerated ROU model.This lease classification would be assessed only at lease commencement or upon a modification of the lease.
We have distinguished between the straight line model and the accelerated model – but what is the difference - next we will look at the two different models and the differences for both the lessor and the lessee.
Let’s look at the accelerated approach. Firstly for the lessor on the left hand side. We expect to see a new receivable and residual model. Under the receivable and residual model, the lessor would: derecognise the underlying asset; recognise a lease receivable, initially measured at the present value of the estimated future lease payments; and recognise a residual asset, representing its rights in the underlying asset at the end of the lease term.And for the lessee - on the right hand side. The lessee will apply a right of use model – an accelerated right of use model. Under this model, the lessee would: recognise a ROU asset and a lease liability.
In the income statement of the lessee the accelerated ROU model features separate presentation of amortisation of the ROU asset in operating expenses and interest expense on the lease liability. The interest expense woudl be higher at the beginning of the lease and lower at the end. This will lead to a front-loaded profile of the total lease expense for the lessee (hence the name accelerated model) – we will look at an example of this in more detail in the next video.
Now let’s turn to the straight line model, again firstly for the lessor A revised version of the operating lease model is retained - similar to current operating lease accounting. The lessor would continue to recognise the underlying asset and recognise lease income over the lease term. And for the lessee - the lessee will again apply a right of use model – a straight line right of use model.Under the right of use model, the lessee would recognise a ROU asset and a lease liability.
The straight line ROU model features a total lease expense as an operating expense, with no interest charge presented. This will lead to a straight-line recognition of total lease expense (hence the name straight line model).It important to note that for the lessee a ROU asset and liability is recognized regardless of whether the accelerated model or the straight line model is applied. So for the lessee the difference is not whether the leased asset are brought on the balance sheet but mainly the income statement impact.
That’s the end of this video introducing the proposed leasing models. There is a lot more to the proposals and in the next videos we will take a more detailed look at proposals and consider the potential implications for technology companies.
Thank you for watching this video.
The first in our series of videos looking at the joint IASB and FASB leasing project. This video provides an overview of the new leasing proposals.
This video is also available on our YouTube channel.
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