Lease Accounting Reform


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CHP Consulting Whitepaper.

Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

August 2012

CHP Consulting Limited

© CHP Consulting Limited, 2012

CHP Consulting has been delivering systems and consultancy services to the global leasing and asset finance industry since 1990. Our best practice methodologies and specialised knowledge of asset finance mean that we deliver the largest system implementations and most complex business change projects. With a 100% delivery record over our 20 years in the industry, CHP’s track record is unrivalled.

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CHP has offices in London, Paris, Boston and Sydney. For more information, visit www.chpconsulting.com.

In the fourth quarter of 2012, the International Accounting Standards Board (IASB) and US Financial Accounting Standards Board (FASB) are expected to issue a revised proposal for a new lease accounting standard. Their original proposal, published as an Exposure Draft in August 2010, was widely criticised for being overly burdensome and subjective. Overall, the industry – lessors, lessees and the users of financial statements alike – has welcomed many of the subsequent revisions. In June 2012, the boards resolved significant issues with respect to lessees’ recognition of lease expense, which had been subject to much deliberation and outreach throughout the first half of 2012. In this update of our whitepaper, CHP provides an overview of the current accounting standards, summarises the key features of the latest proposals, highlights some of the changes from the original Exposure Draft, and considers the implications for lessors from a systems perspective.

This paper is based on the tentative decisions reported up to July 2012. Decisions may change in the revised Exposure Draft.

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Introduction The aim of the lease accounting project is to provide new standards under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) to resolve perceived problems with existing accounting, especially with respect to lessees. The work is part of a larger programme of work to achieve a convergence of the two sets of standards.

1

The balance sheet is a statement that summarises a company’s assets, liabilities and shareholders’ equity.

2

Financial leverage refers to the use of debt to acquire assets.

Under both IFRS and US GAAP, existing accounting includes the classification of leases into two categories: operating leases and finance leases (known as capital leases under US GAAP). If a lease is classified as a finance lease it is shown as an asset and a liability on the lessee’s balance sheet1, whereas for an operating lease the lessee simply accounts for the lease payments as expenses over the lease term. This means that investors and other users of financial statements must estimate the effect of operating leases on financial leverage2 and earnings. In 2008 David Tweedie, then chairman of the IASB, said memorably: “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet”. It looks as if his wish will be granted.

01 WHO WILL THE CHANGES AFFECT? Although lessee accounting is regarded as requiring more attention than lessor accounting, consistent accounting between lessors and lessees is desirable. The new standard will be mandated for all lessors and lessees that prepare their accounts under IFRS or US GAAP. The scope will include leases of property (land and buildings), plant and equipment. This paper is concerned primarily with leasing of plant and equipment; property lessors will not be significantly affected.

Countries that require or permit IFRS Countries seeking convergence with the IASB or pursuing adoption of IFRS FASB (United States)

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Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

Within the EU, IFRS is mandated for publicly listed companies. Cut-down versions have been adopted by local jurisdictions, such as the UK Accounting Standards Board, for privately held organisations and SMEs.

02 PROJECT TIMELINE The draft proposals are published as an Exposure Draft for public comment. It is rare for a draft standard to be re-exposed; however, there have been significant changes as a result of the feedback received to the first draft, and the boards have confirmed that the leasing standard will be re-exposed. The re-exposure is expected in the fourth quarter of 2012, and will have a 120-day comment period. The final standard can be expected in 2013, although the timing is still to be confirmed. Refer to the Adoption section for explanation of the comparative accounts timeline.

2015

Comparative accounts IFRS

2006

2010

Leasing project commenced

2013

Exposure Draft issued

2009

Discussion paper issued

Final standard

2012

Re-Exposure Draft

2016

Projected effective date

2014

Comparative accounts US publicly listed companies

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03 CURRENT LEASE CLASSIFICATION Lease accounting is governed by IAS17 within IFRS and FAS13, now ASC840, under US GAAP. These standards are very similar, and both include a lease classification applied by lessors and lessees:

3

4

For lessee classification, a lease is classified as an operating lease or capital lease. For lessor classification a lease is classified as an operating lease or direct finance lease. The two terms are often used interchangeably. The lessee has an option to purchase at a price lower than the fair market value.

FAS13

IAS17

A lease is classified as an operating lease or a direct finance lease/capital lease3 according to four rules (“brightline” tests). A lease is a direct finance lease if any of the following tests are met:

A lease is classified as a finance lease or operating lease based on whether it transfers substantially all the risks and rewards incidental to ownership of the asset. The following indicators that a lease is a finance lease are provided:

• There is automatic transfer of title.

• There is automatic transfer of title.

• There is a bargain purchase option.

• There is a bargain purchase option.

• The lease term is equal to or greater than 75% of the leased asset’s useful life.

• The lease term is the major part of the leased asset’s useful life.

4

• The present value of the minimum lease payments is equal to or greater than 90% of the asset’s fair market value. Sales-type and leveraged leases are varieties of direct finance lease.

• The present value of the minimum lease payments is substantially all of the leased asset’s value. • The asset is of a specialised nature. • The lessee guarantees the lessor’s investment if the lessee can cancel the lease. • The lessee receives the residual upside and bears the residual losses at lease end. • There are bargain renewal options. In practice, the FAS13 bright-line tests are often used to interpret the IAS17 indicators.

Classification by lessor and lessee could differ should they use different inputs. For example, from the lessee’s perspective, the discounted lease payments might be less than 90% of the fair market value and so it is classified as an operating lease. In contrast, the lessor might have a residual value guarantee from a third party, so the minimum lease payments (which include the residual value) exceed 90% of the fair market value and it is classified as a finance lease.

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Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

Key Changes for Lessor Accounting 01 CURRENT STANDARDS (LESSOR) For operating leases under both IAS17 and FAS13, the lessor holds the underlying asset on its balance sheet and depreciates it (typically on a straight-line basis) to its assumed residual at the end of the lease. The lessor accounts for the rentals as income, usually on a straight-line basis over the lease term. $14 000

Rental income

$12 000

5

In this example, the asset is $100,000 and the residual value is $20,000. The total depreciation is $80,000. The asset is depreciated by $8,000 every year for 10 years. The total rentals are $129,200. $12,920 is recognised as income every year, so the net income is $4,920.

Annual Lease Income

$10 000 $8 000 $6 000

Operating lease net income5

$4 000 $2 000 $0 -$2 000 -$4 000 -$6 000

Asset depreciation

-$8 000 -$10 000 Yr 1

7

8

The implicit rate in the lease is the rate that, when applied to the minimum lease payments and residual value, causes their aggregate present value at the start of the lease to be equal to the value of the leased equipment. Present value means the value of a future cash flow movement expressed at today’s value. A payment of $1,000 in a year’s time is worth less than $1,000 received today. See the present value calculation in the example on page 7. Accretion means the gradual increase of the residual value from its present value at the start of the lease to its actual value at the end of the lease. The year-on-year increase of the present value of the residual is recognised as income. The separate accretion of the residual value is illustrated in the Proposed Changes section, below.

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

For finance leases, the lessor records a right to receive the lease receivables on its balance sheet. If the lessor had previously recognised the underlying asset, this is removed from the balance sheet. The receivables are discounted using the implicit rate in the lease6 (IRR). The lessor recognises the net interest income to Profit & Loss (P&L). Under FAS13, the residual value is accreted7 separately from the income received from the minimum lease payments. $8 000 $7 000

Annual Lease Income

6

Yr 2

$6 000 $5 000

Net finance lease income8

$4 000 $3 000 $2 000 $1 000 $0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

Using the same figures as above, the net interest income is $49,200. This interest is recognised in proportion to the outstanding balance, and consequently greater income is recognised at the start of the lease than at the end.

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02 PROPOSED CHANGES (LESSOR)

9

Leases of property (land or a building – or part of a building – or both) should be accounted for using the straight-line approach, unless: • The lease term is for the major part of the economic life of the underlying asset, or • The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

For lessors, the 2010 Exposure Draft proposed a dual approach with lease classification (refer to the Changes from the 2010 Exposure Draft section for further details). Subsequently, this was replaced by a single ‘receivable and residual’ (R&R) model. Now the boards have reintroduced a lease classification: broadly, leases of property will be accounted for using existing operating lease accounting, and leases of assets other than property will be accounted for under the R&R approach9. In its basic form, the R&R model is very similar to the current treatment of finance leases, with any residual value accretion shown separately as it is under US GAAP. At lease commencement, the lessor will de-recognise the underlying asset (should it previously have been recognised) and recognise a right to receive lease payments, discounted at the implicit rate, and a residual asset. The interest component of the lease payments will be recognised at a constant rate according to the outstanding balance, and the residual value will be accreted.

Leases of assets other than property should be accounted for using the R&R approach, unless:

$8 000

• The lease term is an insignificant portion of the economic life of the underlying asset, or

$6 000

Annual Lease Income

• The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

Residual Receivable Finance leases under IAS17

$7 000

$5 000 $4 000 $3 000 $2 000 $1 000 $0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

In comparison to existing lessor operating lease accounting, the proposed model gives a more appropriate income recognition that reflects the lessor’s funding interest costs. Under the existing straight-line income model, it is possible for the lessor to report a loss after funding interest. $8 000

Proposed lease income

Annual Lease Income

$6 000

10

6

Funding interest is greater at the start of the lease as the balance is higher. At the start of this lease, the funding interest is greater than the straight-line income recognised under operating lease accounting.

Operating lease income

$4 000 $2 000

Proposed lease profit

$0

Operating lease profit

-$2 000 -$4 000

Funding interest10

-$6 000 -$8 000 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

EXAMPLE OF THE LESSOR RECEIVABLE AND RESIDUAL APPROACH This example assumes that the asset is purchased by the lessor for its fair value. • Asset fair value: 20,000 • Residual of 25%: 5,000 • 5 annual rentals in arrears: 4,457 • Implicit rate in the lease: 10% The lessor recognises a right to receive lease payments and a residual asset at the commencement of the lease. • At commencement the lease payments are measured as the sum of the present value (PV) of the lease payments, discounted using the rate that the lessor charges the lessee. 16,895

For example, year 1:

• The residual asset is the remainder of the asset’s fair value. 20,000 - 16,895 = 3,105

Amount amortised = 4,457 - 1,690 = 2,767

• The right to receive lease payments is measured at amortised cost using the effective interest method.

Amortised cost = 16,895 - 2,767 = 14,128

• The residual asset is accreted to the estimated residual value at the end of the lease. Year

Rental

Residual

PV of Rental

PV of Residual

Interest

Interest = 16,895 × 10% = 1,690

Amount Amortised

0

Amortised Cost 0

16 895

1

4 457

4 052

1 690

2 767

14 128

2

4 457

3 683

1 413

3 044

11 084

3

4 457

3 349

1 108

3 349

7 735

4

4 457

3 044

774

3 683

4 052

5

4 457

5 000

2 767

3 105

405

4 052

0

22 285

5 000

16 895

3 105

5 389

16 895

Total

Balance Sheet Year 0 Underlying asset Residual asset

Year 1

Year 2

Year 3

Year 4

Year 5

20 000 3 105

3 415

3 757

4 132

4 545

5 000

Receivable

16 895

14 128

11 084

7 735

4 052

0

Total assets

20 000

17 543

14 840

11 867

8 597

5 000

Income Statement Year 1

Year 2

Year 3

Year 4

Year 5

Lease income Interest Accretion of residual asset

1 690

1 413

1 108

774

405

310

342

376

413

455

Sales turnover Sales

5 000

Cost of sales Profit Return on assets

(5 000) 2 000

1 754

1 484

1 187

860

10.00%

10.00%

10.00%

10.00%

10.00% 7

CHP Consulting Whitepaper.

Accounting for Sales Profit The proposed standard introduces new lessor accounting for sales profit on lease commencement and on subsequent changes to the expected lease term (such as extensions). If there is a difference between the accounting book value and the fair market value of the asset, there is a sales profit or loss. For standard business-to-business leases, sales profit will not occur on lease commencement as the lessor finances the purchase price of the asset. There are two instances in which it could often occur: 11

• For captive finance companies where the book value of the asset in inventory differs from the retail price11

This could be relevant to a manufacturing company or dealer lessor but not, for example, a vehicle finance company where the vehicle is sold to a dealer, realising the profit on sale, and then repurchased from the dealer by the finance subsidiary.

• For true operating lease lessors that re-lease their assets – for example, train rolling stock companies – where the second-hand market value of the asset differs from its book value Under existing standards, the treatment of this sales profit depends on the lease classification. For operating leases, because the underlying asset is kept on the balance sheet, the book value is retained and the sales profit is realised through the rentals. Consequently the sales profit is deferred. For finance leases, because the lessor derecognises the asset and recognises the right to receive lease payments, the sales profit is realised in full up-front. Under the proposed standard the lessor will be able to recognise a sales profit on all leases, apportioned between the right to receive lease payments and the residual asset (refer to the example). This will be advantageous for current operating leases, since sales profit will be brought forward, but would be slightly disadvantageous for current finance leases because an element of the sales profit will be deferred. However, in reality there will be little change for finance leases as residuals are small. $70 000

$16 000

$60 000

Existing finance lease Existing operating lease Proposed

$12 000

$50 000

$10 000 $40 000 $8 000 $30 000 $6 000 $20 000

$4 000

$10 000

$2 000

$0

$0 Yr 0

8

Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

Total Income (lines)

Annual Lease Income (bars)

$14 000

Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

EXAMPLE OF SALES PROFIT ON LEASE COMMENCEMENT • Asset fair value: 20,000 • Accounting book value (carrying amount): 16,000 • Residual of 25%: 5,000 • 5 annual rentals in arrears: 4,457 • Implicate rate in the lease: 10% From the previous example: • The present value of the lease payments is 16,895. • The amount to be de-recognised is the carrying amount × (right to receive lease payments / asset fair value): 16,000 × (16,895 / 20,000) = 13,516 • The residual asset is the carrying amount less the de-recognised amount: 16,000 - 13,516 = 2,484 • This residual comprises two amounts: (i) the present value of the residual value (‘gross residual’), less (ii) the deferred profit which is the difference between the gross residual and the residual portion of the carrying amount. (i) 3,105 (ii) 3,105 - 2,484 = 621 • The profit on commencement is the sum of the right to receive lease payments and the residual asset, less the carrying amount of the underlying asset. (16,895 + 2,484) - 16,000 = 3,379 • The gross residual is accreted over the lease term using the lease rate. The deferred profit is not recognised until the residual asset is sold or released.

Balance Sheet Year 0 Underlying asset

Year 1

Year 2

Year 3

Year 4

Year 5

16 000

Gross residual asset

3 105

3 415

3 757

4 132

4 545

5 000

(621)

(621)

(621)

(621)

(621)

(621)

Receivable

16 895

14 128

11 084

7 735

4 052

0

Total assets

19 379

16 922

14 220

11 246

7 977

4 379

Deferred profit

Income Statement Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Lease Income Sales profit on lease commencement

3 379

Interest Accretion of residual asset

1 690

1 413

1 108

774

405

310

342

376

413

455

Sales Turnover Sales

5 000

Cost of sales Profit

(4 379) 3 379

2 000

1 754

1 484

1 187

1 481

9

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Variable Rate Rentals 12

Contingent rentals are defined as lease payments that are not fixed amounts, but are based on factors including usage, price indices and market rates of interest.

Under existing standards, the treatment of contingent rentals12 is slightly ambiguous but the established view is that the definition of lease payments excludes contingent rentals, and that contingent rentals should be recognised as income in the periods in which they are earned. In the first Exposure Draft, all contingent rentals were included in the definition of lease payments. This has now been changed to include only those rentals that are linked to a rate or index, such as market interest rates or tax rates. These variable rate rentals will be included in the balance sheet presentation of lease receivables. When the underlying rate changes, the receivables will need to be reassessed with any change recognised in profit and loss. It is not clear how changes relating to future periods – for example, for known future tax rate changes – should be accounted for, but further guidance on tax variable rentals in particular is unlikely.

Short-Term Leases 13

A short-term lease is defined as a lease that has a maximum term, including any renewal options, of no longer than 12 months.

Short-term leases13 will be excluded from the scope of the receivable and residual model. For these leases, the lessor will continue to apply existing operating lease accounting, i.e. recognise and depreciate the leased asset and recognise lease income over the lease term.

Initial Direct Costs 14

15

Initial direct costs are costs that are directly attributable to negotiating and arranging the lease, which would not have been incurred had the lease transaction not been made. They include, for example, commissions and legal fees.

Initial direct costs14 will be included on the balance sheet within the right to receive lease payments and amortised as an offset to interest income. This is similar to existing finance lease accounting.

A sale and leaseback involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negotiated as a package.

The accounting for sale and leasebacks15 will be dependent on whether a sale has occurred, which will be determined using the relevant revenue recognition standard. If a sale has not occurred, it will be accounted for as financing under the revenue recognition standard. If a sale has occurred, the lessor will account for the purchase of the entire underlying asset and for the lease using the standard receivable and residual approach.

Sale and Leasebacks

Back-to-Back Leases 16

In a back-to-back lease, an intermediary acts as a lessee to lease an asset from a head lessor, and as a lessor to lease the same underlying asset to a sub-lessee in a sub-lease agreement.

Back-to-back leases16 (head-lease sub-lease arrangements) will be accounted for as separate transactions. The intermediate lessor, as lessee in the head lease agreement, should account for its assets and liabilities in accordance with the proposed lessee accounting. As lessor in the sub-lease agreement, it should account for its assets and liabilities in accordance with proposed lessor accounting. Consequently, where the standard diverges between lessor and lessee accounting, the intermediate lessor will account for the difference on their balance sheet and profit and loss statement.

US Leveraged Leases 17

A leveraged lease is a type of direct finance lease. In a leveraged lease, a long-term creditor provides substantial leverage to the lessor and is non-recourse to the lessor’s general credit, and the lessor’s net investment declines during early periods and rises during later periods.

10

FASB has specific accounting for leveraged leases17. The proposed standard will eliminate leveraged lease accounting.

Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

Lessee Accounting Although this whitepaper is concerned with the impact on lessor accounting, it is worth reviewing the lessee accounting proposals and the changes they could trigger in lessee behaviour.

01 CURRENT STANDARDS (LESSEE)

Amortisation is the same as depreciation, but in practice amortisation is used for intangible assets while either term is used for tangible fixed assets. Intangible assets are non-monetary amounts that cannot physically be measured.

The asset is amortised19 in accordance with the depreciation policy for owned assets, typically on a straight-line basis over the lease term. The finance charge is allocated at a constant rate according to the outstanding liability, so is greater at the start of the lease. $18 000 $16 000

Total expense

$14 000

Annual Lease Expense

19

The lessee’s incremental borrowing rate is the rate the lessee would have incurred either under a similar lease (IAS17) or to borrow over a similar term the funds necessary to purchase the asset (FAS13). The rate implicit in the lease is the IRR. The lessee uses the implicit rate if known (or the lower of the two under FAS13). The lessee will only know the lease’s implicit rate if it is aware of the assumptions made by the lessor; for example, if the lessee guarantees the residual value or has a guaranteed purchase option price.

$12 000 $10 000 $8 000

Asset depreciation Finance lease interest

$6 000 $4 000 $2 000 $0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

Operating leases are off balance sheet. The rentals are recognised as an operating expense, usually on a straight-line basis over the lease term. $14 000

$12 000

Annual Lease Expense

18

Under IFRS and US GAAP, finance leases are capitalised on the lessee’s balance sheet. The lessee shows a right-of-use asset and a liability to make the lease payments. The future lease payments are discounted at the lessee’s incremental borrowing rate or the rate implicit in the lease18.

Operating lease rental expense

$10 000

$8 000

$6 000

$4 000

$2 000

$0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

11

CHP Consulting Whitepaper.

02 PROPOSED CHANGES (LESSEE) The 2010 Exposure Draft proposed a single approach, similar to the current standards for finance/capital leases. Lessees would recognise a right-of-use asset and a liability (debt) of the present value of the lease payments. The asset would be amortised on a straight-line basis over the lease term, and the finance charge would be expensed according to the outstanding liability so as to maintain a consistent rate of interest. However, there were significant concerns over the front-loading of the lease expense (described further below), especially with respect to property leases. As a consequence, the boards decided in June 2012 to introduce a lease classification, as described in the Key Changes for Lessor Accounting section. All leases will be recognised as a right-ofuse asset and a liability, but for property leases the right-of-use asset will be amortised as a balancing figure such that the total lease expense is recognised on a straight-line basis, as illustrated below: $14 000

Annual Lease Expense

$12 000

Proposed total expense

$10 000

Proposed amortisation

$8 000

$6 000

Proposed interest expense

$4 000

$2 000

$0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

Short-term leases can continue to be accounted for under existing operating lease accounting, i.e. as a rental expense. Similarly to lessor accounting, lessees will have to account for contingent rentals linked to a rate or index. There will be practical difficulties for the lessee in estimating future rentals for changes in assumptions, such as the impact of a change in the current interest spot rate on future rentals.

12

Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

Rental Expense is Front-Loaded

$18 000

Proposed lease expense Existing operating lease expense Cash flow

$16 000 $14 000

Annual Lease Expense

20 The actual cash flow expenditure increases towards the end of the lease. Under existing operating lease accounting, the total rentals are expensed on a straight-line basis. Under the proposals the expense will be greater at the start of the lease.

Contrary to the desirable P&L impact for lessors, the front-loading of lease expense is undesirable for lessee accounting as it diverges the accounting from the economic reality (cash flow) of the lease contract. This example shows an agreement where the rentals increase year on year20:

$12 000 $10 000 $8 000

Proposed amortisation

$6 000

Proposed interest expense

$4 000 $2 000 $0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Yr 7

Yr 8

Yr 9

Yr 10

For lessees with large operating lease commitments, the impact of the changes will be significant. However, with the new treatment for property leases the effect on companies with many leased stores or branches will not be as great as under the 2010 Exposure Draft.

Debt Liabilities Will Increase

21

Gearing is an analysis ratio of a company’s debt to its equity (capital).

22

Continue to account for existing assets and liabilities under existing GAAP.

Existing operating leases will be shown as a liability on the balance sheet. Some companies will therefore increase their gearing21 significantly; possibly breaking debt covenants they have with lenders. The covenants will need to be reviewed as they convert to the new standard, and if necessary renegotiated to be based on frozen GAAP22. Credit ratings agencies routinely adjust the financial statements for operating lease disclosures; other credit and stock analysts may not. Large debt increases could adversely affect the lessee’s ability to get new credit, and also their stock price. For banks, bringing all leased retail branches on balance sheet may also impact Basel capital adequacy requirements depending, in part, on whether they are treated as tangible or intangible assets.

EBITDA 23 Earnings Before Interest, Tax, Depreciation and Amortisation. This is a key performance indicator.

EBITDA23 will improve under the proposals. Operating lease rent expense is included in the calculation, but asset amortisation is excluded.

13

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Changes from the 2010 Exposure Draft The boards received almost 800 comment letters on the original Exposure Draft. Feedback reflected a broad support for bringing all leases onto the lessee balance sheet, but there was plenty of criticism about the detail. It was thought that much of the accounting was subjective, and required regular reassessment. Overall the proposals were regarded as overly complex, burdensome, generating volatile balance sheet and P&L statements, and failing to achieve comparability between companies. Consequently, the costs of implementing the new standard would outweigh the benefits delivered significantly.

01 LESSOR ACCOUNTING MODEL

25

Under the performance obligation approach, the lessor would have retained the underlying asset on the balance sheet. In addition, it would have recognised the right to receive the lease payments as an asset, and the obligation to provide use of the asset to the lessee as a liability.

This two-model approach was inconsistent with the lessee accounting and contrary to the project’s objective of a single model, and was subsequently replaced by the single receivable and residual approach.

Under the de-recognition approach, the lessor removes the proportion of the underlying asset for which it is receiving lease payments (leaving a residual amount), and recognises the right to receive lease payments. The receivable and residual approach is a development of the derecognition approach.

02 LESSOR ACCRETION OF RESIDUAL VALUE The de-recognition approach disallowed the accretion of the residual value, deferring the income until disposal. The receivable and residual approach allows accretion of the residual value. De-recognition: total income R&R: total income

$12 000

De-recognition: receivable income R&R: receivable and residual income

$10 000

Annual Income (bars)

$50 000

$40 000

$8 000 $30 000

De-recognition: sales profit

$6 000

$20 000 $4 000

Total Income (lines)

24

Firm proposals on lessor accounting were added only shortly before the first Exposure Draft was issued. Two models were proposed, depending on whether the lessor retained significant exposure to the risks or benefits related to the leased asset (therefore similar in substance to the existing lease classification). Where the lessor retained risks and benefits, it would use a performance obligation24 approach. Where it did not, a derecognition25 approach would be used.

$10 000

$2 000

$0

$0 Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

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03 LEASE TERM In the 2010 Exposure Draft, the lease term was defined as the longest term more likely than not to occur. This meant that, at lease inception and at each reporting period thereafter, the lessor and lessee would be required separately to determine how likely the lessee was to take each of the available purchase and renewal options.

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Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

This would be based on the contractual terms; non-contractual factors, such as statutory law and financial consequences; business factors, such as whether the leased asset is specialised or crucial to the lessee’s operations; and other lessee-specific factors, such as intentions and past practice. Within the notes to their financial statements, the lessor and lessee would have to disclose their reasoning, potentially giving away commercially sensitive information. The definition of lease term has now been greatly simplified. Under the current proposals, renewal and purchase options should only be considered when there is significant economic incentive to exercise the option (i.e. they represent a bargain). Subject to final guidance, this is likely to be substantially the same as the existing standards.

04 CONTINGENT RENTALS In the 2010 Exposure Draft, contingent rentals were defined as any variable amounts including, for example, rentals linked to variable interest rates and other indices, residual value guarantees, usage-based payments, and rentals linked to lessee sales performance. These contingent rentals would have been included in the definition of lease payments. Lessees and lessors would have to reassess the expected amount of any future contingent rentals including future usage payments, and account for any movement, regularly. In the revised Exposure Draft, only residual value guarantees (to the extent that a liability is expected under the guarantee) and rentals linked to a variable rate will be included.

05 SCOPE AND DEFINITION OF A LEASE There was concern about the definition of a lease in the Exposure Draft. This was about determining whether a contract was a lease or contained a lease, or was a service contract. Under the current standards, the distinction between an operating lease and service contract is largely immaterial since the accounting is the same. Under the proposed standard, any lease component will need to be capitalised, while service contracts will remain off the lessee’s balance sheet. In the revised Exposure Draft guidance will be more extensive and the definition will be tightened to whether the fulfilment of the contract depends on the use of a specified asset, and the contract conveys the right to control the use of the asset.

06 LESSEE RECOGNITION OF LEASE EXPENSE As described in the Lessee Accounting section, the first Exposure Draft caused front loading of the lease expense for existing operating leases t. In the revised Exposure Draft, for property leases the right-of-use asset will be amortised so as to straight-line the total lease expense.

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CHP Consulting Whitepaper.

Adopting the New Standard When the new standard comes into force, it will be retrospective. This means it will apply to all contracts existing on the date of initial application.

01 ADOPTION TIMING Effective Date The effective date is the date from which companies will need to apply the new standard. They will use the new standard in their first financial year on or after the effective date. The effective date is subject to separate consultation. The boards had agreed on an effective date no earlier than January 2015, but with the delays in re-exposure a deferral to at least January 2016 seems likely. In the US, the FASB is considering deferred effective dates for private entities.

Date of Initial Application For major changes in accounting policy, companies must provide comparative accounts using the new standard for periods before the effective date, having originally filed their accounts for those periods under the existing rules. The date of initial application is the beginning of the first comparative period presented in the financial statements. US publicly listed companies must provide two years of comparative accounts. Assuming an effective date of January 2016, the transition rules for the new standard will apply from January 2014. US private companies do not need to provide comparatives. Companies subject to IFRS must provide one year’s comparative accounts. Assuming an effective date of January 2016, the transition rules for the new standard will apply from January 2015.

02 TRANSITION APPROACH The 2010 Exposure Draft proposed a simplified retrospective approach, whereby the new standard will be applied only to the remaining lease term. This was intended to have a reduced compliance burden but would have an increased impact on the income statement for lessees. The boards have now proposed to allow an option of a modified full retrospective approach, where contracts are restated from their original commencement. This will spread the financial effect of the up-front interest charge but will be simpler to apply than the conventional full retrospective approach, where each lease must be restated based on inputs evaluated as at the lease commencement date. Companies will have to apply the transition approach consistently to all leases.

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Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

$15 000

Simplified retrospective

Annual Lease Expense

$14 000

$13 000

Existing rent expense

$12 000

Full retrospective

$11 000

$10 000

$9 000

$8 000 2011

2012

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2016

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CHP Consulting Whitepaper.

Systems Implications for Lessors In this section, we consider the likely software changes required to support the new standard, how to manage the transition, and the overall implementation approach.

01 SOFTWARE CHANGES The extent of changes required to lessor accounting systems will very much depend on the system’s functionality and the lessor’s portfolio. For lessors with a simple finance lease portfolio, the move towards the receivable and residual model could mean that minimal changes are required. Conversely, for lessors whose systems are built around operating lease accounting, the changes could be very complex.

Lease Classification If systems include any hard-coded lease classification rules, these will need to be removed or updated to reflect the new classification rules and exemption for short-term leases.

Residual Value Accretion Existing finance lease accounting may need to be enhanced to support the separate accretion of the residual value.

Sales Profit on Lease Commencement For captives and true operating lessors, software changes are almost inevitable. It is highly unlikely that existing accounting systems will support the proposed accounting for sales profit. Sales profit on existing finance leases will be realised by the sale recorded on the manufacturer’s inventory system. There is no sales profit on existing operating leases.

Variable Rate Rentals Interest and tax-variable rentals will need to be included in the balance sheet presentation of receivables, and recalculated periodically.

Segregation of Lease and Service Payments The service component of any rental will need to be accounted for separately in accordance with the Revenue Recognition standard.

Tax Some tax jurisdictions, including the UK, are dependent on the current accounting standards. HMRC, the UK tax authority, has already stated that lease taxation will initially continue to be based on the current accounting standard. Lessors will need to keep two sets of auditable accounts until such time that the tax laws are updated. At this point, there might be further system changes required to support the new tax accounting.

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Lease Accounting Reform: The Systems Impact for Asset Finance Lessors.

Head Leases For lessors with head leases, their accounting systems will also need to support the new lessee accounting standard. As for lessor accounting, if the systems already support accounting for finance leases then minimal changes could be required; whereas if they only support operating leases, more complex changes are likely.

Supporting Lessees As expenditure moves from operating to capital expenditure budgets, decision making will move towards the Chief Financial Officer. Lessor systems, especially sales systems, may need to provide more information to support lessee decision making. Lessees will require more sophisticated systems and processes to manage their lease expenditure. Consider a company that has a large fleet of car leases. These leases might be administered by an HR team on a spreadsheet, with the monthly expenditure accounted for via payroll. Under the new proposals, all the vehicles will need to be capitalised and amortised. Lessors could assist and provide this information as part of their service offering, although many will neither want to share information with their lessees (for example, presenting the split of finance rental and maintenance), nor assume the risk of incorrect accounting.

New Product Offerings

26 Service contracts (where the lessee is provided with a service rather than the use of a specified asset) will continue to be off balance sheet.

The burden of administering lease accounting may cause some lessees to consider alternative methods of finance. For those companies for which off-balance-sheet accounting is important, they might push for more service contracts26 or short-term leases, although it is important to note that the value that will be on the balance sheet for what were operating leases will still be significantly less than if the asset were purchased. Some lessor systems may be very restricted in the products they can administer, so system changes will be required to offer a wider product range.

02 TRANSITION Transition is likely to represent a key challenge for companies with existing operating leases. Firstly, lessors and lessees will need to source additional data required for the new standard and upload it manually or automatically to existing contracts. Secondly, all of the contracts existing at the date of initial application will need to be restated under the new standard, using the simplified or fully retrospective approach. The software may influence the decision; if accounting entries are calculated on the date they are needed, the simplified approach may be preferable, whereas if income projections are calculated in advance for the full contract term then the fully retrospective approach may be simpler. In either case, a method is required to restate the contracts in bulk, preferably carried out automatically to avoid expensive and error-prone manual input. Thirdly, between the date of initial application and the effective date, the contracts will need to be accounted for under the existing and new standards to provide the comparative accounts. Once again the approach will depend on the system. Two possible approaches are (i) to repeat the bulk restatement for each reporting period, or (ii) to raise concurrent accounting entries under both standards.

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03 APPROACH Designing, developing and testing the necessary software changes may prove a significant challenge for lessors that rely on in-house systems or those based on legacy technology. Where systems use a more flexible architecture, the challenge posed by the introduction of the new accounting models will be far less onerous than for homegrown systems built around the existing accounting standards. Deployment of the new accounting logic will be made much simpler for systems that allow for additional accounting methods to be placed alongside existing ones. Each lessor’s approach to the new standard will differ, depending on portfolio and existing systems support. When assessing the changes required, any off-system processes and calculations must also be considered: spreadsheet models may be adequate for existing straight-line calculations but will become much more complex under the proposals. Many lessors will have been through a similar process with the adoption of IFRS in the EU in 2005. Nevertheless, if changes to existing systems are considerable it may be more cost-effective to consider a new system. Many businesses are behind the IT curve and risk being left behind in terms of customer satisfaction, product offering, efficiency and flexibility. Invasive changes will require considerable testing, especially from comparatively small Finance teams, so businesses will want to maximise the benefits of the disruption. Some lessors have been following the proposals closely as they have developed, while others – since there has been so much change from the original Exposure Draft – have waited. However, when the standard is re-exposed, it is crucial for all lessors to understand the impact, define their approach, and engage with their software suppliers early.

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© CHP Consulting Limited, 2012 21

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