Transformation in lease classification -MOHAN R. LAVI

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The proposed amendments consider a 'right-of-use' model where both lessees and lessors record assets and liabilities arising from lease contracts.

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Classification of leases into operating and financial leases has not been very ambiguous, with clear rules for sometime now. But this is proposed to be radically altered by the International Accounting Standards Board (IASB), considering its revised Exposure Draft on International Accounting Standard 17 — Accounting for Leases.

Normally, a finance lease is one where the lease term exceeds the life of the asset, there is a transfer of title at the end of the lease term, an option to purchase the asset is built into the agreement or the present value of lease payments exceed a substantial portion of the fair market value of the asset.

Operating lease has been negatively defined — that is, one that is not a finance lease. It has been estimated that $640 billion of lease commitments do not appear on the balance-sheets of companies (as they are classified as operating leases and expensed), resulting in unclear financial leverage and gearing ratios.

Lessee

The proposed amendments consider a 'right-of-use' accounting model where both lessees and lessors record assets and liabilities arising from lease contracts. The assets and liabilities are recorded at the present value of the lease payments. They are subsequently measured using a cost-based method.

A lessee has acquired a right to use the underlying asset, and it pays for that right with the lease payments. A lessee would record: an asset for its right to use the underlying asset (the right-of-use asset), and a liability to pay rentals (liability for lease payments). The right-of-use asset would originally be recorded at the present value of the lease payments. It would then be amortised over the life of the lease and tested for impairment. A lessee (under IFRS) could revalue its right-of-use assets. The right-of-use asset would be presented within the property, plant and equipment category on the balance-sheet but separately from assets that the lessee owns.

Lessor

The accounting would reflect the exposure of the lessor to the risks or benefits of the underlying asset. When the lease transfers significant risks or benefits of the underlying asset to the lessee, the lessor would apply the de-recognition approach. When the lessor retains exposure to significant risks or benefits of the underlying asset the lessor would apply the performance obligation approach. The de-recognition approach requires the lessor to take part of the underlying asset off its balance-sheet (derecognise it) and record a right to receive lease payments. It is possible that a lessor could record a gain on commencement of the lease under this approach.

The performance obligation approach requires the lessor to keep the underlying asset on its balance-sheet and to record a right to receive lease payments and a liability to permit the lessee to use the underlying asset (a lease liability).

The lessor records income over the expected life of the lease. Many lease contracts include variable features.

For example, leases often include options to renew or terminate the lease, contingent rentals (for example, rentals that vary depending on sales) or residual value guarantees.

The proposals would require lessees and lessors to determine the assets and liabilities on the basis of the longest possible lease term that is more likely than not to occur. Lessees would always include contingent rentals but lessors would only include contingent rentals that they can measure reliably.

Lessees and lessors must also include estimates of residual value guarantees. Including these items informs investors about expected cash flows. Current requirements generally exclude such items, making it more difficult for investors to estimate future cash flows.

The proposed amendments would entail a revision to Indian Accounting Standard 19 on Leases since both differ conceptually. The frequent issue of revised standards by the IASB is forcing the Institute of Chartered Accountants of India (ICAI) to keep pace.

The ICAI is mulling whether to move over to the brand-new IFRS- 9 (Part 1 of 4 of which is now out) or to go ahead with IAS 39 on Financial Instruments from next year. A standard on financial instruments being extremely important, it would probably be better to implement IAS 39 and assess the impact instead of going in for a half-baked IFRS-9. The only constant in the accounting world these days is change.

(The author is a Bangalore-based chartered accountant.)