BUSINESS INSIGHTS | SPRING 2011 EFFECT

IFRS Overhauls Accounting for Leases

by Jessie Koepplin

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are collaborating on a single set of international accounting standards companies worldwide will use for both domestic and cross-border financial reporting. As part of this convergence project, exposure drafts were released for public comment in August 2010. They highlight specific areas of change in the new International Financial Reporting Standards (IFRS), including accounting for leases, which will be radically different.

The new standards will impact both sides of the lease agreement: the lessee and the lessor. Under generally accepted accounting principles (GAAP), lease agreements are treated as operating leases or capital leases. Currently, operating leases don’t appear in a business’s financial statements, but in the near future, all leases are expected to be on the balance sheet.

Right of use

Under IFRS, assets and liabilities from lease contracts are treated in the financial statements as right-of-use. In other words, operating leases, as we know them today, will no longer exist. The proposed standard only applies to property, plant, and equipment (PP&E) and does not cover lease incentives. Lease contracts after a lessee has exercised a purchase option are also not in the scope of the exposure drafts because the exercise of the option terminates the lease. Capital leases will continue to be treated similarly to the way they are now.

What does the proposed standard mean for the lessee?

The lessee will record a right-of-use asset and a lease liability on the balance sheet (under IFRS it will be called a statement of financial position). The rent expense on the profit and loss statement would be replaced with amortization and interest expense. Disclosures will also be more extensive and include lease payment maturities.

The first time you incorporate these changes into your financial statements, you need to determine the lease term and payments. The term is the longest possible time frame and takes renewal options into consideration. The payments would be the present value, discounted using the lessee’s borrowing rate at the start of the lease. Once the term and payment are determined, the asset and liability is recorded.

Going forward, the asset should be assessed for impairment, and the lease term and payments should be reviewed to determine if they are still accurate.

What does the proposed standard mean for the lessor?

A lessor will be required to use one of two methods to account for the lease, depending on the situation. The performance obligation approach applies to businesses that lease an asset several times over the life of the asset, and the lessor retains its risks and benefits (e.g., a building owner). The derecognition approach would be used if the lessor (like an auto dealership) is not responsible for the risks (or benefits) of the assets.

Both methods will recognize a lease receivable based on the present value of the lease payments. Under the performance obligation approach, the leased asset will remain on the balance sheet, be depreciated, and a lease liability will be recorded. The derecognition approach does not recognize lease liability for the life of the lease, although a gain or loss could still be recognized at start, similar to sales-type leases today.

Short-term leases

Today, month-to-month leases are the easiest to account for. Under the proposed standard, they will become the most difficult.

Short-term leases are considered to be 12 months or less. Under the proposed rules, amortization expenses would be calculated, but the lessee would not have to discount the lease payments. Lessors may be able to opt out of the proposed standard for short-term leases.

When do we change?

Though these exposure drafts highlight the important issues being discussed as the accounting world comes closer to a single standard, many of the details have not yet been decided. No official date is set for implementation by FASB, though a final standard is expected to be published in June 2011. Realistically, however, it could take nearly four years to be put into effect.