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IFRS Ready? Lease Accounting is Changing!

by Kent Bettisworth

November 2, 2010

IFRS Ready?  IAS17 for international accounting and ASC840 in the US address the accounting for leases. On August 17 of 2010, the International Accounting Standards Board (IASB) and Financial Accounting Standards Boards (FASB) jointly released proposed identical standards to converge lease accounting under a common principle that both lessees and lessors would follow.  In short, almost all leases would become assets on the balance sheet, thereby broadening transparency to all assets and liabilities for investors world-wide.

The current accounting, both internationally and in the US, allows many asset leases to be expensed to the income statement.  These are referred to as ‘operating’ leases.  If the asset lease extends over substantially all of the asset’s life and the value of the asset is essentially equal to the lease payments, then the lease is accounted for on the balance sheet as a ‘finance’ lease.  This is a simplification of the current accounting process, both internationally and in the US, but for purposes of this discussion is adequate.

Why a new standard?  Lease financing totaled $640 billion in 2008 according to the 2010 World Leasing Yearbook.  The existing standards lack clarity, comparability, and are complex.  Users of the financial statements will adjust their financial analysis of companies where many operating lease assets exist today.  Office buildings, aircraft, trucks, and computers are often simply leased assets.  The new standard will be consistent with two other IFRS in-process standards, the conceptual framework for assets and liabilities and the recently proposed new standard for revenue recognition.

Who is affected? Any entity that enters into lease contracts, with some exceptions, is affected.

What is the core principle?  Lessees and Lessors will record a lease asset and lease liability.

How do I apply the principle?

  • A lessee will record a right-of-use asset in PP&E at present value, plus amortization over the lease life, and a rental liability
  • A lessor will record a lease payment asset at present value as well as interest income and,
  • A lessor will record, based on the transfer of risk, …
    •  a residual PP&E asset and gain/loss, if the derecognition model applies or,
    •  an underlying PP&E asset, depreciation expense, and lease income, if the performance obligation model applies

Question: Are big changes expected for existing finance leases?

  • Yes, because the present value determination will include options and contingent rentals as well as the longest possible lease life

Question: Why not exclude non-core assets like photo-copiers?

  • Non-core assets, in total, can represent significant values

What is the impact?  Here is a brief summary:

  • You will have a new asset class, and potentially many new capital assets
    • ACTION: Review your capital project and project portfolio processes.  You will n eed to budget for more capital money, and ensure your project management and project accountants are prepared to handle a potentially significant increase in volume.
  • The calculation of the right-of-use asset and its life is more complex.  You must consider the life and present value of renewals including all options and contingent rentals.
    • ACTION: Train your project and asset accountants so they understand the nuances of the new calculation and,
    • ACTION: Evaluate your existing operating leases and calculate the value for the new right-of-use asset to be assigned at conversion.
  • The income statement earnings per share may decline due to the elimination of operating leases partly offset by increased amortization expense.
  • The balance sheet will grow with the inclusion of more assets, and therefore return on investment may decline.  This may affect certain bank and regulatory covenants.
    • ACTION: Conduct an early assessment and prepare your company’s management for the potential financial effect
    • ACTION:  Influence the final standard by responding to the Exposure Draft comment period at: www.fasb.org/cs/ContentServer?c=FASBCont...
  • Your SAP Fixed Asset and Project Accounting/Project Portfolio systems will be affected.
    • ACTION: Evaluate the impact and identify opportunities to improve existing processes
    • ACTION: If a lessor, evaluate SAP’s Lease Accounting functionality that better integrates contract management, CRM, vendors, and asset accounting

Don’t delay!  Public comments regarding the proposed changes are being accepted until December 15, 2010.

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