The long awaited International Financial Reporting Exposure Draft on Leases was issued in August 2010. It is expected that the final Standard will issue in 2011 and will become mandatory sometime in 2012.It has been prepared in conjunction with the US and forms part of the Convergence Project between International Standards and US GAAP. The proposals in the Exposure Draft have been flagged for a considerable period of time, and represent the biggest single change in Reporting Standards since the inclusion of Pension Schemes’ Net Obligations in Financial Statements. This article looks at the implications for the Lessee.

Leases serve a vital role in many entities operations and contain provisions that range from simple to complex. This new standard will have a major impact on property leases as typically they were classified as Operating leases in the past. Likewise, Airlines and Shipping companies will be affected, as will any company which has significant Operating Lease commitments. For those less addicted to lease financing, it may be that the only impact will be that the lease of the photocopier and car fleet will be brought on to the Balance Sheet.

The major changes for the Lessee are

1. The distinction between Operating and Finance leases will no longer be relevant.
2. All Leasing Obligations will be recognized in the Balance Sheet together with the corresponding “Right to use” recognized as a Leased asset.
3. The Capitalized value will be based on the Present Value of lease obligations discounted at the lessee’s incremental borrowing rate.
4. The obligations capitalized will include the base rent, and also an estimate of contingent rent and other expected payments that might include guaranteed residual amounts and term option penalties.
5. The lease period is defined as the longest possible term that is more likely than not to occur including options to extend or terminate. 
6. The charge for leasing in the Profit & Loss account will comprise a Depreciation charge on the leased asset and a finance charge on the leasing obligations.
7. Leasing Obligations will be reassessed in subsequent reporting periods, triggerered by changes in estimates of the lease term and contingent rents. The original discount rate will be used to get the Present Value of the revised obligations. The corresponding adjustment if it relates to future periods will be recognized in the Leased Asset; otherwise it will be expensed in the Profit & Loss Account.

The major effect of the proposed standard will be the recognition of additional liabilities on the Balance Sheet. Companies will now have to recognize liabilities for existing operating leases. Finance Leases already on the Balance Sheet may need to be increased if there are contingent rents to be taken account of, or if the new definition of the Lease period results in a longer period being recognized. There is no transition exemptions permitted for existing leases. This may put pressure on existing borrowing agreements where covenants include limits on the size of borrowings and on new applications as lenders will clearly be made aware of lease obligations previously off Balance Sheet.

In addition, the standard will result in a higher reported expense in earlier years in comparison to the straight line charge currently applied for operating leases. However, a higher EBITDA will be reported, as part of the lease payment will be allocated to Finance Costs, which are excluded in the EBITDA calculation.

The proposed standard is also much more complex and more subjective. It will require annual review for possible revisions of Leasing Obligations as the lessee’s intentions, trading performance and circumstances change.

Example

A company signs a five year lease of a commercial unit for Euro 20,000 per annum. The company has an option to renew the lease on the same terms at the market rate on the date of renewal. If the lease is not renewed, it will pay a penalty of six months’ rent .The incremental cost of borrowing to the company is 5%, which will be used to get the present value of the lease payments. If the company’s current intention is more than likely not to renew the lease, then 5 years may be used to capitalize the lease. The Present Value of this lease on that basis is Euro 94,925.The Leased Asset will be initially recognized in Property, Plant & Equipment at $ 94,925 with a corresponding Liability for the same figure. The Leased Asset will be depreciated over 5 years at $18,985 with a Finance Cost of $4,721 in the first year, decreasing thereafter as the liability is paid off.

The lease period is defined as “the longest possible term that is more likely than not to occur including options to extend or terminate”. If the company reconsiders it’s position at the end of the third year, and decides that it will more than likely to take it’s renewal option for another five years, then the Leased Obligations will be revised to eliminate the penalty payment and to take account of the second five years payments, using the original discount rate. The related leased asset will be revised by a similar amount. The carrying amount will be now be depreciated over seven years. (Under IAS 17, the lease period was set at the inception of the lease and there was a clear leaning toward recognizing only the minimum non cancellable period contracted in the lease.)

Lease payments are defined as payments arising under a lease including fixed rentals and rentals subject to uncertainty including but not limited to, contingent rentals and amounts payable by the lessee under residual value guarantees and term option penalties. The calculation of lease Obligations will be complex when it refers to long periods (35 year lease) and includes uncertain amounts such as rent renewals at market prices, CPI increases or extra payments based on turnover or footfall. These amounts may change regularly as a result of market changes or the lessee’s intentions. The Company will be required to estimate this amount at the outset of the lease and revise it annually for material changes.

Who will be affected?

The change will have a pervasive effect for FRS and IFRS preparers, as almost all companies enter into lease arrangements. Some companies will be affected more than others, depending on the number and type of leases in existence at the transition date.

What needs to be done?

The comment period ends on 15 December 2010 and a final standard is expected mid-2011. Given the potential impact of the proposed changes on accounting and operations, companies should begin to assess the implications on their existing leases and any new leases that are contemplated. Leases may need to be renegotiated especially with regard to renewal options. Loan Covenants may need to be amended to avoid unplanned breaches. Fore-warned is fore-armed.

Christy Kearney
kearneychristy@eircom.net

Note;
This is an International project not directly effecting local Irish GAAP. However, the Accounting Standards Board monitors international developments, and will most probably adapt the IFRS immediately in order to avoid further differences from IFRSs emerging in Ireland and the UK.  Irish and UK GAAP will effectively cease to exist with the adaption of the IFRS for SME’s.