Challenges In Lease Accounting
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Challenges in lease accounting – A different view Accounting for leases has been of debate always. IASB has issued a discussion paper which proposes a new accounting model of recognizing all leases on balance sheets of lessees. Presently only finance leases are recognized on the balance sheets of lessees. The discussion paper attempts to address a few concerns in lease accounting including: • An entity procuring a major asset on operating lease is not required to show the asset on its balance sheet; • Lessee, in an operating lease, obtains a source of unrecognized financing which is difficult for users of financial statements to understand; • Present accounting model provides opportunities to structure transactions in such a manner so as to achieve a particular class of lease classification. Accounting by Lessee The rights and obligations of lessee can be summarized as: •
Rights Right to use the asset for the lease term
• •
Obligations Obligations to pay rentals; Obligations to return the asset at end of lease term.
IASB defines “assets and liabilities” as: Assets Entity controls the economic resource or benefit It arises out of a past event Future economic benefits are expected to flow to entity
Liabilities Entity has a present obligation Obligation arises out of a past event Obligation is expected to result in outflow of economic benefits
If the above definitions of “asset and liability” are applied to “lessee rights and obligations” the existing lease accounting model is inconsistent, with the definitions of “asset and liability”. Instead of treating finance leases as “purchase of assets” and operating leases as “executory contracts”, IASB proposes to treat all lease contracts as “acquisition of a right to use” the leased item for the lease term. Proposal of IASB It is proposed to initially measure “at present value of lease payments” (discounted using the lessees’ incremental borrowing rate) the:
• •
Obligations of Lessees to pay lease rentals; and Cost to Lessees of “right to use the asset”.
It is proposed to measure in subsequent period the • Obligation to pay rentals at an “amortized cost” where the interest is accrued on the outstanding obligations to pay rentals; • Right to use asset at amortized cost by amortizing the asset at shorter of the “lease term” and “economic life of the asset”. Accounting by Lessor “Right to use” model could be applied to lessor in two ways: • Lessor transfers a portion of leased item to the lessee; or • Lease contract is viewed as creating a new right (leaving lessors’ right to leased asset unchanged) Under the first approach • Lessors exchange all or a portion of the leased asset in exchange for right to receive payments over the lease term; and • Retains right to lease item at the end of lease term. This would result in derecognizing the leased item and recognizing a receivable and residual value of asset. The “right to receive payment” and “right to receive economic benefits from residual value” would meet the definition of the asset and thus would qualify to be assets Under the second approach the lease contract is viewed as creating a new right (an unconditional right to receive payments) with a corresponding liability (an unconditional obligation to permit to use the leased asset). Thus the lessor creates a new asset and liability apart from the leased asset continuing to appear on the balance sheet. One of the principal objectives of this article is getting familiarized with the terms and language used by IASB. This would greatly help in IFRS implementation and debating the various issues arising there from.
Rights Right to use the asset for the lease term
• •
Obligations Obligations to pay rentals; Obligations to return the asset at end of lease term.
IASB defines “assets and liabilities” as: Assets Entity controls the economic resource or benefit It arises out of a past event Future economic benefits are expected to flow to entity
Liabilities Entity has a present obligation Obligation arises out of a past event Obligation is expected to result in outflow of economic benefits
If the above definitions of “asset and liability” are applied to “lessee rights and obligations” the existing lease accounting model is inconsistent, with the definitions of “asset and liability”. Instead of treating finance leases as “purchase of assets” and operating leases as “executory contracts”, IASB proposes to treat all lease contracts as “acquisition of a right to use” the leased item for the lease term. Proposal of IASB It is proposed to initially measure “at present value of lease payments” (discounted using the lessees’ incremental borrowing rate) the:
• •
Obligations of Lessees to pay lease rentals; and Cost to Lessees of “right to use the asset”.
It is proposed to measure in subsequent period the • Obligation to pay rentals at an “amortized cost” where the interest is accrued on the outstanding obligations to pay rentals; • Right to use asset at amortized cost by amortizing the asset at shorter of the “lease term” and “economic life of the asset”. Accounting by Lessor “Right to use” model could be applied to lessor in two ways: • Lessor transfers a portion of leased item to the lessee; or • Lease contract is viewed as creating a new right (leaving lessors’ right to leased asset unchanged) Under the first approach • Lessors exchange all or a portion of the leased asset in exchange for right to receive payments over the lease term; and • Retains right to lease item at the end of lease term. This would result in derecognizing the leased item and recognizing a receivable and residual value of asset. The “right to receive payment” and “right to receive economic benefits from residual value” would meet the definition of the asset and thus would qualify to be assets Under the second approach the lease contract is viewed as creating a new right (an unconditional right to receive payments) with a corresponding liability (an unconditional obligation to permit to use the leased asset). Thus the lessor creates a new asset and liability apart from the leased asset continuing to appear on the balance sheet. One of the principal objectives of this article is getting familiarized with the terms and language used by IASB. This would greatly help in IFRS implementation and debating the various issues arising there from.
