Operating Lease Moving to the Balance Sheet

By mid-2011, FASB and the IASB will likely require your leases to be booked on the Balance Sheet

This project ongoing for some time is now gathering a lot of momentum. An exposure draft is due out in Q2 of 2010 with final framework chapters expected in 2011.

Objective

The objective is to create common lease accounting requirements to ensure that the assets and liabilities arising from lease contracts are recognized in the statement of financial position.

Background

In 2006 the boards set up a joint accounting working group to address the problems users of financial statements were experiencing with the current standards. On March 19, 2009 the boards jointly issued a Discussion Paper on the changes on lease accounting. The invitation to comment period ended on July 17, 2009. This step precedes the development of an Exposure Draft and a new Statement of Financial Accounting Standards for leases by mid-2011.

Criticisms with the existing accounting model

Leasing is an important source of finance to business. Therefore, it is important that lease accounting provides users of financial statements with a complete and understandable picture of the entity’s leasing activities. The existing accounting model has been criticized for failing to meet the needs of users of financial statements in particular:

· The existence of two different models for leases (the finance model and the operating lease model) means that similar transactions can be accounted for differently reducing comparability.

· The existing standards provide opportunities to structure transactions as to achieve a particular lease classification that can be difficult for users to understand.

· Users routinely attempt to make adjustments to financial statements involving operating leases to recognize unrecognized assets and liabilities. However, the information available in the notes to the financial statements is insufficient for them to make reliable adjustments.

· Preparers and Auditors have found it difficult to define the dividing line between finance leases and operating leases in a principled way making the standard’s use difficult to apply.

Key Determinations

1 In a simple lease the lessee obtains a right to use the leased item that meets the definition of an asset and that the related obligation to pay rentals meets the definition of a liability. Consequently, the lessee will recognize:

o An asset representing its rights to use the leased asset

o A liability for its obligation to pay

2 The asset will include rights acquired under options such as renewal and purchase options.

3 The liability will include obligations arising under contingent rentals and residual value guarantees.

4 The asset and liability will initially be measured at the present value of the lease payments discounted at the lessee’s incremental borrowing rate.

5 The assets and liabilities recognized by the lessee will be based on the most likely lease term.

The factors to be considered in determining the lease term are:

· Contractual - explicit terms that could affect whether the lessee extends or terminates

a. Termination penalties

b. Bargain, discounted, market or fixed rate in secondary lease periods

c. Residual value guarantees

d. Return costs

· Non-Contractual financial factors – financial consequences not explicitly stated in the terms

e. Significant leasehold improvements lost if the lease were terminated

f. Non-contractual relocation costs

g. Lost production costs

h. Tax consequences

i. Costs associated with sourcing an alternative item.

· Business factors – non financial factors

j. Core vs. non core asset

k. Specialized vs. non specialized asset

l. Location of the asset

m. Industry practice

· The lessee’s intentions and past practice will not be considered as a factor in determining most likely lease term.


6 The lease term will be reassessed at each reporting date.

7 The incremental borrowing rate will not be reassessed

8 The obligation to pay rentals is amortized using the effective interest method over the expected lease term.

9 The right-to –use asset is depreciated on a straight-line basis over the expected lease term.

10 As a financial asset, leases will be subject to annual impairment tests.


Open Items currently being discussed

· Methodology for the annual impairment test.

· Short-term leases (less than a year) could be accounted for as operating leases.

Steps to Mitigate Risk

· Work with finance and auditors to initially measure the affected leases and create a process for ongoing evaluation.

· Identify performance metrics and related management reporting.

· Revisit existing leaseholds contracts to identify problems and opportunities under the new expected standards.

· Evaluate each leasehold asset and identify opportunities to optimize financial performance.