The Bruce Column — The perennial challenges of leasing
04 Mar 2011
The prospect of putting all operating leases on balance sheet has led to concern over the scope of the proposals, and not solely over the number of short-term and possibly immaterial leases subject to asset and liability recognition and measurement.
The bewilderment does not stop there. Today there are two types of leases: operating and finance leases. As the Boards debate further the more than 750 comment letters they have received, they have tentatively decided there should be two types of leases: finance leases and 'other than finance' leases. They have also decided tentatively that, for 'other than finance' leases, the pattern of expense recognition in profit or loss should be straight-line; that is, exactly the same as under current operating lease requirements. This may resolve the issue for lessees of recognition of a higher expense in earlier years of a lease on all leases but it is difficult to understand the full effects of 'other than finance lease' accounting without an understanding of its mechanics which are as yet undetermined by the Boards. Annuity amortisation of the right-of-use asset would be one way of achieving a straight-line charge but would also be at odds with permitted patterns of amortisation under IFRSs today.
A straight-line charge also reopens the question of whether the 'other than finance lease' expense in the statement of comprehensive incomes could be presented as 'rental' expense or part rental and part finance cost, or whether a split between amortisation and finance cost will be required. The more one contemplates the reintroduction of what looks like a very familiar operating/financing distinction with different profit and loss treatment for leases currently called operating, the greater the complexity of application appears to become. It is difficult to suppress a thought that perhaps the costs do not outweigh the benefits.
Then there is the question of renewal options and contingent rentals. The exposure draft said both were simply measurement issues. On renewal options the Board has stepped down with a tentative decision to only include renewal options where there is a "significant economic incentive" for an entity to exercise the option. This is a clear change from the proposed lease term as the longest possible lease term more-likely-than-not to occur including an assessment of all options to renew. It appears similar to the existing "reasonably certain" threshold for renewal/extension options. However, unlike today, reassessment of the lease term would be required.
On contingent rentals, it is less clear, at least for some types of contingencies, what the Boards intend. The exposure draft required a probability-weighted expected outcome approach. The tentative decision now is to include all variable lease payments that are "reasonably certain" of being paid in the measurement of a lessee's liability and the lessor's receivable. But, how do you determine, for payments contingent on usage or performance, the amount that is reasonably certain of being paid? This revised threshold may work for contingent rent based on an index. But for rent contingent on retail sales, say over a twenty-year period, how do you forecast the "reasonably certain" figure? Some say the likely decision is that it will be based on whatever is thought probable. But a notable observation during the joint discussions of the Boards was that the 'probable' threshold itself is problematic. To one Board member it can mean greater than 50%, to another greater than 80% probability.
It is the perennial problem of standard-setting: the theory can be difficult to fault but the application in practice is rather different. And the IASB has been somewhat taken aback by the comments, feedback and outreach responses. Some investors have surprised the Board by saying that they don't mind if a lease is on balance sheet or not and that they don't really need the additional information the exposure draft would give them. Small wonder that – as the IASB revealed at the Global Preparers Forum discussion – analysts are telling the Boards they've never had such lobbying from preparers.
In the first instance, the Boards have tentatively reconfirmed the right of use model for lessees for all lease arrangements and, under this model, 'other than finance' leases will end up on balance sheet when the standard is finalised. But how is far from clear, and the existing distinctions, guidance and approaches in IAS 17 unwittingly gain credibility. Furthermore, while the Boards decided in January to consider both the lessee and lessor sides of the equation as they re-deliberate, they are only scheduled to begin to consider lessor accounting specifically from April.
As we said in a previous column looking ahead to the leasing exposure draft last year: 'It is all going to be complex, and it is going to be hard work'. In the IASB podcast summing up its most recent deliberations on the topic Board member Steve Cooper concluded by saying that the IASB was 'trying to be pragmatic'. That is always a good objective.