IFRS – LEASES NEWSLETTER December 2011, Issue 9

The future of lease accounting

Highlights

• Leases of investment property out of scope of the lessor accounting model

• Income from investment property leases generally recognised on a straight-line basis

• Requirement for lessors to assess whether profit is reasonably assured dropped

• Boards to discuss lessee expense recognition in the New Year

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The IASB and FASB (the Boards) discussed the leases project in December, almost a year to the day after the comment period on the 2010 ED closed. The proposals have changed significantly in that year.

In many ways, the current proposals would be simpler to apply than those in the 2010 ED.

One key area of simplification is measurement of the obligation to pay/right to receive lease payments. Lease term is easier to determine, would often be shorter and there would be a single threshold for the recognition of renewal options and purchase options. Many contingent rents would be excluded from initial measurement.

Another area of simplification is the lessor accounting model. The derecognition and performance obligation approaches would be replaced with a single receivable and residual model. That model has been refined, to remove the need to assess whether profits arising are ‘reasonably assured’.

However, complexities would remain. The Boards are sticking by proposals to re-assess lease payments in some circumstances, which may lead to balance sheet volatility, and the mechanics of lessor accounting would remain formidable.

Crucially, the proposals continue to characterise nearly all leases as financing transactions. This would result in a front-loaded profile of income/expense. Earlier this year, the Boards discussed but rejected approaches to reconcile the model with the straight-line profile of income/expense, the so-called ‘other-than-finance-lease’ approach.

The Board’s current proposals to mitigate the front-loading of income/expense take the form of scope exemptions. All short-term leases may be out of scope for lessees and lessors. More recently, the Boards decided to exempt all leases of investment property by lessors.

The scope exemption for investment property, a major class of leased asset, is particularly striking. The exemption has been proposed for all leases of investment property, including leases of investment property measured at cost.

There is a risk of moral hazard here.

Many tenants will ask why they must account for property leases as financing transactions when their landlords do not. Indeed, many retailers highlighted income statement recognition as a key concern in their responses to the 2010 ED. Similarly, lessors of other big-ticket items will want to understand why they are not being offered a similar scope exemption.

The lease proposals are simpler than a year ago but remain controversial. The Boards have indicated that they will return to the topics of lessee expense recognition and other big-ticket items in 2012.

A year is a long time in standard-setting

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Recent decisionsDuring the final quarter of 2011, the Boards continued to devote significant time and effort to the leases project. Much of the discussions were focused on lessor leases of investment property, and how the lessor accounting model would operate.

Tentative decisions regarding lessors of investment property include the following.

• For lessors, all leases of investment property are outside the scope of the receivable and residual model, irrespective of whether the lessor measures its investment property.

• IFRS lessors of investment property would recognise rental income on a straight-line basis, or another systematic basis if that basis is more representative of the time pattern in which the rentals are earned from the investment property.

• Lessors of investment property would recognise only the underlying investment property (as well as any accrued or prepaid rental income) in the financial statements.

• Disclosure in respect of leases of investment property would include:

– a maturity analysis of the undiscounted future non-cancellable lease payments for a lessor’s lease of investment property;

– both minimum contractual lease income and variable lease payment income within the table of lease income;

– the cost and carrying amount of property on lease or held for leasing by major classes of property according to nature or function, and the amount of accumulated depreciation in total as of the date of the latest balance sheet presented; and

– information about those leases consistent with the disclosures required by paragraph 73 of the 2010 ED, updated for the Boards tentative decision to date.

Tentative decisions regarding the operation of the lessor receivable and residual (R&R) model include the following.

• On initial recognition, the lessor would measure the residual asset as an allocation of the carrying amount of the underlying asset. The initial measurement of the residual asset comprises two amounts: (a) the gross residual asset, measured at the present value of the estimated residual value at the end of the lease term, discounted using the rate that the lessor charges the lessee and (b) the deferred profit, measured as the difference between the gross residual asset and the allocation of the carrying amount of the underlying asset to the residual asset (see example below).

• Subsequently, the lessor would measure the gross residual asset by accreting it to the estimated residual value at the end of the lease term using the rate that the lessor charges the lessee. The lessor would not recognise any of the deferred profit in profit or loss until the residual asset is sold or re-leased.

• The gross residual asset and the deferred profit would be presented together as a net residual asset.

The Boards also abandoned the concept of assessing whether profits arising are ‘reasonably assured’ effectively concluding that it created unnecessary complexity in applying the R&R model, and that the concept is a difficult one to articulate in a way which does not leave the door open for structuring opportunities. Accordingly all profit on the residual asset element would be deferred and all profit on the leased element would be recognised immediately.

The Boards still have some remaining lessor accounting matters to discuss under the R&R model. One of these issues is that the net residual asset may be greater than the gross residual asset when a lessee transaction contains variable lease payments. This adds significant complexity to the mechanics of the R&R model.

In addition, the Boards tentatively agreed that leases in which both the lessee and the lessor each have a right to cancel the lease at any point in the future without a significant penalty (i.e. the penalty is not a nominal charge such as a month’s rent) would meet the definition of short-term leases when the notice period, together with any initial non-cancellable period, is less than one year. The Boards also discussed transition, first-time adoption and consequential amendments. Their tentative decisions in these areas are set out in the Appendix.

Next stepsThe IASB’s workplan states that the ED will be released during the first half of 2012, with a final standard to be released in the second half of 2012.

Topics that the Boards plan to discuss prior to re-exposure include:

• straight-line expense recognition pattern for lessees;

• the definition of investment property;

• remaining presentation and disclosure matters for lessees and lessors;

• disclosures about the fair value of investment property;

• remaining lessor accounting matters under the receivable and residual model; and

• cost/benefit considerations of the proposals as a whole.

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Real estate leases illustrated Much recent discussion focused on the application of the Boards’ proposals to leases of real estate. We set out below an example of a real estate lease and compare the accounting treatment under the current proposals, the 2010 ED and IAS 17.

Fact pattern

• A lessee and lessor enter into a lease of retail premises for a 10-year lease period with a renewal option for a further 10 years. The lessee’s base rental is 412,500 per year (paid in arrears) plus 5 percent of the lessee’s turnover.

• The lessee and lessor determine that:

– the lessee does not have a significant economic incentive to renew the lease, such that the lease term would be 10 years under current proposals; and

– the longest possible term that is more likely than not to occur is 20 years, such that the lease term would be 20 years under the 2010 ED.

• The expected turnover of the lessee in year one is 2,750,000. Turnover is assumed to grow at 5 percent per annum for the first five years, 0 percent growth is assumed thereafter.

• The total undiscounted rentals over the 10-year term would be 5,720,000 and over the 20-year term would be 11,517,000.

• The residual value of the retail premises is expected to 7,500,000 and 5,000,000 in years 10 and 20 respectively. The retail premises is expected to have a 40-year life at inception of the lease. The fair value of the premises is 10,000,000 at commencement of the lease.

• The rate the lessor charges the lessee under the current proposals and 2010 ED is 3.589 and 4.08 percent respectively, due to the difference in assessed lease terms.

• The lessor classifies the retail premises as investment property, measured using the cost model.

• The retail premises has a carrying amount of 10,000,000 in the lessor’s financial statements prior to lease commencement.

• For simplicity, this example ignores initial direct costs and remeasurements, and assumes the lessee applies the cost model.

Lessee accounting

Under the right-of-use (ROU) model included in the current proposals and the 2010 ED, a lessee would recognise an asset for its right to use the leased asset and a liability for its

obligation to make future lease payments. Over the lease term, the lessee would recognise amortisation of the ROU asset and finance expense arising on the liability. Under IAS 17, the lease is likely to be an operating lease.

The following table compares the amounts the lessee would recognise in its statement of financial position on commencement of the lease under the current proposals, the 2010 ED and IAS 17.

Statement of financial position

Current proposals

‘0002010 ED

‘000IAS 17

‘000

ROU asset 3,415 7,752 0

Lease liability (3,415) (7,752) 0

Some points to note in relation to the statement of financial position:

• Under IAS 17 this lease would be likely to be classified as an operating lease as the lease does not transfer substantially all the risks and rewards of ownership of the retail premises to the lessee. Thus, the lessee would not recognise any amounts on its statement of financial position on lease commencement.

• The changes in relation to variable lease payments (VLPs) are likely to have a big impact in practice compared to the 2010 ED. Under the current proposals VLPs are excluded from the measurement of the lessee’s lease liability unless they contain a fixed element or are based on an index or rate. In this example, if the lease term was determined under the 2010 ED and the VLPs accounted for under current proposals then the liability to be recognised would be 5,567,000 which is the present value of the base rentals over the 20 years. On this basis the lease receivable would be 2,186,000 less than the amount which would have been recognised under the 2010 ED’s proposals (7,752,000 - 5,567,000 = 2,186,000).

• As a result of the changes to the definition of lease term, lessees will be likely to determine shorter lease terms than under the 2010 ED, resulting in lower amounts to recognise on the statement of financial position at lease commencement. In this example the impact is to reduce the liability by 2,152,000 (5,567,000 - 3,415,000).

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The following table summarises the amounts arising in the lessee’s statement of comprehensive income under the current proposals, the 2010 ED and IAS 17 during the first year of the lease.

Profit or Loss ‘000 ‘000

Current proposals

Depreciation charge 342

Interest expense 123

Contingent rental 138

Total expense 603

2010 ED

Depreciation charge 388

Interest expense 316

Total expense 704

IAS 17

Operating lease expense 550

Total expense 550

A point of note in relation to the statement of comprehensive income:

• If the lessee’s EBITDA for year one of the lease term was 1,000,000 before reflecting any adjustment for this lease transaction, then EBITDA would be 1,465,000 under the current proposals, 1,704,000 under the 2010 ED and 1,000,000 under IAS 17 after reflecting the adjustment for this lease. Interest expense and depreciation would be taken into account in the calculation of EBITDA, due to the fact that under the 2010 ED the lease liability includes VLPs, the add back for interest expense is far greater compared to the current proposals.

The following chart illustrates the total lease expense recognition profile over the lease term:

Some points to note on the profile of lease expense recognition:

• Under the 2010 ED, total lease expense in years one to 10 is 807,000 higher than under IAS 17. Over 50 percent or 411,000 of the lease expense front loading occurs in the first three years of the lease term.

• Under the current proposals lease expense recognition is still front-loaded. However, the frontloading effect is reduced due to the lower amount of interest arising on the reduced lease liability. This arises as a result of the changes made to the definition of lease term and accounting for VLPs (that are not based on an index or rate, e.g. the consumer price index (CPI) or LIBOR as incurred.

• The front-loading effect is consistent with the Boards’ view that nearly all leases are financing transactions, as it is a faithful reflection of the time value of money. For example, if a lessee fully prepaid a lease, its total lease payments would be lower and its pattern of expense recognition would be straight-line. The ROU asset recognised in a fully prepaid lease would be approximately the same amount as a ROU asset recognised in a lease with lease payments during the lease term.

Some additional points of note about this example:

• Under the current proposals, if the lessee did exercise its option to renew the lease, the resulting extension would be accounted for by determining a revised discount rate as if the lease were a new lease and the lessee would adjust its lease liability and ROU asset. The lease term would be re-assessed if contract, asset or entity specific factors affecting the decision to extend or terminate change significantly.

• The lessee’s accounting policy is to depreciate its ROU asset on a straight-line basis, and in this example the depreciation does follow a straight-line profile. However, under the current proposals if the VLPs in the lease were based on an index or rate, the depreciation profile may be an increasing one. This is because the lessee re-assesses its lease liability at each balance sheet date to reflect the change in the index or rate and adjusts the carrying amount of the ROU asset.

Lessor accounting

Under the current proposals, the lessor is outside the scope of the receivable and residual model. Under the 2010 ED, the lessor would have been likely to have applied the performance obligation approach under which it would have continued to recognise the retail premises. It also would have recognised a receivable for its right to receive lease payments and an obligation to make the retail premises available to the lessee.

The following table summarises the amounts arising in the lessor’s statement of financial position on commencement of

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the lease in respect of this lease transaction under the current proposals, the 2010 ED and current practice.

Statement of financial position

Current proposals

‘0002010 ED

‘000IAS 17

‘000

Underlying asset 10,000 10,000 10,000,

Lease receivable 0 7,752 0

Lease liability 0 (7,752) 0

Some points to note about the statement of financial position:

• In this example the lessor would not account for this lease using the receivable and residual model as all leases of investment property are outside the scope of the model for lessors.

• The lessor, under the 2010 ED, retains significant risks or benefits associated with the underlying asset during the expected term of the lease, and therefore would be likely to apply the performance obligation approach. Under IAS 17 the lessor would classify the lease as an operating lease as it does not transfer substantially all the risks and rewards to the lessee.

• Under all three approaches, the lessor would recognise the same net amount of assets and would not recognise a profit on lease commencement.

The following table summarises the amounts arising in the lessor’s statement of comprehensive income under the current proposals, the 2010 ED and current practice over the first year of the lease term.

Profit or loss ‘000 ‘000

Current proposals

Lease income 550

Depreciation (250)

Total income 300

2010 ED

Interest income 316

Lease income 388

Depreciation (250)

Total income 454

IAS 17

Lease income 550

Depreciation (250)

Total income 300

Some points to note about this example:

• Under the current proposals the lease term would be the contractual minimum lease term plus any optional

periods for which there is a significant economic incentive to exercise the renewal option. It is likely that the lessor would not be able to assert that the lessee has a significant economic incentive to renew as assumed in the fact pattern. Conversely, the lessee may well be able to assert that it has a significant economic incentive to renew the lease and in practice situations may arise in which the lessee and lessor assess the lease term to be different durations for the same contract.

• Under the fair value model, lease income would be the same amount in year one (550,000), no depreciation would be charged and the lessor would also recognise a gain or loss arising from any change in the fair value of the retail premises.

• Under the 2010 ED performance obligation approach, lessors would be required to estimate all VLPs and include those in the measurement of the lease receivable. The current proposals now would only require the estimation of VLPs based on an index or rate (using the spot rate at lease commencement) and in substance fixed rentals.

• The total lease income for the lessor under the 2010 ED and the current proposal would be the same assuming the lessee renewed the lease and there is no change to the assumptions (i.e. the term is 20 years under both proposals). However, as can be seen from the above table the profile of income recognition would be frontloaded compared to what the expense recognition profile would have been under operating lease accounting in accordance with IAS 17 and the current proposals for leases of investment property.

Equipment leases – lessor accountingLessors of other asset classes would apply the receivable and residual model to their leases. The mechanics of the model have been refined in recent Board meetings. For example, the earlier proposal that a lessor assess whether the profit arising on transfer of the ROU asset is ‘reasonably assured’ has been dropped.

The following example illustrates the application of the revised lessor proposals to a simple equipment lease.

Fact pattern

A lessee and lessor enter into a transaction to lease an asset for a four-year lease term. The asset has a useful life of five years. The lease stipulates that the lessee’s base rental is 275 per year (paid in arrears) and that the base rental will be adjusted each year to reflect the cumulative change in CPI since lease commencement.

The rate the lessor charges the lessee is 7.33 percent. Therefore at inception of the lease the lessee would measure the lease liability as the present value of 275 per year over four

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years discounted at 7.33 percent, i.e. the lessee would not anticipate future increases in price levels when measuring the lease liability on initial recognition.

The table below shows the increase in CPI and the resulting lease payments.

Year 1 2 3 4

Annual change in prices (CPI) 1% 2% 3% 4%

Actual lease payments 278 283 292 303

Assume also that the underlying asset has a carrying amount of 950 in the lessor’s financial statements prior to lease commencement. The fair value of the underlying asset at lease commencement is 1,000. The lessor estimates that the residual value of the underlying asset will be 100 at the end of the lease. For simplicity, this example ignores initial direct costs and remeasurements.

Lessee accounting

The accounting for lessees would be consistent in principle with the illustration of the real estate lease shown above. The lessee’s accounting entries for this equipment lease are illustrated in the previous edition of this newsletter.

Lessor accounting

As highlighted above the Boards have proposed to remove the concept of profit being reasonably assured. Instead the current proposals would require the deferral of any profit related to the portion of the underlying asset which has not been transferred. The Boards have also proposed to change the measurement basis of the residual asset, which now would be based in part on the estimated future fair value of the residual asset at commencement of the lease.

The following table summarises the amounts that would arise in the lessor’s statement of financial position and income statement following the removal of the concept of profit being reasonably assured.

Lessor: Receivable and residual model

Balance sheet Profit or loss impacts

Yr Leas

e re

ceiv

able

Gro

ss re

sidu

al a

sset

Def

erre

d pr

ofit

Net

resi

dual

ass

et

Inte

rest

inco

me

Acc

retio

n

Upf

ront

pro

fit

Varia

ble

leas

e in

com

e

Tota

l

0 925 75 (4) 71 46 46

1 725 81 (4) 77 68 6 0 10 84

2 510 87 (4) 83 53 6 0 16 75

3 272 93 (4) 89 37 6 0 16 59

4 0 100 (4) 96 20 7 0 12 39

178 25 46 54 303

Some points to note about this example:

• The lessor’s net residual asset is an allocation of the carrying amount of the underlying asset. The lessor calculates the opening balance of the net residual asset as the previous carrying amount of the underlying asset (950) less the amount derecognised for the right of use sold to the lessee (950 x 925/1,000 = 879) being the carrying amount of the asset x (lease receivable/fair value of the asset), giving an opening balance of 71.

• The lessor’s gross residual asset is measured at the present value of the estimated residual value at the end of the lease term, discounted using the rate that the lessor charges the lessee. In this example, 100 is discounted at 7.33 percent to give a gross residual asset of 75. The lessor then accretes that amount at the rate it charges the lessee, such that the gross residual asset increases to 100 by the end of the lease term.

• The lessor then determines the amount of profit to defer on the residual element, being the difference between the gross residual asset and the net residual asset, in this case 75 - 71 = 4. As a result the lessor will always recognise upfront profit or loss when the fair value of the underlying asset is different compared to its carrying amount. The upfront profit is calculated as (the present value of estimated lease payments + net residual asset) - carrying amount of the underlying asset, (925 + 71) - 950 = 46.

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• The lessor would present in its statement of financial position a single balance in respect of the residual asset, being the net of the gross residual asset and deferred profit.

• The lessor would recognise the deferred profit when the underlying asset is generally either sold or re-leased at the end of the lease term.

• Note where the lease receivable is measured using the spot rate for CPI, which is zero at commencement. The proposals would require that the lease receivable is remeasured each time there is a change in CPI. These remeasurements further complicate the model. If there had been VLPs associated with the lease then the current proposals would require the residual asset to be adjusted for the VLPs if they were reflected in the rate the lessor charges the lessee. For example, when a lessor of photocopiers determines the rate to charge lessees based on a base rental of 100 plus a usage charge estimated as 100 per period on lease commencement. This would make the model even more burdensome for lessors to apply and operate.

• Note also that the Boards have tentatively decided that the lessor would exclude amounts receivable under residual value guarantees from measurement of its lease receivable. This means that a lessor’s receivable and a lessee’s payable may be different in leases featuring residual value guarantees. Instead, the lessor would consider the effect of residual value guarantees when assessing whether the residual asset is impaired.

Transition for operating leasesThe Boards tentatively decided to provide both lessees and lessors an option to apply the requirements of the proposed new leases standard on a fully retrospective basis or to apply a modified retrospective transition approach. The modified retrospective transition approach would require the lessee to measure its remaining liability to make lease payments as of the effective date using the discount rate at that date.

The ROU asset calculation uses the same information as is required in the liability calculation (discount rate, lease term, and lease payments) to approximate the ROU asset at the effective date based on the proportion of the remaining lease term. Having calculated the liability, the lessee would then calculate an annuity payment necessary to amortise the liability to zero at the end of the lease term. That annuity payment is then used to calculate the present value of the lease liability for the full lease term and the ROU asset is calculated as the remaining lease term proportion of that amount.

This modified retrospective approach may be quite complex to apply in practice, particularly for lessees with a profile of lease payments that do not follow a straight-line profile. The following example illustrates this complexity.

Fact pattern

A lessee has an operating lease and at the effective date the:

• lease has a remaining lease term of five years and the original lease term was 10 years;

• remaining lease payments annually in arrears over each remaining year in lease term are equal to 1,000, 1,050, 1,100, 1,150, and 1,200, respectively, 5,500 in total; and

• lessee’s incremental borrowing rate is 10 percent.

Lessee accounting

At the effective date, the lessee would calculate its remaining lease liability to be 4,134 being the present value of the remaining lease payments (5,500) discounted, in this case, using the lessee’s incremental borrowing rate of 10 percent at the effective date. The lessee would then be required to determine the annuity payment that amortises the liability to zero at the end of the lease term, which amounts to 1,091.

Using this amount the lessee would calculate what the lease liability would have been at the beginning of the lease term, in this case 10,910 (1,091 x 10). Then the lessee would calculate the present value of that amount using the discount rate at the effective date, in this case the incremental borrowing rate of 10 percent, which amounts to 6,701. Finally, the lessee would calculate the proportion of that amount which represents the remaining lease term, in this case 3,350 (6,701 x 5/10; the remaining lease term over the original lease term).

Constituents may welcome the fact that the Boards have added the option to apply the fully retrospective approach or the modified retrospective approach. However, given the complexity of the mechanics of the modified retrospective approach, many constituents will question whether the Boards have gone far enough in simplifying the transition requirements in respect of operating leases.

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8

Tentative decisions compared with key proposals in the 2010 ED

Key proposal in the 2010 ED Current proposals KPMG observations

Sco

pe

Definition of a lease

A lease is a contract in which the right to use a specified asset, i.e. the underlying asset, is conveyed for a period of time, in exchange for consideration.

Similar to IFRIC 4, a contract is or contains a lease if the following conditions are met:

• it conveys the right to use a specified asset; and

• it conveys the right to control the use of the underlying asset.

The proposed definition of a lease and the key conditions (existence of a specified asset and control) would be retained.

A specified asset would need to be uniquely identifiable and a physically distinct portion of a larger asset could be a specified asset, e.g. a floor of an office building.

A contract may identify explicitly or implicitly an underlying asset. However, an asset would not be the subject of a lease if the asset is inseparable from a service, e.g. a digital box included as part of a cable subscription.

A revised description of control that is aligned with the proposed new revenue recognition standard would be developed. Control would be conveyed when a customer can direct the use, and receive the benefit from the use, of a specified asset.

The line between what is considered a lease and what is considered a service will move. Distinguishing between leases (on-balance sheet for lessees) and service contracts (off-balance sheet) is likely to become a key accounting judgement under the new standard.

The approach to physically distinct portions of a larger asset is consistent with the practice of tenants who rent parts of a building which are typically accounted for as leases. It is not clear how the Boards’ decision will affect other fact patterns.

The exclusion of assets that are ‘inseparable from services’ is a pragmatic step that will reduce the number of occasions in which entities will be required to identify leases in some arrangements. Further work will be required to assess how widely this principle will be applied in practice.

In-substance purchases and sales

A contract that represents the purchase/sale of an underlying asset would not be a lease. A transaction would be an in-substance purchase/sale if an entity transfers control of the underlying asset and all but a trivial amount of its risks and benefits to another entity.

The Boards revisited the guidance in the 2010 ED to distinguish between a lease and a purchase/sale of an underlying asset. They tentatively decided that if an arrangement does not contain a lease, then it would be accounted for in accordance with other applicable standards, for example IAS 16 or the new revenue standard.

The Boards no longer expect to provide guidance in the new leases standard for distinguishing a lease of an underlying asset from a purchase/sale of an underlying asset.

The guidance in the 2010 ED created tension for some constituents because, similar to the manner in which operating and finance leases are distinguished currently, it would be necessary to make a binary distinction between two different types of lease transactions.

The Boards appear to believe that an appropriate definition of a lease combined with appropriate revenue recognition guidance would remove the need to provide guidance to distinguish a lease and a purchase/sale. However, this puts further pressure on the definition of a lease.

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9

Key proposal in the 2010 ED Current proposals KPMG observations

Th

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els

Lessee accounting model

A lessee recognises:

• an asset for its right to use the leased asset and a liability for its obligation to make future lease payments; and

• amortisation of the ROU asset and finance expense arising on the liability.

Recognition of amortisation of the ROU asset and finance expense arising on the liability gives rise to a front-loaded pattern of lease expense.

Lessees would apply the lessee model proposed in the 2010 ED.

To address constituents’ concerns that a front-loaded pattern of lease expense recognition is not appropriate for all leases there will be enhanced disclosure. The Boards would require lessees to present a tabular disclosure of all lease expenses in one note to the financial statements.

The proposed lessee model reflects the Boards’ objective of a single lease accounting model. It will be simpler to apply than current lease accounting, in that there will be no lease classification test.

The model treats all leases as being financing transactions. Some constituents will continue to believe that a straight-line profit or loss recognition pattern is appropriate in some circumstances. Future decisions in relation to lease disclosures will be of particular importance to these constituents.

Accounting model for lessors

Two accounting models for lessors were proposed:

• the performance obligation approach; and

• the derecognition approach.

If a lessor retained exposure to significant risks and benefits associated with the underlying asset, then it would apply the performance obligation approach; otherwise it would apply the derecognition approach. The approach to be applied to each lease would depend on its terms.

Under both approaches, the lessor would recognise an asset representing its right to receive future lease payments and interest income, on the grounds that there is a financing component to the arrangement that affects the pattern of profit or loss recognition.

A lessor would not be required to apply either approach to leases of investment property measured at fair value.

A version of the derecognition approach, now renamed the ‘receivable and residual’ model, would apply to all leases. Under this model the lessor derecognises the underlying asset and recognises:

• a lease receivable;

• a residual asset;

• profit on the portion of the asset transferred to the lessee at lease commencement; and

• interest income on the lease receivable and income on accretion of the residual asset over the term of the lease.

A lessor would not apply this model to leases of investment property (see page 2).

A lessor would measure the lease receivable initially at the present value of the lease payments discounted at the rate the lessor charges the lessee and subsequently using the effective interest method.

A lessor would measure the residual asset initially as an allocation of the carrying amount of the underlying asset, less any deferred profit relating to the portion of the asset not transferred to the lessee. The deferred profit would be recognised after the end of the lease term generally when the underlying asset is sold or re-leased.

There will be no option to fair value measure lease receivables and revaluation of the lessor’s residual asset is prohibited.

Applying the receivable and residual model to all leases within scope removes the ‘lease classification’ approach in the 2010 ED. However, the exemptions for investment property and short-term leases still introduce lease classification requirements.

Furthermore, some may find the accounting requirements for the residual asset complex and the measurement attribute of the residual asset unclear.

Both the lessee model and the lessor model treat every lease as containing a financing component. Some constituents believe that property leases are different from equipment leases and therefore different models should apply.

Extension of the proposed scope exception for all investment property will allay these concerns for at least some lessors.

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10

Key proposal in the 2010 ED Current proposals KPMG observations

Th

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Sub-leases

Generally, an intermediate lessor would apply the proposed requirements to account for its interest in:

• the head lease in accordance with the lessee ROU model; and

• the sublease in accordance with either the performance obligation approach or the derecognition approach.

Separate accounting would apply to the head lease and the sublease. An intermediate lessor would therefore account for its interest in:

• the head lease in accordance with the lessee ROU model; and

• the sublease in accordance with the lessor receivable and residual model.

The proposals do not include any measurement exceptions for subleases. As such an intermediate lessor may measure the lease liability related to a head lease differently from its lease asset related to a sublease of the same underlying asset.

In practice, subleases are common and there are some arrangements that intermediate lessors treat as a pass-through. The possibility that an intermediate lessor may act as an agent was not addressed, including whether the guidance in the revenue project, or the guidance in IAS 39 would apply to such arrangements.

Short-term leases

A short-term lease was defined as a lease that, at the date of commencement, has a maximum possible lease term, including any options to renew or extend, of 12 months or less.

Lessees and lessors can, on a lease-by-lease basis, apply simplified requirements to short-term leases:

• a lessee could initially measure the lease liability at the undiscounted amount of the lease payments and the ROU asset at the amount of the lease liability plus initial direct costs; and

• a lessor could continue to recognise the underlying asset and nothing additional on its balance sheet.

The Boards confirmed that a short-term lease is a lease that, at the date of commencement, has a maximum possible term, including any options to renew or extend, of 12 months or less.

The Boards propose to permit lessees and lessors to elect on a class of asset basis to apply the same simplified requirements to short-term leases. Under the simplified requirements lessees and lessors would not recognise lease assets or lease liabilities. Instead, lessees and lessors would recognise lease payments in profit or loss over the lease term similar to current operating lease accounting.

With these tentative decisions regarding short-term leases, the Boards have moved away from the requirement that lessees recognise all leases on balance sheet. Instead, lessees would have an option not to recognise short-term leases on balance sheet. This option would apply irrespective of the total size of an entity’s commitment to short-term leases.

The proposal is likely to be welcomed by lessees and lessors with multiple short-term low-value lease arrangements. The simplified requirements are recognisable to constituents currently applying IAS 17 as they are based on current operating lease accounting. They now offer lessees the same relief as lessors.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Separating lease and non-lease components

The FASB and IASB versions of the 2010 ED included different proposals on when and how to separate the lease and non-lease elements of a multiple-element contract.

Both versions of the 2010 ED proposed that in some circumstances an entity would not separate the lease and non-lease elements of a multiple-element contract and instead would apply the lease accounting proposals to the whole of the contract, including the non-lease element.

A lessor always would account separately for the lease and non-lease elements of a multiple-element contract, allocating payments between the elements of the contract using the guidance on revenue recognition.

A lessee would account separately for the lease and non-lease elements of a multiple-element contract if the purchase price of either the lease or non-lease elements is observable, allocating payments by reference to the observable prices.

A lessee would account for the whole contract as a lease if there are no observable purchase prices.

The Boards have now reached a converged position on when to separate the lease and non-lease elements of a multiple-element arrangement. Broadly, these proposals will reduce the circumstances in which an entity will be required to apply lease accounting to a service element of a contract compared to those in the 2010 ED.

However, the circumstances in which a lessee and lessor will be required to separate a contract, and how they will allocate contract payments, will be different. This may result in lessees and lessors accounting for the same contract in different ways.

Inception vs commencement

A lessee and lessor:

• measure the assets and liabilities arising from a lease at the date of inception, being the earlier of the date of the agreement or commitment to the terms of the lease; and

• recognise the assets and liabilities arising from a lease at the date of commencement, being the date on which the lessor makes the underlying asset available for use by the lessee.

A lease contract that is onerous between the dates of inception and commencement would be within the scope of IAS 37. Costs and lease payments incurred by a lessee prior to lease commencement, and lease incentives, are not addressed.

A lessee would measure and recognise the assets and liabilities arising from a lease contract at the date of commencement using the discount rate at that date.

A lease contract that is onerous between the dates of inception and commencement would be within the scope of IAS 37.

The leases standard would include application guidance on:

• costs incurred by a lessee prior to lease commencement;

• lease payments made before lease commencement; and

• lease incentives, which the Boards tentatively decided a lessee would deduct from the carrying amount of its ROU asset.

Many constituents expressed concerns that the 2010 ED was unclear on how to account for a lease contract between the dates of inception and commencement. The Boards’ focus in this discussion on the nuts and bolts of the accounting entries may help to re-assure some that the Boards are aware of the practical issues that entities will face in applying the new standard.

Lease term

The 2010 ED proposed that the lease term be determined at inception as the longest possible term that is more likely than not to occur.

The lease term would be the contractual minimum lease term plus any optional periods for which there is a significant economic incentive to exercise the renewal option. This assessment would be based primarily on economic factors.

IAS 17 uses the phrase ‘reasonably certain’ when describing the recognition threshold of renewal (and purchase) options. A key practice question will be whether the Boards intend ‘significant economic incentive’ to describe a materially different recognition threshold from ‘reasonably certain’.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Purchase options

The 2010 ED proposed that:

• the exercise price of a purchase option is not a lease payment and therefore is excluded from a lessee’s lease liability and a lessor’s lease receivable;

• a lease contract ceases to be a lease and is considered to be a purchase/sale at the point a lessee exercises its purchase option; and

• a lease with a bargain purchase option is considered to be a purchase/sale and therefore is not within the scope of the standard.

During redeliberations, the Boards tentatively decided that:

• lessees and lessors would treat the exercise price of a purchase option as a lease payment if the lessee has a significant economic incentive to exercise the purchase option; and

• if it is determined that the lessee has a significant economic incentive to exercise the purchase option, then the leased asset would be amortised over the economic life of the underlying asset, rather than over the lease term.

The same accounting approach will be applied to renewal options and purchase options when there is a significant incentive to exercise the purchase option. This may dissuade criticism from some constituents who thought that the 2010 ED proposals could create structuring opportunities.

As noted above, a key practice question for both renewal and purchase options will be whether the Boards intend ‘significant economic incentive’ to describe a materially different recognition threshold from the current IAS 17 threshold of ‘reasonably certain’.

Discount rate

At the date of inception of a lease:

• a lessee measures its lease liability by discounting lease payments at its incremental borrowing rate or, if it can be readily determined, the rate the lessor charges the lessee; and

• a lessor measures its lease asset by discounting lease payments at the rate it charges the lessee.

The Boards confirmed the approach set out in the 2010 ED, clarifying that if a lessee can determine the rate that the lessor charges the lessee then the lessee would use that discount rate in preference to its incremental borrowing rate.

The Boards tentatively decided to develop application guidance on the determination of the discount rate.

Many constituents felt that the 2010 ED’s proposals regarding discount rates were unclear. The new application guidance will address practical issues such as determining the discount rate when multiple rates are available and determining the yield on a property.

Variable lease payments – Initial measurement

The 2010 ED proposed the following for VLPs on initial recognition:

The approach for VLPs on initial recognition would be to recognise:

As compared to the 2010 ED, the proposals substantially reduce the VLPs that would be accounted

• recognise using an expected outcome technique, i.e. • VLPs that are based on an index or rate, using spot for on balance sheet.

probability-weighted average; rates at the commencement of the lease; and This will be a significant relief, for example, for retailers

• for lessors, include only expected outcomes that can • VLPs that are in-substance minimum lease payments, with real estate leases with lease payments that are

be measured reliably; and through anti-avoidance measures. based in whole or in part on the retailer’s turnover, and

• if contingent rentals are based on an index or rate, Other VLPs would not be included in the initial certain vehicle leases in which the lease payments

then use: measurement of the lessee’s lease liability or the depend on mileage.

– forward rates if readily available; otherwise lessor’s lease receivable. In addition, the Boards have clarified that if lease

– spot rates at inception of the lease.payments depend on an inflation index, then inflationary increases are not included in the lease payments on initial recognition.

Conversely, constituents of the view that many of these VLPs meet the definition of a liability at the time the contract is entered into will be disappointed that they remain off balance sheet.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Initial direct costs

Initial direct costs are defined as recoverable costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made.

• A lessee would capitalise its initial direct costs as part of the carrying amount of its ROU asset.

• A lessor would capitalise its initial direct costs by adding them to its lease receivable.

The Boards confirmed the definition of initial direct costs, other than deleting the reference to ‘recoverable’.

The Boards confirmed that lessees and lessors would capitalise initial direct costs, as proposed in the 2010 ED.

At present, each of the Boards’ four priority projects (financial instruments, insurance, leases and revenue) includes guidance on the costs of obtaining a contract. However, the 2010 ED on each project uses different terminology and there are differences in the proposed criteria for recognising such costs as an asset.

Other lease payment considerations

Lease payments would:

• not include an estimate of amounts payable/receivable under residual value guarantees (RVGs) provided by an unrelated third party;

• include an estimate of the expected payment/receipt under RVGs that are provided by the lessee; and

• include term option penalties.

A lessee’s lease payments would:

• not include an estimate of amounts payable under RVGs provided by an unrelated third party;

• include an estimate of the expected payment under RVGs that are provided by the lessee; and

• include term option penalties.

A lessor’s right to receive lease payment would not include RVGs, and only amounts received would be recognised at the end of the lease term.

The treatment of RVGs by lessees and lessors is inconsistent and there seems to be no conceptual basis for this. Rather, the Boards choose this treatment for lessors to simplify the accounting that would arise when a residual asset is impaired and the lessor has an RVG in the lease arrangement.

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t Re-assessment of options in a lease

Lease term would be assessed at inception of the lease and re-assessed subsequently if facts or circumstances indicate that there has been a significant change in the lessee’s lease liability or the lessor’s lease receivable. The revised lease term would be determined using the same criteria as at inception.

Both renewal periods and purchase options would be included in lease accounting when there is a significant economic incentive to exercise the option. When assessing and re-assessing whether a significant economic incentive to exercise an option exists, an entity would take into consideration:

• market-based factors (initial assessment only)

• contract-based factors

• asset-based factors

• entity-specific factors.

Also the Boards re-affirmed the proposals in the 2010 ED that a change in estimated lease payments due to a re-assessment would result in a lessee adjusting its ROU asset.

The Boards intend that an entity would assess the indicators in their entirety. However, issues will arise with regard to which indicators should be considered more persuasive in evaluating whether a significant economic incentive exists. The Boards intend that an entity-specific factor based on management intent would not be considered persuasive in this evaluation. They intend to develop further application guidance to articulate how an entity might perform this evaluation.

Options will be re-assessed on a basis consistent with the initial determination, except that market-based factors would be excluded from the re-assessment. Generally, re-assessment would occur only when economic factors affecting the decision to exercise an option change.

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Key proposal in the 2010 ED Current proposals KPMG observations

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tRe-assessment of the discount rate in a lease

Neither the lessee nor the lessor should change the rate used to discount the lease payments except to reflect changes in reference to interest rates when VLPs are based on those reference interest rates.

When VLPs are based on reference interest rates, a lessor should recognise any change to the right to receive lease payments arising from changes in the discount rate in profit or loss.

The discount rate would be re-assessed only when there is a change in lease payments due to:

• a change in the assessment of whether the lessee has a significant economic incentive to exercise an option to extend a lease or purchase the underlying asset; or

• the exercise of an option that the lessee did not have a significant economic incentive to exercise.

A revised discount rate would be determined at the re-assessment date and that would apply to the remaining lease payments.

Many constituents commented that the 2010 ED proposals on discount rates were unclear. The Boards in their redeliberations have gone a long way to addressing these concerns. Thus far, they have clarified that lessees should use the discount rate implicit in the lease in preference to other available discount rates and the discount rate should not be re-assessed if there is no change in the lease payments. Many constituents will feel these are welcome developments.

Re-assessment of variable lease payments

Both the lessee and lessor would re-assess VLPs.

For a lessee, the change in the lease liability would be recognised:

• in profit or loss to the extent that it relates to the current period; and

• as an adjustment to the ROU asset to the extent that the change relates to future periods.

A lessor under the performance obligation model would recognise the change in the lease receivable:

• in profit or loss to the extent that the performance obligation is satisfied or zero; otherwise

• as an adjustment to the performance obligation.

Under the derecognition model, the change in the lease receivable would be recognised in profit or loss.

Both the lessee and lessor would re-assess only those VLPs that depend on an index or rate.

For a lessee, the change in the lease liability would be recognised:

• in profit or loss to the extent that it relates to the current period; and

• as an adjustment to the ROU asset to the extent that the change relates to future periods.

For a lessor, the change in the lease receivable would be recognised entirely in profit or loss.

Remeasurement of contingent rents based on an index or rate may be burdensome. However, these proposals compared to the 2010 ED reduce the amount of work required significantly. Rather than having to continuously consider all VLPs, practical relief has been provided by only requiring re-assessment of VLPs based on a rate or index.

The Boards considered the burden of remeasurement, but concluded that once the lease measurement formula is set up making an adjustment for a rate or index should be relatively straightforward.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Re-measurement of residual asset

Not addressed. Subsequently measure the gross residual asset by accreting it to the estimated residual value at the end of the lease term using the rate that the lessor charges the lessee. The lessor would not recognise any of the deferred profit in profit or loss until the residual asset is sold or re-leased. Thus, the accretion would adjust both the gross and net residual asset.

If the rate that the lessor charges the lessee doesn’t reflect an expectation of receipt of VLPs, then no adjustment would be made to the residual asset on receipt of VLPs.

Otherwise, the residual asset would be adjusted by recognising a portion of the residual asset as an expense as VLPs are recognised in profit or loss.

The tentative decisions on adjustment of the residual asset when VLPs impact the pricing of the lease likely will need to be revisited. This is because the tentative decisions were taken when accretion of the residual asset was based on its allocated carrying amount rather that the present value of the estimated future value of the residual asset. The combined effect of the current tentative decisions is that a lessor with identical leases would have different total lease income based on its expectation of receipt of VLPs.

Impairment

The lessee’s ROU asset would be assessed for impairment in accordance with IAS 36.

The lessor’s lease receivable would be assessed for impairment in accordance with IAS 39.

Both the lessee’s ROU asset and the lessor’s residual asset would be assessed for impairment under IAS 36.

The lessor’s lease receivable would be assessed for impairment under existing financial instruments guidance within IFRSs.

The lessor would consider any residual value guarantees when determining whether the residual asset is impaired.

Many constituents will be pleased to hear that the Boards have retained existing guidance for impairment of the assets and liabilities arising from lease contracts. Moreover, the removal of the performance obligation approach from the current proposals reduces the significant complexity of carrying out impairment assessments as proposed in the 2010 ED.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Contract modifications or changed circumstances

The 2010 ED proposed that a lessor would not change its accounting approach after the date of inception of the lease.

However, the 2010 ED did not provide any guidance on accounting for a modification to the terms of a contract or a change in circumstances that would affect whether a contract is, or contains, a lease.

A substantive contract modification would result in the modified lease being accounted for as a new lease (i.e. terminate the existing lease and account for the modified lease as if it were a new lease).

A change in circumstances that affects the assessment of whether a contract is, or contains, a lease would result in a re-assessment of the contract by the lessee and lessor. On re-assessment if it is determined that the contract contains a lease, then the lessee and lessor would apply lease accounting from the date of change in circumstances and vice versa.

Some constituents saw inconsistency with current guidance in the 2010 ED’s proposal that a lessee/lessor should not, after the date of inception of the lease, change the assessment of whether a contract is or contains a lease. They will be pleased that the Boards have addressed this issue. The new proposal will address practice issues that would have arisen had those in the 2010 ED been adopted; this is a welcome development.

Sale and leaseback transactions

An entity would apply sale and leaseback accounting when the sale leg of the transaction is considered to be a sale/purchase of the whole of the underlying asset. Otherwise, an entity would account for a sale and leaseback transaction as a financing transaction.

The 2010 ED included specific guidance on determining whether the underlying asset should be considered to be sold/purchased.

The Boards confirmed that the assessment of whether an entity would apply sale and leaseback accounting should depend on whether the sale leg of the transaction is considered to be a sale of the whole of the underlying asset. However, they tentatively decided that this assessment would be based on the revenue recognition guidance.The Boards confirmed that the mechanics of sale and leaseback accounting would follow the proposals in the 2010 ED.Sales and leaseback transition guidance would be aligned with the proposed transition requirements of the new standard (detailed in the transition section below).

The Boards’ proposals appear to confirm that sale and leaseback accounting will be less common as compared to current practice for companies applying IFRSs, under which it is not necessary to meet the definition of a sale in order to apply sale and leaseback accounting.

Additionally, more transactions are likely to qualify for sale and leaseback accounting than would have qualified under the 2010 ED, given that revenue recognition guidance is likely to be less restrictive than the initial proposals in the 2010 ED.

Securitisation of lease receivables

Not addressed in the 2010 ED. There would be no option to fair value the lease receivable, including if part or all of it is held for sale.

A lessor would:

• apply existing financial instrument derecognition requirements to lease receivables. However, the allocation of the carrying amount would be on the basis of fair value excluding any option elements and/or VLPs that are not transferred; and

• apply the disclosure requirements of IFRS 7 for transferred lease receivables.

This tentative decision differs from the tentative decisions in the Boards’ project on accounting for financial instruments, which would require receivables held for sale to be measured at fair value.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Lessee cash flow presentation

Classify cash payments of principal and interest as financing activities, separately from other financing cash flows.

Cash payments would be split between principal and interest, with the principal component presented as a financing activity and the interest component presented as either an operating or a financing component, consistent with the entity’s accounting policy.

Cash payments for short-term leases and cash payments for VLPs, other than those included in the measurement of the ROU asset and corresponding lease liability, would be classified within operating activities.

The requirement in the 2010 ED for lessees to classify the entire lease payment as a financing activity meant that the interest portion of the lease payments would automatically be classified as a financing activity. This proposal was inconsistent with interest payments on other debt obligations, which may be classified as operating or financing activities under IFRSs. The Boards’ proposals are now consistent with the treatment of payments under other debt obligations.

Lessor presentation

Present lease receivables separately from other financial assets and the residual assets separately within property, plant and equipment.

Classify cash receipts from lease payments as operating activities in the statement of cash flows.

A lessor shall present lease income and lease expense in profit or loss either in separate line items or net in a single line item so that the lessor provides information that reflects the lessor’s business model.

The receivable and residual would be presented under a single caption in the statement of financial position with separate presentation on the face or in the notes.

All lessor cash inflows associated with leases would be classified as operating activities.

In the statement of comprehensive income a lessor would present:

• accretion of the residual asset as interest income;

• amortisation of initial direct costs as an offset to interest income; and

• lease income and lease expense (e.g. revenue and cost of sales) on a gross or net basis depending on which presentation best reflects the lessor’s business model.

Some constituents may consider leasing transactions as investing activities. However, the Boards tentatively decided to require all cash inflows to be classified as operating in the statement of cash flows to enhance comparability and to simplify the presentation requirements.

The Boards had in mind that financial institutions likely would use net presentation, whereas manufacturers likely would use gross presentation.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Transition – Lessees & Lessors

An entity should recognise and measure all outstanding contracts within the scope of the proposals as of the date of initial application using a simplified retrospective approach.

An entity should provide transition disclosures required by IAS 8 without the disclosure of adjusted basic and diluted earnings per share.

The Boards tentatively decided to provide both lessees and lessors an option to apply the requirements of the new leases standard on a fully retrospective basis or to apply a modified retrospective transition approach.

In addition an entity would:

• not be required to evaluate initial direct costs for contracts that began before the effective date;

• be allowed to use hindsight in comparative reporting periods;

• disclose the reliefs, if any, it elected; and

• provide transition disclosures consistent with IAS 8 except disclosure of the effect of the change on financial statement line items and EPS.

Many constituents will welcome the addition of the option to apply the new requirements using a fully retrospective approach or a modified approach and the additional relief from providing all the transition disclosures required by IAS 8. Other constituents may be of the view that the transition proposals reduce the comparability of financial statement without a tangible reduction in the cost of implementing the new proposals.

Transition – Lessee

At the beginning of the earliest comparative period presented, a lessee entity would:

• recognise a liability to make lease payments for each outstanding lease, measured at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate;

• recognise a ROU asset for each outstanding lease, measured at the amount of the related liability to make lease payments, subject to any impairment adjustments; and

• when lease payments are uneven, adjust the ROU asset by the amount of any prepaid or accrued lease payments.

For finance leases, a lessee would reclassify lease assets as ROU assets, and lease liabilities as liabilities to make lease payments.

For operating leases, a lessee entity would:

• recognise liabilities to make lease payments, measured at the present value of the remaining lease payments discounted using the incremental borrowing rate for each portfolio of leases with similar characteristics and remaining terms;

• recognise right-of use assets, measured at an amount proportionate to the decrease in the lease liability since commencement;

• when lease payments are uneven, adjust the ROU asset by the amount of any prepaid or accrued lease payments; and

• record any difference in the amount of the assets and liabilities recognised in retained earnings.

The 2010 ED included relief for finance leases with no option, VLPs, term option penalties and residual value guarantees. Many constituents will welcome its proposed extension to all finance leases as it represents a simplification of the transition requirements.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Transition – Lessor

At the beginning of the earliest comparative period presented a lessor entity would recognise:

• a right to receive lease payments for each outstanding lease, measured at the present value of the remaining lease payments, discounted using the rate charged in the lease determined at the date of inception of the lease, subject to any impairment adjustments; and

• a residual asset at fair value determined at the date of initial application.

• [Note that these were the transition proposals for a lease accounted for under the derecognition approach.]

For finance leases, a lessor would have the option to either apply the new requirements fully retrospectively or to make no adjustments on transition.

For operating leases, a lessor would:

• recognise a right to receive lease payments;

• recognise a residual asset under the receivable and residual approach;

• derecognise the underlying asset; and

• when lease payments are uneven, adjust the cost basis of the underlying asset derecognised by the amount of any recognised prepaid or accrued lease payments.

A lessor would continue to account for the securitisation of lease receivable associated with operating leases as secured borrowing in accordance with existing IFRSs regardless of whether a fully retrospective approach is applied.

Many preparers’ constituents will be pleased to see the addition of the option to apply the new requirement prospectively or retrospectively to existing finance leases. Conversely, some users may view this as compromising financial statement comparability.

Constituents may be surprised by the decision to require lease payments to be discounted using the rate charged in the lease determined at lease commencement, while the residual asset is measured using information available at the beginning of the earliest comparative period presented. Constituents may have expected a consistent point in time at which to determine measurement inputs to be applied on transition to the new requirements.

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First time adoption

Paragraphs D9 and D9A of IFRS 1 would be amended so that first-time adopters generally would apply transitional provisions based on those provided in the proposals.

A first-time adopter would permitted to:

• apply to all of its lease contracts the transitional provisions and reliefs applicable to operating leases; and

• initially measure a ROU asset at fair value in its opening statement of financial position and to use that amount as deemed cost.

Many constituents will be pleased to see the addition of the ability to apply the transition provision and relief applicable to operating leases to all leases on first-time adoption of the new standard.

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Key proposal in the 2010 ED Current proposals KPMG observations

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Business combinations and borrowing costs

If the acquiree is a:

• lessee, the acquirer would recognise a liability to make a lease payment and a right of use asset;

• lessor, the acquirer would recognise a right to receive lease payments and a lease liability for all leases to which the performance obligation approach is applied; and

• lessor, the acquirer would recognise a right to receive lease payments and derecognise the portion of the carrying amount of the underlying asset that represents the cost of the right to use the underlying asset for leases to which the derecognition approach is applied.

Delete paragraph 6(d) of IAS 23 Borrowing Costs, which refers to finance charges in respect of finances leases.

If the acquiree is a:

• lessee, the acquirer would recognise a liability to make lease payments and a ROU asset;

• lessor applying the receivable and residual model, the acquirer would recognise a right to receive lease payment and a residual asset; and

• lessor of investment property, the acquirer would apply the guidance in IFRS 3.

Interest expense incurred in a lease would be included in the scope of IAS 23 Borrowing Costs for the purpose of determining the interest cost or borrowing costs that could be capitalised.

Some constituents will be disappointed that the Board have not elaborated on the proposals set out in the 2010 ED in respect of the treatment of operating leases in business combinations rather than reaffirming them. For example, would the ROU asset be required to be measured at fair value, as for other intangible assets in a business combination? Also, respondents to the 2010 ED sought clarification around the accounting at transition for operating lease intangible assets from previous business combinations.

For more information For more information on the project, including our publication on the 2010 ED, New on the Horizon: Leases, see our

website.

The IASB’s website and the FASB’s website contain summaries of the Boards’ meetings, meeting materials, project summaries and status updates.

AcknowledgementsWe would like to acknowledge the efforts of the principal authors of this publication: Brian O’Donovan and Daniel O’Donovan.

We would also like to thank the following reviewers for their input: Kimber Bascom, Wolfgang Laubach and Kris Peach.

© 2011 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.

KPMG International Standards Group is part of KPMG IFRG Limited.

Publication name: IFRS – Leases Newsletter

Publication number: Issue 9

Publication date: December 2011

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

kpmg.com/ifrs

IFRS – Leases Newsletter is KPMG’s update on the joint IASB/FASB leases project.

If you would like further information on any of the matters discussed in this IFRS – Leases Newsletter, please talk to your usual local KPMG contact or call any of KPMG firms’ offices.