“To lease or to buy? [1st of 2 parts]” by John T. Villa (September 13, 2010)

Business World (09/13/2010)

(First of two parts)

A common management decision usually driven by economics is whether to lease or to buy. Another key consideration is the impact the transaction will have on key financial ratios that measure company performance and indirectly affect stock price.

For example, entering into operating leases is oftentimes preferred over buying on long-term installments, since the former will result in a better rate of return on investments and lower leverage ratios.

However, this preferred treatment under an operating lease may soon disappear, given the changes in accounting for leases proposed by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (the Boards).

But why are the boards changing the rules?

Despite the “benefits” that operating leases offer, the current lease accounting rules encounter criticisms. A major criticism is that lessees do not reflect all lease obligations on their balance sheets, based on what some consider to be arbitrary distinctions between operating and finance leases.

To address this, the IASB released on August 17, 2010 an exposure draft (ED) intended to replace IAS 17. This is a joint project of the boards that began in March 2009. This article takes a look at the key proposals of the ED.

The ED proposes a single model to account for all leases, effectively ending the off-balance sheet treatment of operating leases. It proposes to recognize all lease rights and obligations from the commencement of the lease agreement. The ED covers the accounting for both lessor and lessee, and will bring about significant change for both parties.

For lessors, two models are being proposed, namely: the Performance Obligation model and the Derecognition model.

Neither of the proposed lessor models, however, applies to lessors of investment properties that apply the fair value model.

Performance Obligation (PO) model

For leases that do not substantially transfer to the lessee the risks and rewards related to the underlying asset, the lessor will apply the PO model.

This model assumes that the asset remains an economic resource of the lessor; as such, it is retained in the lessor’s books. This asset will be depreciated over its useful life and is subject to impairment testing.

The PO model also requires that the lessor initially record a lease receivable (net of any initial direct costs) at the present value of expected lease charges over the lease term. This asset is carried at amortized cost, with interest being recognized using the effective interest rate method. It also requires the lessor to record a performance obligation liability initially equal to the amount of the recorded receivable, and then subsequently amortized on a systematic basis (usually straight-line) as lease revenue over the lease term.

Because the lease receivable and related liability are initially measured based on expected cash flows specified in the lease agreement, the lessor is required to reassess the carrying amount of the receivable if facts or circumstances indicate that there would be a significant change in the right to receive lease payments since the previous reporting period.

Such subsequent reassessment is expected to create volatility in the financial statements.

Under the PO model, the balance sheet will reflect the following separate line items: the leased assets as property under lease, plus the lease receivable less the amount of performance obligation, resulting in either a net asset or a net liability.

‘Derecognition’ model

For other leases, where the risks and rewards are presumed to have been substantially transferred to the lessee, the lessor will apply the Derecognition model.

The lessor will “derecognize” the underlying asset and recognize a lease receivable and a residual asset representing the portion of the underlying leased asset that is effectively retained with the lessor. This residual asset represents an allocation of the carrying value of the leased asset (based on the relative fair value of the residual asset) to the fair value of the underlying asset, calculated at inception of the lease.

There is a considerable degree of judgment and estimation in doing such allocation.

As in the PO model, the lessor will record a lease receivable at the present value of the expected lease charges (net of initial direct costs), with interest accounted for using the effective interest rate method.

After initial recognition, the lessor is required to reassess the lease term if there is any indication of change. The effect of such reassessment results in either an adjustment to the rights “derecognized” (i.e., profit or loss) or the residual asset.

The lessor is also required to reassess the expected amount of any contingent rentals and any expected payments under term option penalties and residual value guarantees, with resulting changes recognized in profit or loss.

On the balance sheet, the lessor is required to separately present as assets the lease receivable and the residual asset (the latter as part of property, plant and equipment).

Lessee accounting — the right-of-use model

Probably the biggest impact of the ED’s proposed changes is on lessees, especially on existing and future operating leases.

Under the proposed rules, the lessee will record a financial liability and a corresponding right-of-use asset at the start of the lease. The financial liability will be measured at the present value of the expected future cash flows, discounted using the lessee’s incremental borrowing rate. This liability will be carried at amortized cost with interest accounted for using the effective interest rate method.

On the other hand, the right-of-use asset, representing the right of the lessee to use the asset over the lease term, is separately shown on the balance sheet as part of property, plant and equipment, and is subject to amortization and impairment testing.

The lease will initially be measured based on the estimates of the lease term, contingent rentals, penalties, and residual value guarantees. These estimates need to be re-evaluated at each reporting date, and any change would impact either the right-of-use asset and liability, or profit or loss.

As in the case of lessors, these re-measurements are expected to create volatility in the financial statements.

In next week’s column, we will discuss the business implications of the proposed lease accounting rules.

(As of publication, John T. Villa is an Assurance partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.