Profit and loss recognition patterns on lease
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The document discusses the feedback and proposed changes to accounting standards for lease accounting. It notes that while the initial Exposure Draft treated all leases as financing transactions, stakeholders expressed concerns about this approach. As a result, the boards are considering distinguishing between leases based on whether they are primarily financing transactions or not. For leases that are financing transactions, the profit and loss recognition pattern would be similar to a financed purchase. For other leases, the pattern would be closer to current straight-line operating lease accounting. The boards are seeking additional feedback to help differentiate between these two lease types.
Profit and loss recognition patterns on lease
- 1. Profit and Loss Recognition Patterns on Lease AN OVERVIEW Presented by: Radhika Chittoor Balani
- 2. Reason for New Leasing Standard OBJECTIVE: TO ENSURE THAT ASSETS AND LIABILITIES ARISING FROM LEASE CONTRACTS ARE RECOGNIZED ON THE BALANCE SHEET.
- 3. Timelines August 2010: The FASB and IASB jointly issued an ED of a proposed accounting standard for leases January 2011: The boards identified 5 key areas Definition of a lease Lessor accounting Definition of lease term Variable/uncertain cash flows Profit and loss recognition pattern May 2011 –till date: Deliberations, comments, roundtables Final Recommendations: Towards end of 2011 Implementation: 2014 tentative
- 4. Feedback and Comments Process 770 Comment letters received Direct outreach with users and preparers by the boards Public roundtable discussions in London, Hong Kong, Chicago and Norwalk Profile of respondents: industry trade organizations, professional organizations, local standard setters/regulators, individuals, auditors, consultants, academic s and users
- 5. Discussions & Deliberations on P&L Recognition Patterns All leases treated as financing transactions with an accelerated profit and loss recognition pattern by the Exposure Draft (ED) Concerns expressed across industries on this Pattern inconsistent with the economics of diverse lease transactions that are priced in reference to other market transactions Adjustments usually made to the balance sheets of lessees and not to the income statements Usefulness of the income statement or operating cash flow as performance metrics doubtful if all leases were reflected as financings
- 6. Discussions & Deliberations on P&L Recognition Patterns Fundamental distinction between those leases that are primarily financing transactions in nature and those that are "other than financing." Though all leases would be on balance sheet, the profit and loss recognition pattern will vary on the basis of lease type Impact of this approach: Leases that are primarily financing transactions in nature would have a recognition pattern similar to a financed purchase. Leases that are "other than financing" would have a recognition pattern more closely aligned with today's straight line rent under an operating lease. Leases to be differentiated on the basis of: two new sets of indicators Targeted outreach being done currently
- 7. Comments on P&L Recognition Pattern Contd.. Majority felt that the ED effectively views lease transactions fundamentally as the purchase of a right to use an asset with seller financing thus accepting the resultant accelerated expense recognition pattern due to the financing element Some concerned about the expense recognition pattern as certain types of leases are not inherently financings Suggested use of “Linking Approach” or sinking fund depreciation methods
- 8. Comments on P&L Recognition Pattern The ED proposes the right-of-use model. Recognition pattern for the lessee changes the expense recognition pattern of operating leases from rental expense to a combination of amortization and interest expense Results in acceleration of expenses compared to today's operating lease accounting and the timing of cash payments. Usefulness of the model questioned
- 9. Follow Up Amendments by ED as on May 2011 The ED implicitly treats all leases as financing transactions with an accelerated profit and loss recognition pattern Fundamental distinction between leases based on financial transactions basis Indicators identified: IAS 17, Leases, as the basis for distinguishing between the two categories of leases. All leases to be recorded on the balance sheet, with the exception of short-term leases. Initially the board directed that expense recognition pattern for leases will differ Leases that are primarily financing transactions would have a recognition pattern similar to a financed purchase Other leases will have a straight-line recognition pattern, with expense reflected in a single line item in the income statement This has been removed as it is a complex exercise to differentiate the leases
Editor's Notes
- #7: Note: As per PWC, If the boards ultimately conclude that a dual model by lessees for financing and "other than financing" leases is appropriate, this may alleviate many of the concerns about the project. However, we believe that the boards have substantial work remaining in this area—in particular, describing the lease characteristics under each model and how each model would be applied.
- #9: PWC Note: the “right-of-use” model is adoptedHowever, the application of the proposal in the ED might reduce the income statement’s usefulness to many users.
- #11: Accounting by the lessee –Recognition, Measurement, Reassessment, Presentation and Disclosures, and Transition.Highlight: This would replace the current two model approach – capital/finance lease (which gives rise to a recorded asset and liability) or operating lease (which is viewed as an executory contract and is accounted for off balance sheet) with one accounting model for lessees where the asset and liability are recorded on the B/S at lease inception.
- #12: The lessee records asset, liability, and related expenses in the financial statements.
- #13: If adopted, this ASU could have significant impact on companies’ balance sheets and income statements. The reclassification and split-up of expense from “rent” (included in operating income/loss) to “amortization” (included in operating income/loss) and “interest” and (below the operating line) will alter the landscape of the income statement. EBITDA figures may actually increase as a result. Companies will want to assess early what impact recording the ROU asset and Lease Liability will have on their key ratios, and possibly on debt covenants.
- #14: accounting by lessors - Recognition, Measurement, Reassessment, Presentation and Disclosures, and Transition
- #15: Highlight that under current GAAP, usually a lessor simply records rental income.Under proposed GAAP, the lessor will record both interest income on the RTR and lease/rental income as the liability is satisfied.