By: María Candelas Instituto Tecnológico Autónomo de México
Leasing activities in companies are very common. For those companies that assume the role of lessee, it means to agree to the use of assets required for its operations, without being exposed to the risks of taking ownership of them, in what was until now known as an “operating lease.”
Renting computer equipment, transportation, real estate or machinery, instead of making them company property, offers advantages that allow the company’s resources to be dedicated to its core business and not be affected, for example, by the obsolescence of these assets.
Another way in which the entities may acquire assets under long-term financing is the “capital lease,” also known as the “financial lease,” a concept in which the basic postulate of economic substance is applied clearly on the legal form, considering that the risks and benefits of the asset are borne by the lessee from the start of the term of the contract.
The Mexican standard, in force since 1991 for this issue, is Bulletin D-5 Leases, which was issued by the Mexican Institute of Public Accountants and is now part of the Financial Reporting Standards (FRS), released by the Mexican Council of Financial Reporting Standards (CINIF, acronym in Spanish).
This standard defines a lease as an “agreement that grants the right to use movable and immovable property, plant and/or equipment, in exchange for a rent” and states that, at the start of the contract, it must be classified as a capital lease or an operating lease.
The capital lease is defined as that “which transfers substantially all the risks and benefits inherent in the ownership of an asset, whether the property is transferred or not.” The operating lease is defined as “any lease that is not classified as a capital lease.”
The standard that applies to this matter in the International Financial Reporting Standards (IFRS), issued by the International Accounting Standards Board (IASB) is the International Accounting Standard 17 (IAS 17, Leases). This standard also classifies operating and financial leases, depending more on the nature of the transaction than the form of the contract.
For a lease to be classified as “financial,” it must comply with one or more of the following requirements:
that ownership of the asset be transferred to the lessee at the end of the contract;
that the lessee have the option to purchase the asset at a price sufficiently lower than the reasonable value and that at the beginning of the lease term it can be expected with reasonable certainty that the option will be exercised;
that the term of the lease cover the major part of the asset’s economic life;
that the present value of the minimum lease payments be substantially the entire fair value of the asset; and
that the leased asset be of such a specialized nature that only the lessee may use it without making major modifications.
Other additional indicators for classifying a lease as “financial” are presented, but if the lease does not comply with the conditions mentioned above, or with any of these indicators, the lease must be classified as “operating.”
Since 2010, a comprehensive analysis to amend the IAS 17 has been underway through the joint work of the IASB and the Financial Accounting Standards Board (FASB), the organization that issues the US GAAP. The need to revise the content of this standard arose from the concern of some users of financial information, who questioned whether the current standard actually reflected the nature and impact of this activity on the financial statement.
In May of 2013, the regulatory bodies issued an exposure draft. Since then, they have held discussions; however, given the complexity that the modifications of this standard represent, it has taken time to reach agreements that meet the objective of increasing the transparency and the comparability of financial information based on the appropriate recognition, measurement and disclosure of the operations that are conducted regarding leases.
During the present year, 2014, deliberations have continued, without reaching a final version. The new standard is expected to be completed in 2015 and, perhaps, will go into effect in 2017.
This exposure draft changes in the definitions of “leases” and in the scope of the standard. It defines, among other things, the accounting model to be applied to the lessor and the accounting model to be applied to the lessee as well as the applicable approach for the classification of leases and the requirements for measurement and disclosure.
Something that stands out is that exceptions for smaller and for short-term leases could be applied, as companies would be asked to determine whether the fulfillment of the contract depends on the use of an identified asset and if the contract conveys the right to control the use of the identified asset for a period of time. The latter refers to the lessee having the ability to both direct the use of the identified asset and to derive economic benefits from its use during the period of use.
The exposure draft aims to classify leases as Type A and Type B. This classification would be based on the economic benefits of the underlying asset, which the lessee is expected to consume during the term of the lease, and not by the fulfillment of a condition or an indicator, such as those established by the existing standard.
The new way to classify would be used to determine the method and the time when the income or expense generated by the lease must be recognized.
It is considered that the existing standard applies a model that does not always meet the need for reliable financial information. For example, in a lease that is classified today as operating, the lessee acknowledges the payments made and expenses incurred during the period of the lease. Under the new approach of the standard, which refers to the financial lease as Type A and the operating lease as Type B, the lessee should classify the contract as “Type A Lease” and recognize the leased item as part of the lessee’s assets, if the lessee complies with the characteristic of having the “right to control the use” of the corresponding asset.
The consequence of this different way of treating the financial accounting of the leases is that the numbers on the statement of the financial position and the consolidated financial statement would be different from those obtained by applying the standard still in force and, therefore, would also affect the results of the financial accounts related to the assets, liabilities and profits. Depending on the agreements that are made, some companies may benefit from the change and others may be affected negatively.
Regulatory agencies must reach an agreement on the definition, the scope of the standard, the way to separate the components of the lease from those that are not part of it, in addition to clearly identifying the applicable accounting models for lessors and lessees, taking into account all the factors that relate to the topic.
As has happened in other cases, the Mexican standard concerning leases must be analyzed and the CINIF must decide if it should issue an FRS adhering in whole or in part to the international standard, as part of the convergence process.
Conclusion
The proposed changes to the draft of the IAS 17 Leases will have a significant impact, mainly because the number of contracts that would qualify as operating leases will be reduced. This will have an effect on the financial statements and the financial performance of companies that have signed these contracts.
It is recommended that each company analyze to what extent these changes in the standard affect it, taking into account that this is an accounting change that must be applied retroactively in accordance with the guidelines established in the International Accounting Standard 8, Accounting Policies, Changes in Accounting Estimates and Errors.?
Leases: The Approach Proposed to Modify the Standard Will Greatly Impact Financial Information
Instituto Tecnológico Autónomo de México
Leasing activities in companies are very common. For those companies that assume the role of lessee, it means to agree to the use of assets required for its operations, without being exposed to the risks of taking ownership of them, in what was until now known as an “operating lease.”
Renting computer equipment, transportation, real estate or machinery, instead of making them company property, offers advantages that allow the company’s resources to be dedicated to its core business and not be affected, for example, by the obsolescence of these assets.
Another way in which the entities may acquire assets under long-term financing is the “capital lease,” also known as the “financial lease,” a concept in which the basic postulate of economic substance is applied clearly on the legal form, considering that the risks and benefits of the asset are borne by the lessee from the start of the term of the contract.
The Mexican standard, in force since 1991 for this issue, is Bulletin D-5 Leases, which was issued by the Mexican Institute of Public Accountants and is now part of the Financial Reporting Standards (FRS), released by the Mexican Council of Financial Reporting Standards (CINIF, acronym in Spanish).
This standard defines a lease as an “agreement that grants the right to use movable and immovable property, plant and/or equipment, in exchange for a rent” and states that, at the start of the contract, it must be classified as a capital lease or an operating lease.
The capital lease is defined as that “which transfers substantially all the risks and benefits inherent in the ownership of an asset, whether the property is transferred or not.” The operating lease is defined as “any lease that is not classified as a capital lease.”
The standard that applies to this matter in the International Financial Reporting Standards (IFRS), issued by the International Accounting Standards Board (IASB) is the International Accounting Standard 17 (IAS 17, Leases). This standard also classifies operating and financial leases, depending more on the nature of the transaction than the form of the contract.
For a lease to be classified as “financial,” it must comply with one or more of the following requirements:
Other additional indicators for classifying a lease as “financial” are presented, but if the lease does not comply with the conditions mentioned above, or with any of these indicators, the lease must be classified as “operating.”
Since 2010, a comprehensive analysis to amend the IAS 17 has been underway through the joint work of the IASB and the Financial Accounting Standards Board (FASB), the organization that issues the US GAAP. The need to revise the content of this standard arose from the concern of some users of financial information, who questioned whether the current standard actually reflected the nature and impact of this activity on the financial statement.
In May of 2013, the regulatory bodies issued an exposure draft. Since then, they have held discussions; however, given the complexity that the modifications of this standard represent, it has taken time to reach agreements that meet the objective of increasing the transparency and the comparability of financial information based on the appropriate recognition, measurement and disclosure of the operations that are conducted regarding leases.
During the present year, 2014, deliberations have continued, without reaching a final version. The new standard is expected to be completed in 2015 and, perhaps, will go into effect in 2017.
This exposure draft changes in the definitions of “leases” and in the scope of the standard. It defines, among other things, the accounting model to be applied to the lessor and the accounting model to be applied to the lessee as well as the applicable approach for the classification of leases and the requirements for measurement and disclosure.
Something that stands out is that exceptions for smaller and for short-term leases could be applied, as companies would be asked to determine whether the fulfillment of the contract depends on the use of an identified asset and if the contract conveys the right to control the use of the identified asset for a period of time. The latter refers to the lessee having the ability to both direct the use of the identified asset and to derive economic benefits from its use during the period of use.
The exposure draft aims to classify leases as Type A and Type B. This classification would be based on the economic benefits of the underlying asset, which the lessee is expected to consume during the term of the lease, and not by the fulfillment of a condition or an indicator, such as those established by the existing standard.
The new way to classify would be used to determine the method and the time when the income or expense generated by the lease must be recognized.
It is considered that the existing standard applies a model that does not always meet the need for reliable financial information. For example, in a lease that is classified today as operating, the lessee acknowledges the payments made and expenses incurred during the period of the lease. Under the new approach of the standard, which refers to the financial lease as Type A and the operating lease as Type B, the lessee should classify the contract as “Type A Lease” and recognize the leased item as part of the lessee’s assets, if the lessee complies with the characteristic of having the “right to control the use” of the corresponding asset.
The consequence of this different way of treating the financial accounting of the leases is that the numbers on the statement of the financial position and the consolidated financial statement would be different from those obtained by applying the standard still in force and, therefore, would also affect the results of the financial accounts related to the assets, liabilities and profits. Depending on the agreements that are made, some companies may benefit from the change and others may be affected negatively.
Regulatory agencies must reach an agreement on the definition, the scope of the standard, the way to separate the components of the lease from those that are not part of it, in addition to clearly identifying the applicable accounting models for lessors and lessees, taking into account all the factors that relate to the topic.
As has happened in other cases, the Mexican standard concerning leases must be analyzed and the CINIF must decide if it should issue an FRS adhering in whole or in part to the international standard, as part of the convergence process.
Conclusion
The proposed changes to the draft of the IAS 17 Leases will have a significant impact, mainly because the number of contracts that would qualify as operating leases will be reduced. This will have an effect on the financial statements and the financial performance of companies that have signed these contracts.
It is recommended that each company analyze to what extent these changes in the standard affect it, taking into account that this is an accounting change that must be applied retroactively in accordance with the guidelines established in the International Accounting Standard 8, Accounting Policies, Changes in Accounting Estimates and Errors.?
References