The New Models for Revenue and Lease Accounting
A Review of the IASB’s Exposure Drafts ED/2010/6 and ED/2010/9
By Tan Liong Tong
The IASB has published proposals to introduce new models for revenue and lease accounting. These are: (a) ED/2010/6, Revenue from Contracts with Customers, and (b) ED/2010/9, Leases. The proposed new accounting models would affect all reporting entities and would bring about fundamental changes to the current practice. Hence, it is imperative that preparers and other users of financial statements are aware, and understand these developments, which would latter be part of the IFRS Framework when the proposals are finalised.
This article examines the history, reasons for and rationale of the proposed standards, explains the salient features and draws some implications on practice. It aims to assist preparers and users of financial statements better understand the requirements of the proposed standards and prepare for application when they become part of the IFRS-compliant Malaysian Financial Reporting Standards in the near future.
1. The New Model for Revenue Accounting
1.1 History, Reasons and Rationale
Revenue is a crucial number to users of financial statements in assessing an entity’s performance and prospects. Currently, the two main standards for revenue accounting in the IFRSs are IAS 18, Revenue, and IAS 11, Construction Contracts. IAS 18 was first issued in December 1982 by the then IASC to deal with sales of goods, rendering or services, and use of entity’s resources by others (interest, dividend and royalties). The IAS was revised in December 1993 as part of the IASC’s Comparability of Financial Statements Project. There were some consequential amendments to IAS 18 made by the issuance of IAS 39, Financial Instruments: Recognition and Measurement, in December 1998. In July 2008, the guidance on real estate accounting in the Appendix to IAS 18 was superseded by the issuance of IFRIC 15. In April 2009, the Appendix to IAS 18 was amended to include guidance on whether an entity is acting as a principal or an agent in a sale of good or rendering of service transaction.
The first version of IAS 11 was issued by the then IASC in March 1979. It permitted either the completed contract method or the stage of completion method. The revised IAS 11 was issued in December 1993 as part of the IASC’s Comparability of Financial Statements Project. This revised IAS, which remains effective to date, removes the completed contract method in the original IAS 11 and requires that contract revenue should be recognised based on stage of completion if the outcome can be measured reliably. If the outcome cannot be measured reliably, contract revenue is recognised to the extent of recoverable contract costs.
Some related interpretations on revenue accounting were issued over the years to deal with areas and emerging issues not specifically provided in the IFRSs. These are:
a) SIC-31 Revenue – Barter Transactions Involving Advertising Services (issued in December 2001);
b) IFRIC 12 Service Concession Arrangements (issues in November 2006);
c) IFRIC 13 Customer Loyalty Programmes (issued in June 2007);
d) IFRIC 15 Agreements for the Construction of Real Estate (issued in July 2008); and
e) IFRIC 18 Transfers of Assets from Customers (issued in January 2009).
IAS 18 requires revenue from sale of goods to be recognised when all five criteria have been met. The criteria are: (a) transfer of significant risks and rewards, (b) entity retains neither managerial involvement nor effective control, (c) the amount of revenue can be measured reliably, (d) probable inflows of economic benefits and (e) the costs can be measured reliably. Criteria (a) and (b) are interrelated in that transfer of risks and rewards would usually coincide with the passing of control to the buyer. The criteria for transfer of control and risks and rewards tend to focus on transfer of legal title or physical possession. It is difficult to apply these two criteria to certain types of contracts that provide for transfers in stages or transfer continuously as the good is being developed. Also, the IAS does not provide sufficient guidance or indicators of when the transfer occurs, such as whether at a single point in time or continuously.
The criteria (c) – (d) relate to measurement uncertainties, which mean that if there are significant uncertainties in the estimates, revenue recognition would be postponed even if the performance obligations in the contract with a customer have been satisfied. This postponement of revenue recognition due to measurement uncertainties may be contrary to the notion that income should be recognised when earned (i.e. the accrual concept). For example, if the good has been delivered to a customer and the performance obligation satisfied, revenue recognition would be postponed under the current IAS 18 if there are significant uncertainties about collectability. The issue of concern is whether the uncertainties should affect the timing of the revenue recognition or whether the uncertainties should be factored in the measurement (eg. by an allowance for credit risk).
For recognition of service revenue, the current IAS 18 requires revenue to be recognised based on the stage of completion method when the outcome can be measured reliably. It prescribes four criteria for the outcome measurement reliability (i.e. the measurement reliability for amount of revenue, costs, stage of completion and probable collectability of economic benefits). By default, if any of these criteria is not met, service revenue would be recognised only to the extent of recoverable incurred service costs. IAS 11 has similar requirements for recognising revenue from construction contracts, as essentially a contractor is a service provider. As in the case of sales of goods, the measurement uncertainties in service contracts affect the timing of the revenue recognition, rather than affecting the measurement itself.
For the measurement requirement, both IAS 18 and IAS 11 require that revenue should be measured at the fair value of the consideration received or receivable. There is only limited guidance provided on this fair value measurement. There is no explicit requirement that if the consideration receivable is variable, a probability-weighted estimate needs to be applied. Similarly, there is no requirement that credit risk be considered in the fair value measurement.
Apart from the deficiencies mentioned above, it is also difficult to apply those two standards to transactions other than the simple sales of goods or rendering of services. They provide only limited guidance on other emerging transactions, such as revenue recognition for multiple-element arrangements. IFRIC 12 was issued to cater for revenue recognition of multiple elements in a service concession arrangement, but the Interpretation applies only to “public-to-private” service concession arrangements. It is unclear whether the requirements in IFRIC 12 can be applied, by analogy, to other concession arrangements, such as “private-to-private” concession arrangements. IFRIC 15 was issued to provide guidance for real estate accounting. It introduces a new concept of continuous transfer of control, but does not define it or provide the indicators of continuous transfer (except for some limited guidance in the illustrative examples). This Interpretation has led to diverse views on the appropriate accounting treatment for developers that operate on the “sell and build” model. Some interpret that the completed contract method should be applied to all property development projects, whilst others opine that for the “sell and build” model, the stage of completion method should be applied.
A discussion paper, Preliminary Views on Revenue Recognition in Contracts with Customers, was published by the IASB in December 2008. The exposure draft, ED/2010/6, was issued by the IASB in June 2010, and it was part of a joint project with the US FASB to clarify the principles and develop a common standard for recognising revenue. They believe that a common model for revenue accounting would:
(a) remove inconsistencies and weaknesses in existing revenue recognition standards and practices;
(b) provide a more robust framework for addressing revenue recognition issues;
(c) improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets; and
(d) simplify the preparation of financial statements by reducing the number of requirements or standards to which entities must refer (when this exposure draft is finalised as an IFRS, it would supersede IAS 18 and IAS 11, and their related Interpretations).
1.2 The Salient Features of the New Model for Revenue Accounting
The new model for revenue accounting proposed in the ED is based on the rationale that an entity should recognise revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the entity receives, or expects to receive, in exchange for goods or services. This serves as the core principle for revenue accounting.
To apply this new model, an entity needs to follow the following five main steps:
(a) Identify the contract(s) with a customer;
(b) Identify the separate performance obligations in the contract;
(c) Determine the transaction price;
(d) Allocate the transaction price to the separate performance obligations; and
(e) Recognise revenue when the entity satisfies each performance obligation.
In a straightforward sale of retail goods, applying these requirements to a single performance would not pose any practical problem. However, in some cases, the entity needs to consider the terms of the contract, and the related facts and circumstances, when using judgements in the application of the proposed standards.
(a) Identifying the Contract
An entity needs to apply the proposed IFRS to each contract with its customers. A contract is defined in the ED as “an agreement between two or more parties that creates enforceable rights and obligations”. Contracts can be written, oral or implied by the entity’s customary business practices and processes. An entity shall consider those practices and processes in determining whether a contract exists.
For revenue accounting, a contract exists only if: (a) the contract has commercial substance, (b) the parties to the contract have approved the contract and are committed to satisfying their respective obligations, (c) the entity can identify each party’s enforceable rights regarding the goods and services to be transferred, and (d) the entity can identify the terms and manner of payment for those goods and services. However, a contract does not exist for the purpose of applying the proposed requirements if either party can terminate a wholly unperformed contract without penalty.
In some cases, the entity needs to account for two or more contracts together (i.e. combine the contracts) if the prices of those contracts are interdependent. Indicators that two or more contracts have interdependent prices are: (a) the contracts are entered into at or near the same time, (b) the contracts are negotiated as a package with a single commercial objective, and (c) the contracts are performed concurrently or consecutively. Conversely, an entity needs to segment a single contract and account for it as two or more contracts if some goods or services are priced independently of other goods and services. An entity would need to account for a contract modification together with the existing contract if the prices of the modification and the existing contract are interdependent. If the prices of the modification and the existing contract are not interdependent, the entity should account for the contract modification as a separate contract. Thus, the critical criterion for combining or segmenting contracts, including contract modifications, hinges on the price interdependence. However, it is not explicitly stated whether the combining of contracts applies only to contracts with a single customer or may be applied to contracts with different customers.
(b) Identifying the Separate Performance Obligations
An essential feature of the ED is the concept of performance obligation embodied in a contract with a customer to provide goods and services in exchange for consideration. A performance obligation is defined as “an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer”. Under the new model, an entity should evaluate the terms of the contract and its customary business practices to identify all promised goods or services and determine whether to account for each promised good or service as a separate performance obligation.
The goods and services include not only those routinely sold or provided by the entity but also those that an entity arranges with another party to transfer those goods and services (for example, acting as an agent of another party), standing ready to provide goods and services, constructing or developing an asset on behalf of a customer, granting licences, rights to use and options, and performing a contractually agreed task.
An entity needs to identify all its performance obligations in a contract. If an entity promises to transfer more than one good or service, the entity shall account for each promised good or service as a separate performance obligation only if it is distinct. If a good or service is not distinct, an entity shall combine that good or service with other promised goods and services until the entity identifies a “bundle” of goods or services that is distinct. In some cases, such bundling may result in an entity accounting for all the goods and services promised in the contract as a single performance obligation.
The ED clarifies that a good or service, or a bundle of goods or services, is distinct if either: (a) the entity, or another entity, sells an identical or similar good or service separately; or (b) the entity could sell the good or service separately because the good or service has a distinct function and a distinct profit margin.
The ED also provides guidance on warranties arising from contracts with customers. It identifies two types of product warranties. One type provides coverage for latent defects in the product and this does not give rise to a separate performance obligation. For this type of warranty, an entity would only need to recognise a provision for any unsatisfied performance obligations in respect of defective products transferred to the customer. There is no deferral of revenue recognition. The other type of warranty provides a customer with coverage for faults that arise after the product is transferred to the customer. This type of warranty gives rise to a separate performance obligation. Hence, there is a deferral of revenue recognition as an entity would need to allocate consideration to the product and to the warranty service.
(c) Determining the Transaction Price
Transaction price for a contract with a customer is defined as the amount of consideration that an entity receives, or expects to receive, from a customer in exchange for transferring goods or services, excluding amounts collected on behalf of third parties (for example, taxes). When determining the transaction price, an entity would consider the effects of: (a) collectability, such as credit risk; (b) the time value of money; (c) non-cash consideration; and (d) consideration payable to the customer, if any.
When the consideration receivable is variable or uncertain, the ED proposes that the transaction price should reflect the entity’s probability-weighted estimate of variable consideration (including reasonable estimates of contingent amounts), in addition to the effects of the customer’s credit risk and the time value of money. Some commentators have argued that the probability-weighted estimate might not be the most predictive of the amount of consideration the entity will be entitled to and have proposed that the estimate of variable consideration be based on “the most likely” amount.
The inclusion of credit risk in the estimate of transaction price is something new, quite similar to the “expected loss” model proposed for impairment of financial assets in the current IASB’s IAS 39 replacement project. The issue is whether the credit risk should be included in the measurement of the transaction price itself, or whether the credit risk should be recognised separately, for example, by an allowance for impairment loss.
(d) Allocating the transaction price to separate performance obligations
When a contract contains more than one performance obligation, an entity needs to allocate the transaction price to all separate performance obligations. The proposed allocation method is based on the relative selling prices i.e. in proportion to the stand-alone selling prices of the goods and services underlying each performance obligation. If the good or service is not sold separately, the entity would need to estimate its stand-alone selling price. However, the technique or method to estimate this selling price is not specified.
(e) Recognising Revenue when a Performance Obligation is Satisfied
An entity would recognise revenue when it satisfies a performance obligation identified in the contract by transferring a promised good or service to a customer. The amount recognised is the amount of the transaction price allocated to that performance obligation.
A good or service is transferred when the customer obtains control of that good or service. Control of a good or service is one’s ability to direct the use of, and receive the benefits from, a good or service. Control is thus the most critical criterion for determining the timing of revenue recognition and it should be assessed from the perspective of the customer. A customer obtains control of a good or service when the customer has the ability to direct the use of, and receive the benefits from, the good or service. Control includes the ability to prevent other entities from directing the use of, and receiving the benefits from, a good or service. Ability to use refers to the present right to use the asset for its remaining economic life or to consume the asset. Ability to receive the benefits from an asset refers to the present right to obtain substantially all of the potential cash flows from that asset. The customer can obtain cash flows from an asset directly or indirectly in many ways, such as by using, consuming, selling, exchanging, pledging or holding the asset.
Indicators that the customer has obtained control of a good or service include the following:
(a) The customer has an unconditional obligation to pay – if a customer is unconditionally obliged to pay for a good or service, typically that is because the customer has obtained control of the good or service in exchange. An obligation to pay is unconditional when nothing other than the passage of time is required before the payment is due.
(b) The customer has legal title – legal title often indicates which party has the ability to direct the use of, and receive the benefit from, a good. Benefits of legal title include the ability to sell a good, exchange it for another asset, or use it to secure or settle debt. Hence, the transfer of legal title often coincides with the transfer of control. However, in some cases, possession of legal title is a protective right and may not coincide with the transfer of control to a customer.
(c) The customer has physical possession – in many cases, the customer’s physical possession of a good gives the customer the ability to direct the use of that good. In some cases, however, physical possession does not coincide with control of a good. For example, in some consignment and in some sale and repurchase arrangements, an entity may have transferred physical possession but retained control of a good. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of a good that the customer controls.
(d) The design or function of the good or service is customer-specific – a good or service with a customer-specific design or function might be of little value to an entity because the good or service lacks an alternative use. For instance, if an entity cannot sell a customer-specific asset to another customer, it is likely that the entity would require the customer to obtain control of the asset (and pay for any work completed to date) as it is created. A customer’s ability to specify only minor changes to the design or function of a good or service or to choose from a range of standardised options specified by the entity would not indicate a customer-specific good or service. However, a customer’s ability to specify major changes to the design or function of the good or service would indicate that a customer obtains control of the asset as it is created.
The ED clarifies that not one of the preceding indicators determines by itself whether the customer has obtained control of the good or service. Moreover, some of the indicators may not be relevant to a particular contract (for example, physical possession and legal title would not be relevant to services). Also, the ED does not have specific guidance for determining when a performance is satisfied over time, such as when the entity’s performance creates or enhances an asset that the customer controls as the asset is being created or enhanced. Thus, a reporting entity would need to apply judgements to determine when control has passed, by considering those four indicators and other facts and circumstances.
1.3 Continuous transfer of goods and services
The ED retains the concept of continuous transfer of goods or services introduced in IFRIC 15 by clarifying that when the promised goods or services underlying a separate performance obligation are transferred to a customer continuously, an entity shall apply to the performance obligation one revenue recognition method that best depicts the transfer of goods or services. Suitable methods of recognising revenue to depict the continuous transfer of goods or services to the customer include: (a) output methods (such as units produced or delivered, contract milestone, and surveys of work performed); (b) input methods (such as costs incurred to date); and (c) methods based on the passage of time (such as the straight line method for some licensing arrangements). This requirement basically provides for the use of the stage of completion method for contracts that transfer control continuously to the customers.
The clarification on the control concept is based on the customer’s ability to use, or direct others to use, and obtain the benefits from the good or service. The benefits include the customer’s ability to sell the good or service in its current stage as work progresses. However, the four indicators of transfer of control appear to focus more on the legal title or physical possession. This guidance on continuous transfer is, therefore, not a very significant improvement to the indicators in IFRIC 15. As it stands, property developers using the “sell and build” model will again need to apply judgements on whether a continuous transfer has occurred. The views on this are likely to be divided unless there are further improvements in the final standard. A more definitive guidance is required on the continuous transfer.
1.4 Other Guidance
The ED also proposes additional guidance on accounting for costs of contracts with customers. Costs of obtaining a contract (eg. selling and marketing costs) would be recognised as expenses when incurred. If the costs incurred in fulfilling a contract are not eligible for capitalisation in accordance with other IFRSs, an asset is recognised only if those costs: (a) relate directly to a contract, (b) relate to future performance under the contract, and (c) are expected to be recovered.
Also, an entity would recognise a liability and a corresponding expense if a performance obligation is onerous. A performance obligation is onerous if the present value of the probability-weighted costs that relate directly to satisfying the performance obligation exceeds the amount of the transaction price allocated to that performance obligation.
The ED further proposes enhanced disclosure requirements to help users better understand the amount, timing and uncertainty of revenue and cash flows from contracts with customers. An entity would need to disclose qualitative and quantitative information about: (a) its contracts with customers, including a maturity analysis for the contracts extending beyond one year, and (b) the significant judgements, and changes in judgements, made in applying the proposed standards to those contracts.
1.5 The Improvements and the Implications on Practice
In straightforward contracts for sales of goods or rendering of services, the proposed requirements would have little, if any, effect on current practice. For construction contracts, the proposed IFRS would not change the general requirement that contract revenue should be recognised based on stage of completion. However, there is an implied presumption that the outcome of a construction contract can be measured reliably, which means that a reporting entity can no longer avail the exception of recognising contract revenue to the extent of recoverable contract costs. In other words, with the guidance provided in the proposed standards, the measurement reliability is presumed to be met.
The IASB also noted that the proposed standards may differ from current practice in the following ways:
(a) Recognition of revenue only when control of goods or services has passed to the customer – contracts for the development of an asset (for example, construction, manufacturing and customised software) would result in continuous transfer only if the customer controls the asset as it is developed. This requirement may differ from current practice.
(b) Identification of separate performance obligations – an entity would be required to divide a contract into separate performance obligations for goods or services that are distinct. As a result of this requirement, an entity might separate a contract into units of account that differ from those identified in current practice.
(c) Licensing and rights to use – an entity would be required to evaluate a licence to use the entity’s intellectual property (for less than the property’s economic life) that is granted on an exclusive or non-exclusive basis. If a licence is granted on an exclusive basis, an entity would be required to recognise revenue over the term of the licence. That pattern of revenue recognition may differ from current practice.
(d) Effect of credit risk – in contrast to some existing standards and practices, the effect of a customer’s credit risk (i.e. collectability) would affect how much revenue an entity recognises rather than whether an entity recognises revenue.
(e) Use of estimates – in determining the transaction price (for example, estimating variable consideration) and allocating the transaction price on the basis of stand-alone selling prices, an entity would be required to use estimates more extensively than in applying existing IFRSs.
(f) Accounting for costs – the exposure draft also proposes requirements for contract costs, which might change how an entity would account for some costs.
(g) Disclosure – the proposed standards would require an entity to disclose more information about its contract with customers than is currently required, including more disaggregated information about recognised revenue and more information about its performance obligations remaining at the end of the reporting period.
2. The New Model for Lease Accounting
2.1 History, Reasons and Rationale
The first version of IAS 17 was issued by the then IASC in September 1982 and revised in December 1997. The second revised version was issued by the IASB in December 2003. In April 2009, an amendment was made to the IAS about the classification of land leases as part of the Annual Improvements to IFRSs in 2009. The revised IAS 17 remains effective to date.
The related interpretations on lease accounting issued are:
a) SIC-15, Operating Leases – Incentives (issued in December 1998);
b) SIC-27, Evaluating the Substance of Transactions Involving the Legal Form of a Lease (issued in December 2001); and
c) IFRIC 4, Determining whether an Arrangement contains a Lease (issued in December 2004).
The current IAS 17 classifies leases into one of two categories: finance leases and operating leases. The classification is based largely on the criterion of the extent to which significant risks and rewards incident to ownership of the asset lie. Users have expressed concern that applying this “risks and rewards” approach has resulted in many assets and liabilities under lease contracts failing the recognition test, i.e., they are unrecognised (off-balance sheet). In an operating lease, a lessee would just need to record the lease payments as an expense.
The IASB noted that investors and other users of financial statements have to estimate the effect of operating leases on financial leverage and earnings, as there are deficiencies in the quality of information on lease accounting under the current IAS 17. The current lease accounting does not provide a complete picture of an entity’s leasing activities. Many investors believe that operating leases give rise to assets and liabilities, and hence, should be reflected in the statement of financial position. Otherwise, the indicators of gearing or leverage are understated. If similar transactions are accounted differently, it would be hard for users to compare different entities and the implications of different leases. It could also lead to structuring opportunities whereby lease contracts could be structured in a particular way that they lead to a particular outcome. For example, a lease contract can be structured in a way that it does not meet any of the “bright-line” indicators of IAS 17, and therefore, classified as an operating lease in order to “disguise” the gearing of a lessee, and thereby achieves a particular capital structure.
The IASB’s project on leases aims to correct those deficiencies in IAS 17. In March 2009, the IASB and the FASB published a joint discussion paper on leases. In August 2010, the exposure draft, ED/2010/9, Leases, was issued to set out a proposal for a new IFRS on leases.
2.2 The Fundamental Approach to the New Lease Accounting
The IASB emphasises that similar transactions should be accounted for in a similar manner. It believes that reflecting all assets and liabilities under lease contracts would achieve this requirement. The proposed approach to lease accounting focuses on the rights and obligations of the counterparties in a lease contract (quite similar to the approach used for financial instruments in IAS 39). Recognising all the rights and obligations in leases would provide a more complete picture of an entity’s leasing activities.
The ED proposes a “right-of-use” accounting model where both lessees and lessors record assets and liabilities arising from lease contracts. For example, if a contract conveys a right to use an asset for a consideration, the entity that has received the right to use the underlying asset recognises that right-of-use as an asset, whilst the entity that has conveyed that right-of-use recognises a liability for granting to the counterparty the right to use the underlying asset. With this proposal, there will be no longer a distinction of finance leases and operating leases.
The definition of a lease has also been changed to “a contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for consideration”. Thus, all contracts that meet the definition of a lease, regardless of their legal form (whether termed as a lease or otherwise) and regardless of the period of time, would be subject to this new requirement. Apart from the traditional lease arrangements, the recognition requirement would apply to leases with periods that are significantly less than the economic lives of the underlying assets (under the current IAS 17, such leases would typically fail the finance lease criteria), short to medium term rental of property, plant and equipment, and arrangements that though not having the legal form of a lease, convey a right to use a specified asset (such as a contract in a power plant concession).
2.3 Accounting by Lessees
2.3.1 Recognition Principles
The ED proposes that “at the date of commencement of a lease, a lessee shall recognise in the statement of financial position, a right-of-use asset and a liability to make lease payments”. The term “right-of-use asset” is defined as an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease period. It is more akin to an intangible asset rather than a physical asset. The right to use an asset in a lease need not be for the major part or the entire economic life of the underlying asset. If the lease contract is for five years, the lessee reflects its right to use the underlying asset for five years as its “right-of-use” asset and a corresponding lease liability to make payments in the five-year lease term. This would change the practice of not recognising assets and liabilities in current operating leases. Also, applying a single right-of-use model is synonymous with treating all leases as a financing activity, even if some types of leases, such as short-term rental of property, plant and equipment, are more operating in nature.
The recognition of the items of income, expenses, gains or losses in the statement of comprehensive income is a consequence of the recognition of the assets and liabilities recognised in a lease. Accordingly, the right-of-use asset must be amortised and the liability to make lease payments must bear an interest expense. A lessee would recognise in the statement of comprehensive income (except to the extent that another IFRS requires or permits its inclusion in the cost of an asset): (a) interest expense on the liability to make lease payments; (b) amortisation of the right-of-use asset; (c) revaluation gains or losses as required by IAS 38, when a right-of-use asset is revalued; (d) any change in liability to make lease payments resulting from reassessment of the expected amount of contingent rentals or expected payments under the term option penalties and residual value guarantees relating to current or prior period; and (d) any impairment losses on a right-of-use asset. For current operating leases, rental expense would be replaced with amortisation expense and interest expense. The total expense charged in profit or loss would be higher in the earlier periods of the lease term.
2.3.2 Measurement Principles
For the initial measurement, a lessee would measure: (a) a liability to make lease payments at the present value of the lease payments, discounted using the lessee’s incremental borrowing rate, or if it can be readily determined, the rate the lessor charges the lessee, and (b) the right-of-use asset at the amount of the liability to make lease payments, plus any initial direct costs incurred by the lessee.
For the subsequent measurement of the assets and liabilities in a lease, a lessee would measure: (a) the liability to make lease payments at amortised cost using the effective interest method (with limited exceptions), and (b) the right-to-use asset at amortised cost (with limited exceptions).
Variable lease term
The calculation of the present value is based on the lease payments over the lease term. Lease term is defined as “the longest possible term that is more likely than not to occur”. Thus, if the lease period is variable, the entity needs to estimate the probability of occurrence for each possible lease period, taking into account the effects of any options to extend or terminate the lease.
Lease payments are defined as payments arising under a lease including fixed rentals and rentals subject to uncertainty, including, but not limited to, contingent rentals and amounts payable by the lessee under residual value guarantees and term option penalties. Contingent rentals are broadly defined as “lease payments that arise under the contractual terms of a lease because of changes in facts or circumstances occurring after the date of inception of the lease, other than the passage of time. Any option to purchase the underlying leased asset at a future date is not a lease payment. Thus, option purchase price in a lease should be excluded in the present value calculation. If the option is exercised in a future date, it is a separate event for a purchase of asset.
2.3.3 Presentation Requirements
Under the proposed standards, a lessee would present in the statement of financial position: (a) liabilities to make lease payments, separately from other financial liabilities; and (b) right-of-use assets as if they were tangible assets within property, plant and equipment or investment property as appropriate, separately from assets that the lessee does not lease.
Also, a lessee would present amortisation of the right-of-use asset and interest expense on the liability to make lease payments separately from other amortisation and interest expense, either in profit or loss or in the notes.
A lessee would classify cash payments for leases as financing activities in the statement of cash flows and present them separately from other financing cash flows.
2.4 Accounting by Lessors
Unlike the proposal of a single “right-of-use” model for accounting by lessees, the ED proposes a hybrid model for accounting by lessors. A lessor must assess and decide, at the inception of a lease, whether the lease would be accounted using the “performance obligation” approach or the “derecognition” approach. This is based primarily on whether the lessor retains exposure to significant risks or benefits associated with the underlying asset, either during the expected term of the lease, or after the expected term of the lease by having expectation or ability to generate significant returns, such as re-leasing or selling the underlying asset.
However, the use of the two approaches is not an accounting policy choice as it depends on the economic characteristics of the lease. They are mutually exclusive in that for each lease: (a) if the lessor retains exposure to significant risks or benefits associated with underlying asset, the lessor shall apply the performance obligation approach, and (b) by default, if the lessor does not retain exposure to significant risks or benefits associated with the underlying asset, the lessor shall apply the derecognition approach. The decision made in the selection of the approach is irrevocable. A lessor shall not change its accounting model for a lease after the date of the inception of the lease (even if the economic characteristics of risks or benefits change subsequently).
2.4.1 Application of the Performance Obligation Approach
The performance obligation approach to lessors’ accounting is premised on the notion that if the lessor continues to have significant exposure to risks or benefits associated with the underlying asset, there is no sale of the asset. This approach requires the lessor to continue recognising the underlying asset in the lease in its entirety, in other words, the lessor shall not derecognise the underlying asset. However, because the lessor has conveyed to the lessee the right to use the asset, the lessor has a performance obligation to fulfill. Thus, the lessor recognises a right to receive payments from the lessee as a lease receivable and a corresponding lease liability, representing its performance obligation in the arrangement i.e. its obligation to grant the lessee the right to use the underlying asset over the lease term. For current operating leases, this requirement would result in additional assets and liabilities in the statement of financial position.
For example, if a property owner rents out a property to a lessee for 10 years, it remains exposed to the significant risks or benefits of the property, both during and after the term of the lease. It must, therefore, apply the performance obligation approach to this lease arrangement. The property will continue to be retained in its statement of financial position. It then recognises, as an asset, the right to receive the 10-year rental payments and a corresponding lease liability for its obligation to grant the lessee the right to use the property.
In the statement of comprehensive income, a lessor would recognise in profit or loss: (a) interest income on the right to receive lease payments; (b) lease income as the lease liability is satisfied, for example. by amortisation of the lease liability to profit or loss; (c) any changes in the lease liability resulting from reassessment of the expected amount of contingent rentals and expected payments under term option penalties and residual value guarantees when the lessor satisfies that liability; and (d) any impairment losses on the right to receive lease payments. For current operating leases, rental income would be replaced with interest income and lease income. The total income recognised in profit or loss would be higher in the earlier periods of the lease term.
For the initial measurement, a lessor would measure: (a) the right to receive lease payments at the sum of the present value of the lease payments, discounted using the rate the lessor charges the lessee and any initial direct costs incurred by the lessor; and (b) the lease liability at the amount of the right to receive lease payments.
For the subsequent measurement, the lessor would carry: (a) the right to receive lease payments at amortised cost using the effective interest method; and (b) the remaining lease liability determined on the basis of the pattern of use of the underlying asset by the lessee. If the lessor cannot determine reliably the remaining lease liability in a systematic and rational manner on the basis of the pattern of use of the underlying asset by the lessee, it shall use the straight-line method.
Reassessment of the right to receive lease payments
The proposed standard requires that the lessor reassesses the carrying amount of the right to receive lease payments arising from each lease if “facts and circumstances” indicate that there would be a significant change in the right to receive lease payments since the previous reporting period. When such indications exist, the lessor would: (a) reassess the length of the lease term and adjust the lease liability to reflect any change to the right to receive lease payments arising from changes in the lease term; and (b) reassess the expected amount of any contingent rentals, any expected payments under residual value guarantees and any expected payment under term option penalties. The lessor recognises any resulting change to the right to receive lease payments in profit or loss to the extent that the lessor has satisfied the related lease liability and as an adjustment to the lease liability to the extent that the lessor has not satisfied the related lease liability. A lessor shall not change the rate used to discount the lease payments (except for changes in reference interest rates when contingent rentals are based on those reference interest rates).
Presentation Requirements: Performance Obligation approach
In the statement of financial position, a lessor using the performance obligation approach would present a net lease asset or a net lease liability, being the total of: (a) the underlying assets; (b) rights to receive lease payment; and (c) lease liabilities.
In the profit or loss, a lessor would present separately: (a) interest income on a right to receive lease payments; (b) lease income from satisfaction of a lease liability; and (c) depreciation expense on the underlying asset.
A lessor would classify the cash receipts from lease payments as operating activities in the statement of cash flows.
2.4.2 Application of the Derecognition Approach
The derecognition approach for lessors’ accounting is premised on the notion that if a lessor has not retained exposure to significant risks or benefits of the asset, it has, in substance, “sold” a portion of the underlying asset to the lessee. Accordingly, the portion of the underlying asset sold is derecognised. This requirement is similar to the standard for derecognition in parts prescribed for financial assets in IAS 39.
Applying this notion would imply that if a lessor has not retained any risks or benefits of the underlying asset, then the entire asset should be derecognised i.e. a sale of the whole asset. If this is the case, the arrangement is more akin to a sale and purchase contract with the customer. Accordingly, the arrangement would be more appropriately dealt with by other IFRSs, such as IAS 18, Revenue, or the proposed IFRS on Revenue from Contracts with Customers. Such an arrangement is basically a sale of goods with deferred payments. Thus, the ED scopes out certain types of arrangements, which are in substance, sale of goods, such as, if the lease contract transfers the title to the lessee at the end of the lease term (for example, in a hire purchase contract) or if the lease contract contains a bargain purchase option (with an option price significantly below the expected fair value at the exercise date), and it is reasonably certain at the inception of the lease, the lessee will exercise the option. Note that applying the requirements of the other IFRSs for such arrangements would essentially have the same effects (such as recognising a sale and a corresponding receivable measured on the amortised cost model). However, the focus of the proposed standard is when an arrangement requires a part derecognition.
Under this approach, a lessor would, at the date of commencement of a lease: (a) recognise a right to receive lease payments in the statement of financial position; (b) derecognise from the statement of financial position the portion of the carrying amount of the underlying asset that represents the lessee’s right to use the underlying asset during the term of the lease, and (c) reclassify as a residual asset the remaining portion of the carrying amount of the underlying asset that represents the right in the underlying asset that the lessor retains. This requirement would change the current practice of derecognising the entire asset when substantially, all risks and rewards have been transferred to the lessee. Also, the recognition of a “residual asset” is something new.
In the profit or loss, the lessor would recognise: (a) lease income representing the present value of the lease payments and lease expense representing the cost of the portion of the underlying asset that is derecognised at the date of commencement of the lease (similar to a gain or loss on sale of part of an asset); (b) interest income on the right to receive lease payments; (c) lease income or lease expense upon any reassessment of the lease terms; (d) any changes in the right to receive lease payments resulting from reassessment of the expected amount of contingent rentals and expected payments under term option penalties and residual value guarantees; and (e) any impairment losses on the right to receive lease payments or the residual asset. Under this new requirement, a lessor would be unable to recognise the entire gain on derecognition in profit or loss, as part of that gain is attributable to the residual asset.
For the initial measurement, a lessor would measure, at the date of inception of the lease: (a) the right to receive lease payments at the sum of the present value of the lease payments using the rate the lessor charges the lessee and any initial direct costs incurred by the lessor and (b) the residual asset at an allocated amount of the carrying amount of the underlying asset.
The “splitting” up of the carrying amount of the asset for part derecogntion and part retention is based on the relative fair value approach i.e. in proportion to the fair value of the right transferred and the fair value of the right retained. The fair value of the right transferred is the present value of the lease payments. Thus, the portion of the asset derecognised is computed as = Carrying amount of asset x [Fair value of right transferred/Fair value of asset]
For the subsequent measurement, the lessor would measure the lease receivable i.e. the right to receive lease payments at the amortised cost using the effective interest method (with modifications when a subsequent reassessment of the lease term results in a change to the residual asset or when there is an impairment on the lease receivable). This is similar to the subsequent measurement of lease receivable under the performance obligation approach. However, the lessor would not be permitted to remeasure the residual asset.
Reassessment of the right to receive lease payments
A lessor must reassess the carrying amount of the right to receive lease payments if “facts and circumstances” indicate that there would be a significant change in the right to receive payment since the previous reporting period. When such indications exist, a lessor shall: (a) reassess the length of the lease term. When the reassessment results in a change to the residual asset, the lessor allocates those changes to the right derecognised and the residual asset, using the same relative fair value approach in the initial separation. It shall adjust the carrying amount of the residual asset accordingly, and (b) reassess the expected amount of any contingent rentals and any expected payments under residual value guarantees and expected payments under term option penalties. Any resulting changes in the expected amount is recognised in profit or loss. The lessor shall not change the rate used to discount the lease payments, except for changes in reference interest rates when contingent rentals depend on those reference interest rates. If contingent rentals are discounted at the changed reference interest rate, any change in the present value amount due to the change in the discount rate is recognised in profit or loss.
A lessor using the derecognition approach would present separately in the statement of financial position: (a) the right to receive lease payments; and (b) the residual assets.
For the presentation in the statement of comprehensive income, a lessor would present lease income and lease expense in profit or loss in a manner that provides information that reflects the lessor’s business model. For example, if the lessor’s business is one of selling properties, the lease income shall be presented as revenue and the lease expense shall be presented as cost of sales. For others, the lease income may be presented as a gain or loss on derecognition of a property, plant and equipment.
2.5 Exceptions for Short-Term Leases - Lessees and Lessors
The scope of the proposed standard would capture any lease arrangement that conveys a right to use an asset for a consideration. It will include rental of equipment for one to two years, tenancy agreement for one year with an option to extend and other short-term leases.
The ED proposes to provide exceptions to the requirements for such short term leases. For a lessee, the exception is on the measurement requirement where it may elect to recognise the right-of-use asset and lease liability at the undiscounted amount of the lease payments. For a lessor, the exception is on the recognition requirement where it may elect not to recognise the lease receivable and lease liability, and consequently, not to derecognise any portion of the underlying asset.
The clarification in the application guidance is that the exceptions apply only to short leases with lease terms that are 12 months or less from the commencement date. Thus, leases with terms that are more than 12 months would need to comply with the requirements of the standard. Some commentators have expressed concern that these exceptions are too restrictive.
2.6 Sales and Leaseback Transactions
Under this proposed Standard, the accounting for sales and leaseback transaction is simplified. The key consideration is whether a “sale and purchase” of asset has occurred, not whether the leaseback is a finance lease or an operating lease (there is no longer a distinction of leases into these two categories).
Thus, for sale and leaseback arrangements, if a “sale and purchase” of asset has occurred (for example, when control and significant risks or rewards of the asset have been transferred to the lessor), the lessee-transferor recognises the sale of asset in accordance with applicable IFRSs. The leaseback is accounted as a lease in accordance with requirements of the proposed standards for lessees.
If the transfer of the asset does not meet the condition for a sale, such as when control and significant risks and rewards are not transferred, the lessee does not derecognise the transferred asset. It therefore accounts for the arrangement as a financing. The amount received (i.e. the consideration received) is recognised separately as a financial liability and accounted for in accordance with IAS 39.
In the lessor’s (i.e. the transferee’s) books, if the conditions for a purchase are met, the lessor records the purchase of an asset in accordance with applicable IFRSs. The lessor accounts for the lease using the performance obligation approach. If the transfer does not meet the conditions of a purchase, the lessor does not recognise the underlying asset. The consideration paid is recorded as a receivable in accordance with applicable IFRSs.
If the consideration for a sale or purchase or the lease payments specified by the leaseback are not at fair value, the lessee-transferor shall adjust the measurement of the right-of-use asset to reflect current market rates (fair value) and any gain or loss on disposal of the asset, whilst the lessor-transferee shall adjust the carrying amount of the underlying asset and the lease liability it recognises to reflect the current market values. Thus, under the proposed standard there will be no more deferrals of gains and losses arising from sale and leaseback transactions.
2.7 Sublease Arrangements
The proposed standard defines a sublease as a transaction in which an underlying asset is re-leased by the original lessee (or intermediate lessor) to a third party, and the lease agreement (or head lease) between the original lessor and the lessee remains in effect. The lessee in the original head lease becomes an intermediate lessor in the sublease.
The accounting requirements of the proposed standard apply to each party, The original lessor in the head lease accounts for the head lease using the appropriate approach (performance obligation or derecognition) and the lessee in the sublease accounts for it using the requirements prescribed for lessee. However, the intermediate lessor has to account for two separate arrangements: (a) as a lessee in the original head lease, and (b) as a lessor in the sublease.
The intermediate lessor would present the liability to make lease payments under a head lease separately from other assets and liabilities arising from the sublease and would present together in the statement of financial position: (a) right-of-use assets (which are the underlying assets in subleases); (b) rights to receive lease payments under subleases; (c) lease liabilities; and (d) the total of (a) – (c) as a net lease asset or a net lease liability.
2.8 Contracts that contain both Service Components and Lease Components
Some leases of assets include a component for servicing the assets. For example, a lease of a highly specialised machine that requires the lessor to provide technical and backup services on the use of the machine over the lease term. In such arrangements, the parties need to apply the revenue standard (for example, the proposed IFRS on Revenue from Contracts with Customers), to identify separate performance obligations within the contract.
If the service component is distinct, the entity allocates the payments required by the contract between the service component and lease component using the allocation principle in the revenue standard, for example, the relative stand-alone prices of the two components. The criteria for determining whether a service component is distinct are the same as those used in the revenue standard, such as when the entity or another party sells an identical or similar service separately or when the service component has a distinct function and a distinct profit margin. However, if a lessee or a lessor that applies the performance obligation approach is unable to allocate the payments, the lessee and the lessor applies this draft standard to the whole contract i.e. accounted for wholly as a lease transaction as if the service component is not distinct.
2.9 The Improvements and the Implications on Practice
Although the single right-of-use model would correct many of the deficiencies in the existing lease accounting, there are still many unresolved or debatable issues. For example, the proposed hybrid model for lessors’ accounting (using either a performance obligation approach or a derecogntion approach) is subject to much debate. Some have commented that the single right-of-use model should apply equally to lessors’ accounting. Other comments are on the specific treatments and guidance proposed in the ED. In July 2011, the IASB and the FASB announced their intention to re-expose their revised proposals for a common leasing standard.
Notwithstanding that there would be revisions to the ED, what is evident is that there will be no more off- balance sheet lease accounting. Rights and obligations in all lease arrangements would be appropriately reflected as assets and liabilities in the statement of financial position. This could affect the current practice of many entities. For example, airline entities that currently treat rental of airplanes as operating leases would be required to recognise the airplanes as a right-of-use asset and a corresponding lease liability in the statement of financial position. Similarly, a utility entity that purchases power or energy in a concession arrangement would be required to recognise a right-of-use asset on the power plant or the network infrastructure and a corresponding lease liability. Their financial leverage or gearing would probably increase by these new requirements.
Also, many more items would be within the scope of lease accounting and these may include short-term rental of equipment, property tenancy agreement and other short-term arrangements that convey a right to use an asset for a consideration. It would also include leases of land regardless of the lease period.
In Malaysia, the tax treatment for leases (whether finance or operating leases) is generally based on rentals paid. Bringing in more assets and liabilities in the statement of financial position under the new lease accounting model would also require additional deferred tax assets and deferred tax liabilities. The tax consequences of the changes would require a careful and detailed analysis for all lease transactions.
The two exposure drafts would correct the weaknesses and deficiencies that are apparent in the current IFRSs. For example, the proposed right-of-use model for lease accounting would resolve the long-debated concern on off-balance sheet financing. Rights and obligations, regardless of the form or legal structure, would be reflected as assets and liabilities if they meet the definitions in the Conceptual Framework.
Also, the proposals in the two exposure drafts would result in significant improvements to the current practice. ED/2010/6 would result in systematic and consistent revenue recognition, and thus enhance the comparability characteristic of financial statements. ED/2010/9 would result in rights and obligations of all leasing arrangements to be on-balance sheet, and thus reflecting a more accurate measure of an entity’s financial structure or gearing.
However, there are some issues that need further deliberations. For the proposed revenue standards, further guidance or clarification is required on the “continuous transfer of control” criterion. The proposals, as they stand, may lead to diverse interpretations for certain types of contracts with customers, such as the “sell and build” model contracts on real estate.
The proposals for lessees’ accounting are conceptually sound and need no further deliberations. However, the proposals for lessors’ accounting are somewhat odd and appear to lack theoretical merits. Applying a hybrid model (i.e. two mutually exclusive approaches) would appear contrary to the single right-of-use model that was envisaged in the first instance. The performance obligation approach is conceptually weak in that it recognises both the underlying asset and a lease receivable. The approach also recognises two income streams, i.e. interest income and lease income. In reality, there is only one asset (the underlying asset) and one income stream (the cash flows from lease payments). The approach recognises the underlying asset in its entirety even though a significant portion of the economic benefits could have passed to the lessee. Complications could also arise when testing for impairment of the underlying asset and the lease receivable, such as which streams of cash flows should be attributed to the underlying asset and to the lease receivable. Potentially, there appears to a double-counting of resources (i.e. an over-statement of assets).
The derecognition approach would accord more closely to the single right-of-use model and, on balance, appears to have more theoretical merits. However, it introduces a fairly new concept of residual asset that needs further deliberation or guidance, such as whether it meets the definition of an asset, and if so, whether it is a tangible asset or an intangible asset. If this is the only approach adopted, it may not be suitable for short-term leases, such as short-term rental of properties, as the residual asset retained would constitute a significant portion of the underlying asset. The prohibition on remeasurement of the residual asset needs to be re-considered.
1. ED/2010/6, Revenue from Contracts with Customers, June 2010, IASB.
2. ED/2010/9, Leases, August 2010, IASB.
3. IAS 11, Construction Contracts, March 1979, IASC.
4. IAS 17, Leases, September 1982, IASC.
5. IAS 18, Revenue, December 1982, IASC.
6. IASB Staff Paper, Effects of board redeliberations on Exposure Draft Leases, June 2011, IASB.
7. IFRIC 4, Determining whether an Arrangement contains a Lease, December 2004, IFRIC.
8. IFRIC 12, Service Concession Arrangements, November 2006, IFRIC.
9. IFRIC 15, Agreements for the Construction of Real Estate, July 2008, IFRIC.
10. Summary of Revenue Recognition Model, April 2011, IASB.
Tan Liong Tong is the Project Manager of the MASB Working Group (WG 63) on Consolidation. The views expressed in this article are those of the author and not the official views of the MASB.
Appendix – Illustrative Examples
Case 1 – Revenue Accounting
At the beginning of Year 1, Entity A enters into a contract with a customer to design, manufacture and install a customised machine. The design and manufacture of the machine will take about a year to completion and the installation, including commissioning and testing the machine, will take about 3 months before the machine could be used for production by the customer.
The terms of the contract include:
(a) Entity A shall provide free technical and support services on the use of the machine for 5 years.
(b) Entity A shall provide a warranty to bear all costs of rectifying latent defects related to the design and manufacture of the machine.
(c) The customer shall accept title to the machine upon delivery of the machine.
(d) The customer shall pay a fixed amount of RM2,000,000 per year for 5 years and 10% of the revenue generated from the sales of products for 5 years.
Entity A estimates the following costs:
(a) Cost of designing and manufacturing the machine - RM8 million.
(b) Cost of installation and commissioning of the machine - RM1 million.
(c) Technical and servicing costs per year - RM400,000.
(d) Warrant costs based on past experience are about 5% of the cost of designing and manufacturing the machine.
Entity A further estimates the possible revenue from the sales of the products, as follows:
Years 1 & 2
RM’m per year
Years 3 - 5
RM’m per year
The current risk-free rate of interest is 4%. Based on the customer’s credit rating, there is a 4% change that it will default in payments.
Step 1 – Identifying the Contract
The contract is identified specifically to a customer.
Step 2 – Identifying the Performance Obligations
The performance obligations consist of:
(a) obligation to develop and manufacture a customised machine;
(b) obligation to install and commission the machine; and
(c) obligation to provide technical and support services on the use of the machine.
The obligation to rectify any default in the design and manufacture of the machine does not give rise to a separate performance obligation as it is a warranty for latent defects in the machine. Instead, a provision for warranty cost is recognised separately.
Step 3 – Determining the Transaction Price
The transaction price is measured at the present value of the consideration receivable, taking into account the time value of money, the variable consideration and the collectability (credit risk).
The expected consideration (in RM’m) is probability-weighted as follows:
Years 1 & 2 = RM2 + 10%[20% x RM4 + 50% x RM6 + 30% x RM10] = RM2.68
Years 3-5 = RM2 + 10%[20% x RM6 + 50% x RM8 + 30% x RM12] = RM2.88
The present value of the expected cash flows, net of 4% for credit risk and discounted at the risk-free rate for the time value of money is determined as follows:
Step 4 – Allocating the Transaction Price to the Separate Performance Obligations
The present value of the consideration receivable would be allocated based on the relative stand-alone prices, if available. If not, based on the present value of the expected costs, the relative stand-alone fair values of the three service components may be determined as follows:
Step 5 – Recognising Revenue when Each Performance Obligation is Satisfied
When each performance obligation is satisfied, Entity A recognises costs and revenue, as follows:
(a) When the design and manufacture of the machine is completed and delivered to the customer (title passes) the performance obligation to this component is satisfied. At the end of Year 1, Entity A recognises the following:
Dr Receivable (8.86/.96) 9.23
Cr Revenue (8.523 x 1.04) 8.86
Cr Allowance for credit losses 0.37
Dr Costs as an expense 8.00
Cr Cash 8.00
(b) Entity A further recognises a provision for the obligation to rectify any default of design and manufacture that might arise in the future, as follows:
Dr Warranty expense 4% x 8m 0.32
Cr Provision for warranty 0.32
(c) When the installation obligation is satisfied, Entity A recognises costs and revenue as follows:
Dr Receivable (1.11/.96) 1.16
Cr Revenue (1.068 x 1.04) 1.11
Cr Allowance for credit losses 0.05
Dr Costs of installation as an expense 1.00
Cr Cash 1.00
When payment is received at the end of Year 2:
Dr Cash 2.68
Cr Interest income 4% x (9.23 + 1.16) 0.42
Cr Receivable 2.26
(d) Over the years 2-6, when the technical and back up services are provided i.e. when this performance obligation is satisfied, Entity A recognises costs and revenue based on work done in each year. For example, at the end of Year 2, in undiscounted terms, the recognition is:
Dr Receivable 0.41/.96 0.43
Cr Revenue [1.90/5x (1.04)2] 0.41
Cr Allowance for credit losses 0.02
Dr Services cost as expense 0.40
Cr Cash 0.40
The carrying amount of the receivable, interest income and cash payments over the years 1- 6 would be as follows (assuming no changes in the estimates):
Note: Addition of receivable includes projected receivable arising from provision of services in the years 2-6.
Case 2: Lease Accounting
At the beginning of Year 1, Entity K, a hotel owner, enters into an arrangement to convey to Entity L, a hotel operator, the right to use the hotel property. The carrying amount of the property in the books of Entity K is RM100 million, measured on the depreciated cost basis. The property has a remaining useful life of 25 years. However, the property’s current market value on this date is assessed at RM200 million.
The details of the arrangement are as follows:
(a) A non-cancellable period of 10 years:
(i) Rental for the first five years is fixed at RM16 million per year, payable in advance at the beginning of Year 1 and thereafter at the end of each preceding year (for example, year 2 rental is payable at the end of Year 1).
(ii) Rental for the years 6-10 is determined at the market rate prevailing at the end of Year 5 and payable in advance at the end of each preceding year of the years 5-9 (for example, Year 6 rental is payable at the end of Year 5).
(b) An option to extend the lease for another 5 years at the end of Year 10.
(i) If the option is exercised, rental for the years 11-15 is determined at the market rate prevailing at the end of Year 10.
(ii) If the option is not exercised, a penalty payment of RM8 million is imposed as compensation for the owner to seek a new operator.
(iii) Upon termination of the arrangement at the end of Year 10, the guaranteed residual value is RM80 million. If the market value drops below RM80 million at end of Year 10, the difference in value is the payment of residual value guarantee.
(c) Notwithstanding clause (b) above, the arrangement will terminate at the end of Year 15. Any option to extend the lease thereafter will be renegotiated on a willing-buyer willing-seller basis, giving first priority of renewal to the operator.
(d) Contingent rentals – If at the end of Year 5 or Year 10, whichever is applicable, the benchmark Klibor has increased in the preceding 5-year period, additional rental becomes payable as follows:
(i) Klibor increases by 100 basis point – RM2 million.
(ii) Klibor increases by 200 basis points – RM3.5 million.
(iii) For every further increase of 100 basis points an additional amount of RM.5 million.
(e) The operator has an option at the end of Year 10 or Year 15, whichever is applicable, to purchase the hotel property at the prevailing market value at the date the purchase option is exercised.
The implicit rate of interest that Entity K charges Entity L is 5% per annum. Market rates for rental of similar properties have, in past years, moved in tandem with the property price index with an average increase of 4% per year. The current Klibor is 4%. Entity K estimates that the Klibor will increase by 100 basis points every 5 years.
It further estimates that there is 40% probability that Entity L will extend the lease at the end of Year 10 and a 5% probability that it will renegotiate for a new lease at the end of Year 15. Based on Entity L’s business model as an operator of hotels and other facts, Entity K does not expect Entity L to exercise the purchase option. Entity K further estimates that there is a 50% chance the market value of the property at the end of Year 10 will be at least RM80 million and a 50% chance the value will be RM60 million.
Both the lessor and lessee incur an initial direct cost of RM2 million.
Determining the lease term:
The probability of more than a 15-year lease is 5%, the probability of at least 15-year lease is 45%, whilst the probability of a 10-year lease is 55%. Based on this analysis, the longest possible term that is more likely than not to occur is 10 years.
Estimating the relevant cash flows:
(a) Rental payment for the first 5 years is fixed at RM16m per year payable in advance.
(b) Rental payment for each year in years 6-10 is estimated by an adjustment for the expected increase in the property price index, as follows:
Rental = RM16m (1.04)5 = RM19.5m
(c) Contingent rental is expected to be payable in each of the years 6-10 at RM2m based on the expected increase in Klibor.
(d) Term option penalty of RM8m is expected to be payable at end of Year 10 (using a lease term of 10 years implies that the option to extend will not be exercised).
(e) Payment of residual value guarantee at the end of year 10 = 50% x 20 = RM10m.
Discounting the estimated cash flows:
Using the rate that Entity K charges Entity L, the lease payments (the relevant cash flows above) are discounted at 5%. The calculation of the present value is shown below:
Entity L – Lessee’s Accounting
Recording the lease arrangement
Entity L adds the initial direct costs of RM2m to the right-of-use asset. The journal entry for the recognition at date of inception would be as follows:
Dr Right-of-use asset 162.37
Cr Liability to make payments 160.37
Cr Bank – initial direct cost incurred 2.00
Dr Liability to make payments 16.00
Cr Bank – payment in advance 16.00
The carrying amount of the right-of-use asset is amortised using the straight-line method over 10 year. The amortisation per year is RM162.37/10 = RM16.24m.
The lease liability is carried at the amortised cost effective interest method. The effective rate in the liability is the 5% used in the present value calculation, and this is the rate that interest expense should be recognised each year over the 10-year lease term. For example, the journal entry at the end of Year 1 would be as follows:
Dr Interest expense (5% x 144.37) 7.22
Dr Liability to make payments 8.78
Cr Bank – rental paid 16.00
The carrying amount of the lease liability, interest expense and lease payments made in each year in the lease period would be as follows:
Entity K – Lessor’s Accounting
Assessment of the model to be applied
This case requires the lessor to assess whether it retains significant risks or benefits associated with the underlying hotel property, both during and after the lease term. This is a matter of judgement. Entity K may conclude, on the basis of the 15-year remaining life after the lease term and the market value of the property at the end of the lease term, that it retains significant risks or benefits, and accordingly, applies the performance obligation approach to the lease arrangement.
Entity K’s business model to the hotel property is more of an investment rather than operations of a hotel, where the cash flows are fairly stable rental and interest. The terms of the arrangement are more or less based on prevailing prices. Additionally, Entity K will recover substantially the fair value of the property by the end of the lease term. On those reasons, Entity K may conclude that it does not retain significant risks or benefits of the hotel property. Accordingly, it applies the derecognition approach to the lease arrangement.
Applying the Performance Obligation Model
Under this model, the hotel property remains in the books of Entity K and would be depreciated over the remaining useful life in accordance with IAS 16. On initial recognition, Entity K adds the RM2 million initial direct cost to the lease receivable and records the following:
Dr Lease receivable 162.37
Cr Lease liability 160.37
Cr Bank – initial direct cost 2.00
Dr Bank – payment received in advance 16.00
Cr Lease receivable 16.00
Subsequently, the lease receivable would be carried at amortised cost. The effective interest, taking into account the initial direct cost, is 4.73%. At the end of Year 1, Entity K recognises interest income on the lease receivable and records the following
Dr Bank – lease payment received 16.00
Cr Interest income (4.73% x 146.37) 6.93
Cr Lease receivable 9.07
The lease liability is a form of deferred income and is amortised to profit or loss (assuming at straight line method) as follows:
Dr Lease liability 16.04
Cr Lease income in profit or loss 16.04
The carrying amount of the lease receivable at amortised cost, interest income and lease payment received in each year over the 10-year period would be as follows:
Applying the Derecognition Model
Under this approach, Entity K needs to split up the carrying amount of the hotel property into a portion sold and a portion retained, based on relative fair value, as follows:
Portion derecognised = 160.37/200 x 100m = RM80.18m
Portion retained = 100 – 80.18 = RM19.82 m
The accounting entries:
On inception of the lease arrangement:
Dr Lease receivable 162.37
Cr Lease income – gain on portion sold 80.19
Cr Hotel property 80.18
Cr Bank – initial direct cost 2.00
Dr Residual asset in a lease 19.82
Cr Hotel property 19.82
When the first rental income is received in advance at the beginning of Year 1:
Dr Bank account 16.00
Cr Lease receivable 16.00
The subsequent measurement
The balance of the lease receivable after the above entries = 162.37m – 16m = RM146.37m.
After the initial recognition, the carrying amount of the lease receivable is carried at the amortised cost effective interest method, using an effective rate of 4.73%. The accounting requirements for the lease receivable would be the same as those of the performance obligation model.