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Technical Update: Lease Accounting

Lease Accounting – Piecemeal approach to changes continue – Opportunity for public comment over next few months.

Some more information and detail on the proposals to change lease accounting emerged last week. The two areas covered were the circumstances where profit can be recognised by lessors on entering a lease and dealing with uncertainties.

Lessor Accounting and profit recognition

Lessors will account for leases using a “receivable and residual” approach. Under this approach, a lessor would derecognize the underlying asset and record a lease receivable (during the period of the lease) and residual asset (when the asset comes off lease). It requires an allocation of the carrying value of the underlying asset between the portion related to the lessee’s right-of-use asset (the lease) and the portion retained by the lessor (the residual).

The approach allows for a lessor to recognize profit at lease commencement only if it is “reasonably assured.” This may be a significant change for those in industries which provide vendor financing to their key customers. Profit would be recognized for the difference between the lease receivable recognized and the portion of the carrying amount of the underlying asset derecognized.

When not “reasonably assured,” the timing and recognition pattern of profit would extend over the life of the asset.

For example, a lessor leases an asset to a lessee for approximately half of its useful life. At the commencement of the lease, the asset is carried at €100 but has a fair value of €120. The present value of the lease receivable is measured at €72, which is equivalent to 60% of the fair value of the asset. The residual asset is therefore measured initially at €40, being 40% of the carrying value. Profit of €12 is recognised, being the difference between the lease receivable of €72 and the derecognised portion of the asset of €60.

The receivable and residual approach will likely be complex, particularly for lessors of multi-tenant properties. It also requires judgement in determining the fair value of the lease on day one. No guidance was provided as to how this might be best achieved.

The boards agreed to retain the ED’s proposal to allow lessors to account for short term leases (a maximum lease term of 12 months or less) similar to current operating lease accounting. This is a very welcome accommodation.

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This members’ update is for general information only and should not be regarded as a substitute for tax, legal or other professional advice. Such advice should be taken before acting on or taking steps in relation to matters referred to in this document.

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