EFRAG likely to be critical of lease accounting draft

One of the most significant respondents to the current exposure draft (ED) of the proposed new global leasing standard will be the European Financial Reporting Advisory Group (EFRAG). This is the body that advises the European Union on the final adoption of variations to international financial reporting standards (IFRS), before they are adopted as statutory requirements for listed companies based in EU member states.

Like many other respondents, EFRAG will be taking advantage of the full period allowed for comment, and does not plan to finalize its response until close to the notified deadline date in mid-September. However, it has circulated among its constituent bodies a draft response which is highly critical of key aspects of the global standard setters’ proposals. The draft clearly follows some preliminary internal consultations and anticipates a likely final EFRAG view so far as possible.

The main lessee model

The draft EFRAG response supports the objective of bringing more leases on-balance-sheet for the lessee, but does not favour going as far as the standard setters propose. The EFRAG draft implies that some “low consumption” leases – i.e. those with very high residual value at the end of the lease period, which are mainly real estate leases – should remain off-balance-sheet.

The draft comment suggests that the standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) – should adopt a two-stage approach. As an immediate step, the draft calls for more detailed disclosure of lease commitments in notes to accounts, while leaving off the face of the balance sheet all operating leases that are currently so treated. It suggests that greater on-balance-sheet recognition should wait until there has been further consideration of the Conceptual Framework document underlying all IFRS standards, which is currently being amended under a separate IASB project.

The “right of use” (ROU) model proposed by the Boards is described in the EFRAG draft as “a new approach, which has never been debated on a conceptual level”. It adds: “We are not convinced that the focus on liability recognition has led to capturing the right population [of leases] to which the ROU model should apply… Without a proper debate on the underlying concepts and the related transactions, the ROU model will not be understandable for constituents and this will add to the feeling that this proposed [standard] is unduly complex.”

The draft is supportive of “moving the goal posts” of lease classification so that more contracts are accounted for as financing arrangements than those within the present finance lease category. However, it suggests that those “low consumption” leases that would continue to be treated differently from finance leases should remain off-balance-sheet rather than simply having a different expensing treatment in the profit and loss (P&L) account.

The draft argues that the accounting treatment proposed by the Boards for “Type B” leases (generally comprising typical real estate leases) –  i.e. with the asset and liability values kept in line through the lease period through back-ended amortization of the asset, and with the presentation of a single lease rental expense on a straight line profile in P&L –  is inconsistent with the principle of the ROU model.

As to whether there should be a specified “equipment versus real estate” split in the rules, it is not yet clear which way EFRAG’s comments will go. The Boards have proposed rebuttable presumptions (with possible exceptions on either side) that equipment leases should be classified as Type A contracts and accounted for like current finance leases, and that property leases should generally be Type B.

The draft EFRAG response on this particular question presents alternative views at this stage. On either view of that, however, EFRAG’s emerging position would seem to be that in practice most equipment leases should be on-balance-sheet while many real estate leases should not.

Other issues 

On the accounting treatment of rental renewal options, the draft response again presents two alternative views but the difference between them is relatively narrow. Both would support keeping most renewals out of account at lease inception and therefore off-balance-sheet for the lessee, as proposed in the ED, although both in different ways take issue with the detailed formulation of the rule as proposed there, based on the “significant economic incentive” criterion.

It therefore seems clear that EFRAG is not likely to back the views of a significant dissenting minority of FASB members, and some corporate analysts, who argue that the result of generally excluding renewals is that the ED would not be an improvement on current lease accounting rules. Likewise on the question of other contingent rentals, the EFRAG draft supports the Boards’ proposal to leave most of them out of account, although it takes issue with the wording of the ED’s proposed exception to this exclusion, in terms of “in-substance fixed payments”.

On the transition rules for leases running before the effective date, the EFRAG draft is generally supportive of the ED proposals, with one exception. It suggests that for those lessees who will be required to produce comparative figures on the new rules for certain periods before the effective date of the new standard, they should not have to capitalize current operating leases where the lease term ends between the “date of initial application” (DIA) for comparative figures and the main effective date.

Although it depends on statutory regulations in each jurisdiction, it is in general only listed companies who are affected by requirements for “prior period comparatives” when accounting rules change, and who will therefore have DIAs before the effective date of the new standard.

On the lessor accounting model, the drafters appear to have anticipated that EFRAG may fail to present an agreed view on one important point. This is the ED proposal providing for income recognition through the lease period through accretion of the residual asset (RA), unwinding the initial discount to present value, under the “receivable and residual” (R&R) model which will generally apply to equipment lessors.

The Boards’ proposal in their first ED in 2010 was not to allow accretion of the RA  through the lease period. At the time EFRAG opposed this and supported the accretion principle. However, the present draft, while recalling this earlier view, states that some EFRAG constituents now oppose accretion.

EFRAG’s role

Although it has a key official standing as an advisory body, EFRAG (like the standard setting Boards themselves) is constituted as a private organization. Its constituent members, which are all Europe-wide in scope, are a mixture of professional accountancy bodies and trade associations, mainly in the financial sector. Its supervisory board reflects the pattern of that membership, but also includes a corporate analyst, a representative of one of the national accounting standard setting bodies who oversee GAAP rules for unlisted companies, and other members nominated by the European Commission.

The EU adopted the pre-existing body of IFRS standards en bloc when it made them mandatory for listed companies from 2005, but has always reserved the right to make exceptions for any specific rule. EFRAG advises the Commission and the other EU decision making institutions on the adoption of new IFRS rules as they are finalized, and comments to the IASB when these are being drafted. There has only been one occasion to date when the EU has decided not to adopt a part (which was later amended by the IASB) of a new IFRS standard.

EFRAG’s final comments on the core lessee accounting issues will certainly be significant, whether or not they follow the tendency of the present draft.

By Andy Thompson