Lease Accounting Changes: Impact on Asset Finance Deals and Documents
In August, the IASB and the FASB issued joint proposals which, if adopted, will overhaul lease accounting for all companies which report under IFRS or US GAAP. Nearly all leases will be caught by the proposed rules writes Marisa Chan, William Glaister and Simon Lew of Clifford Chance.
This briefing summarises key implications for asset finance documentation and structures. Broadly, the proposals provide that:
- The accounting distinction between operating leases (which are usually “off-balance sheet” for the lessee) and finance leases (or “capital leases”) will no longer be relevant; instead a “right of use” model will apply.
- From the lessee’s perspective, in respect of any lease arrangement, it will show in its financial statements an asset representing its “right to use” the leased asset (based on the present value of the lease payments, amortised over the expected lease term) and a corresponding liability (reflecting its obligation to make lease payments).
- From the lessor’s perspective, lease accounting treatment will still depend on the transfer of risks and rewards under the lease. If the lessor retains “significant risks and benefits associated with the leased asset” (during or after the lease term), it will apply the “performance obligation” approach: it will keep the leased asset on its balance sheet and also record a receivable (representing the right to receive lease payments over the lease term) and a lease liability (reflecting its performance obligation to allow the lessee to use the leased asset over the lease term).
For other leases, the lessor will apply the “de-recognition” approach (similar to the existing treatment of finance leases): it will take part of the leased asset off its balance sheet (reflecting the rights it has tranferred to the lessee) and continue to record a “residual asset” (representing its rights to the leased asset at the end of the lease term). It will also recognise a receivable (representing the right to receive lease payments over the lease term).
- There are detailed proposals relating to renewal options, termination rights and contingent payments.
- It appears that if a lease includes an automatic title transfer or bargain purchase option at the end of the contract, then it may fall outside the rules and be classified at inception as a purchase or a sale (being a contract where control of the asset and all but a “trivial amount” of associated risks and benefits are transferred at the end).
- There are no grandfathering provisions proposed, therefore all existing leases will be subject to the new regime. However, the IASB and the FASB have not yet indicated an effective date and the proposals have attracted significant industry debate, therefore the above is subject to change.
Operators, leasing companies and other financiers should assess the impact of the proposals on existing and future lease financing documentation and underlying structures. In particular:
- Financial covenants: e.g. any financial covenant linked to a borrower’s (or other obligor’s, including group entities) balance sheet position, such as a simple debt to equity (leverage) ratio, may need to be re-considered. Borrowers (including leasing companies or their subsidiaries and operators/lessees) may wish to review the financial covenants in their existing facilities and re-negotiate these as necessary, if the proposals are adopted. Similarly, the impact of the new rules should be considered when negotiating financial covenants in new facilities.
- Events of default: e.g. an event of default under a loan or a lease may be triggered by a cross-default provision, whereby the borrower or lessee fails to pay a specified level of “Financial Indebtedness” (or similar defined term, including “Indebtedness for Borrowed Money”) or such Financial Indebtedness is accelerated or a commitment for such Financial Indebtedness is cancelled.
A Financial Indebtedness definition typically excludes operating leases but includes finance or capital leases. Borrowers may wish to review such definitions in their existing facilities and to carefully consider the scope of such definitions going forward.
- Structuring: a lease transaction which has been structured for accounting efficiencies, e.g. to achieve off balance sheet treatment for a particular party, may need to be re-considered. Similarly, any tax-advantaged lease arrangement where the classification of the lease for tax purposes is linked to the accounting treatment may need to be reviewed. For example, the UK Inland Revenue’s current “long funding lease” rules refer to the accounting classification of a lease as a finance lease.
- Affected agreements: whether or not an arrangement falls within the new leasing rules will depend on its specific features. The proposals define a lease as “a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration.” Transfer of possession is not required, only a conveyance of the “right to control the use of the asset.” This broad definition may catch arrangements which are not currently considered as “leases” and this may give rise to adverse consequences.