September 2013

RSM Reporting
Issue 17 Issue 12

Welcome from the Editor Marco Mongiello

Welcome to the seventeenth edition of RSM Reporting the newsletter from RSM covering technical developments in global accounting and reporting.
How would it feel if, on the first day back after a summer break, you were given the news that two definitive standards on accounting for leases and accounting insurance contracts had been issued? For many of us the relief would be that the end of these two sagas would give space to some other interesting issues. For the rest of us, it would mean diving into the excitement of implementing these long due standards. But this newsletter is not fiction, so we can only try to help our readers navigate the uncertainty of these standards by shedding light and soliciting debate. This is what Joelle Moughannis Hot Topics in Accounting and Gil Rosenstock and Shlomi Shuvs articles do. The first has a focus on the accounting for leasing current status, the second addresses one of the implications of leasing contracts in the context of the valuation of investment properties. This newsletter also explores the boundaries of accounting and reporting and their developments in less chartered territories. To this end, the guest contributor, Karen Sanderson, shares with us her experience and opinions from the very prominent point of view of her senior position at HM Treasury in the UK and her leading role in the development of the Whole of Government Accounts (WGA). Few countries have ventured into this initiative and others will follow suit by adopting the WGA approach for public accounts. This opens tremendous opportunities for investors, analysts, politicians and economists to make more sense of the actual situation and of the performance of the public sector, and for our profession to have a louder voice in helping the public sector decision makers. Expect more on this and, wishfully, less on the endeavours of amending existing standards! Enjoy your reading.

In this issue: Section 1:  Accounting and reporting this quarter

 Updates from the IASB and EFRAG

Section 2: The point of view of ...

 ... Karen Sanderson on the Whole of Government Accounts - a new frontier of accounting  ... Shlomi Shuv & Gil Rosenstock on investment property - issues in practice
Section 3:  Hot Topics in Accounting by Joelle Moughanni

Dr Marco Mongiello ACA m.mongiello@imperial.ac.uk

Connect to RSM IFRS experts and connect with success

RSM Reporting | Issue 16 17 | September 2013

1 | Accounting & reporting this quarter

IASB | for further news and updates please visit www.ifrs.org EFRAG | for further news and updates please visit www.efrag.org

IASB
June 2013
The IASB published a revised Exposure Draft of proposals for the accounting for Insurance Contracts aiming to provide a consistent basis for accounting for insurance contracts and to make it easier for users of financial statements to understand how insurance contracts affect an entitys financial position, financial performance and cash flows. The focus is on enhanced presentation and measurement of insurance contracts and minimum artificial accounting volatility. The IASB published narrow-scope amendments to IAS 39 Financial Instruments: Recognition and Measurement - Novation of Derivatives and Continuation of Hedge Accounting, aimed at allowing hedge accounting to continue in a situation where a derivative, which has been designated as a hedging instrument, is novated to effect clearing with a central counterparty as a result of laws or regulation. Similar relief will be included in IFRS 9 Financial Instruments.

EFRAG
June 2013
EFRAG contributed to the debate on the Conceptual Framework, focusing in particular on the threshold for recognition of assets and liabilities. EFRAG has been actively seeking and soliciting proposals and feedback on accounting for insurance contracts from the industry. EFRAG has voted in favour of the adoption of the amendments to IFRS 10 and 12 and IAS 27: Investment Entities.

July 2013
EFRAG commented on the IASB exposure draft on leases that constituents do not seem to have a good understanding of the objectives of the project and what economic phenomena the IASB intended to depict in the primary financial statements. EFRAG agrees with the IASB that more leases should be brought onto balance sheets of entities and that application of the right-of-use model to a right population will prove to be useful for users of financial statements. EFRAG supports the IASBs proposal of the credit deterioration approach for expected credit losses in financial instruments. However, it recommends that the IASB reconsiders how the model could be implemented in such a way that entities are able to leverage their existing practices and hence limit the costs and increase reliability of their estimates and reviews the level of proposed disclosures in order to balance appropriately the cost for preparers and benefits for users. EFRAG has endorsed and supports the adoption of the Amendments to IAS 39 Novation of Derivatives and Continuation of Hedge Accounting proposed by IASB. EFRAG has endorsed and supports the adoption of the Amendments to IAS 36 Impairment of Assets proposed by IASB. EFRAG invites comments on its letter on the IASBs revised exposure draft on accounting for insurance contracts.

July 2013
IASB and FASB have stepped up their joint efforts to reach a final consensus on accounting for leases. IASB has stepped up its effort to advance the development of the accounting for insurance contracts.

August 2013
No activity took place.

August 2013
Nothing to report.

RSM Reporting | Issue 17 | September 2013

2 | Point of view
1 Ian Mackintosh Guest Contributor - Karen Sanderson

on on Global the global financial financial crisis and and a change a change at the at the top: top: a crucial a crucial time time for ... the Whole ofcrisis Government Accounts for the IASB IASB athe new frontier of accounting

Editors interview
The words attributed to Karen Sanderson express her own opinion and do not constitute official communication of HM Treasury.

Karen Sanderson: The WGA is seen by professional bodies (e.g. Institute of Chartered Accountants in England and Wales) and by the government as a valuable document that helps to bring about transparency. The public sector has reported using sets of accounts which are essentially fragmented. Even though some users find entity accounts useful because they are interested in the delivery of specific front line services, this fragmentation prevents users from seeing the big picture of the public sector. The national accounts, which are produced by the Office of National Statistics using economics-based measures of activity, are written in a language that is less familiar to users and so may be more difficult to understand and compare with the accounts produced by the private sector entities. The WGA, instead, is written in the much more common language of IFRS and brings the financial position and performance of the UK public sector together in one place. For example, before we published the WGA there was speculation about what government liabilities were, because some liabilities recognised under IFRS were not captured in national accounts measures. What we have done is bring certainty; users of the accounts do not have to wonder whether there is some skeleton in the cupboard. We prepare the accounts based on IFRS as every other listed company does and go through similar rigour. We use the EU adopted IFRS and interpret them or adapt them as necessary to reflect the public sector context. We have a statutory Financial Reporting Advisory Board that reports to the Parliament, which provides advice to the Treasury and other standard setters in the public sector on how to comply with the IFRS framework and whether interpretations or adaptations are acceptable. In the same way as private sector companies, there is a proper process for setting accounting standards and we cannot make up the rules as we go.

It is often reported that the IFRS framework is gaining more and more momentum globally because more countries require or allow its adoption for companies that meet certain conditions. However, there is another dimension to the expansion of the IFRS framework, which is less publicised; its adoption by public sector entities. Adopting International Financial Reporting Standards in the public sector brings big challenges and big opportunities for any government and regional authorities that decide to move into this space. The entrance of the public sector in the realm of international accounting is also an important turning point for the accounting profession globally. This is happening with the partial adoption of the International Public Sector Accounting Standards (IPSAS), by a number of countries and public sector bodies worldwide over the last decade, and with the partial adoption of the IFRS by fewer countries in more recent years. In this context, I had the privilege to talk with the Deputy Director to the Whole of Government Accounts (WGA) at HM Treasury in the UK, Karen Sanderson, about the visionary project of reporting the entire domain of the UK public sector as if it was one large group of companies using IFRS.

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From the technical point of view there are at least two major challenges in this initiative: the first is creating the procedures that are needed to consolidate the sheer number and variety of entities. You currently include around 3,000 bodies, from small local authorities to the National Health Service and the Bank of England. Is this bigger and more varied than any private sector company you can think of? In terms of consolidation procedures, the approach we adopt is probably different from the approach of a private sector group. We take the audited accounts of the individual entities and consolidate them. Private groups tend to audit the group first and the subsidiaries afterwards. Because we do it the other way around, we rely heavily on what is in the accounts of the local entities. Also, as opposed to private sector groups, we do not have detailed monthly intercompany accounting procedures. The WGA is an annual exercise. Although we are currently looking at ways to improve the elimination of counterparty transactions by perhaps introducing additional processes during the year, it is difficult for WGA to operate in the same way as the private sector. We do ask for information about transactions that involved other public sector bodies to be reported, but still we are left with significant numbers of transactions that do not match. For example, there are grants that are made between the central government and local governments that can be difficult to identify. When a grant given to a local authority has not been spent at the year end, it is likely to be reported in the entitys balance sheet, and may not be properly captured for WGA purposes, so we end up with a mismatching item. Although the net impact is small, the impact on individual lines is potentially bigger. We see the challenge and we are getting better at it! The second challenge is perhaps represented by the applicability of the concept of control? We do not see WGA as a set of group accounts; the Treasury is not the parent. We see it as a set of consolidated financial statements for the UK public sector. There is no command centre because the public sector has been developed over time under numerous pieces of legislation.

As a consequence, we have applied a slightly different concept of control, and have taken a different view to applying the IFRS in full. The Act that requires the WGA to be produced allows the Treasury to decide which entities to consolidate. We have taken a view about how to define the boundary of the WGA consolidation; we have chosen to base the WGA on those entities that are classified as part of the public sector by the Office for National Statistics (ONS). In this way we ensure that the scope of the WGA is similar to the scope that is being used in the national accounts measures. This gives better comparability and use of the information. The way that ONS classifies bodies to the public sector is, in turn, based on guidance provided by Eurostat, and part of that guidance in based on control. The definition of control in the Eurostat guidance and IFRS has a strong overlap, but is not exactly the same. So, the concept of control is present in the WGA but is also slightly different than control in the IFRS framework. One other reason for using the ONS classification is that the boundaries of our consolidation are independently determined, and we cannot be accused of fudging them. Admittedly changes are happening at the moment, as in the first year we did not catch all the entities that should be consolidated. So, between year one and year two, for example, we added the Bank of England. These changes are part of getting started and will continue over the coming years, but the aim is that we should get to a point where the boundaries should be fairly static and allow for comparability and trend analysis. What is the rationale for embarking on such a huge task for a government? Fiscal transparency is at the heart of the WGA. The UK has been leading the way. The International Monetary Fund talks about correlations between fiscal health and fiscal transparency: the more fiscally transparent a country is, the better its fiscal health. By using IFRS and being audited independently, WGA gives the readers the hard facts, and the government cannot fudge its position. We are telling the story as it really is and for people to make decisions. This includes people within the government and people outside of the government e.g. the rating agencies which are checking, among other things, if the sovereign debt is sustainable. This is equivalent to the managers and the investors use of accounting information in the private sector. If all members of the European Union (EU) used this accounting approach we would experience less uncertainty about the stability of the member states. In fact, the European Commission is looking at whether harmonised accounting standards should be introduced for member states, to create more consistent reporting among them.

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Rating agencies have taken some interest in our WGA; the very fact that ministers have the WGA is a plus point in managing the governments finances. Although there are people who would argue that cash accounting is fine, it is a fact that cash accounting does not give the reader as complete a picture as accrual based accounting gives: accrual accounting enables decision makers to see the effects of their and others decisions on future finances. The risk in publishing WGA is that by measuring important items like the debt in different ways to those that are used by the Government for fiscal management, and the numbers are different, people start to question whats going on. In fact, nothing has changed! It is not that the liabilities were not there, they have been measured in a different way. The information contained in WGA can help Ministers see the tough decisions that need to be made. Other countries produce consolidated financial statements, even though very few consolidate the whole of the public sector. For example, Estonia has progressed really well with this, and that in part may be because they have been able to adopt accrual based accounting almost from a blank sheet of paper. They have also been able to learn lessons from other countries, and Estonia too is now producing the consolidated accounts for the whole public sector. Other stakeholders? The WGA is of use for the private sector in a twofold sense: as taxpayers, companies are interested in the shape of the government finances and the challenges that it is facing. As providers of services, companies may use the WGA to spot opportunities to propose ideas of ways for improving how we deliver government services more efficiently and more cheaply. On this note, though, we do not have a huge interaction with our user base. Therefore, we are finding ways to communicating with users and ask them whether they do use the accounts and what they use them for, and whether there is other information they would find more helpful. We have launched a piece of work called simplifying and streamlining annual reports and accounts. This includes a public consultation document aimed at users and preparers, to try and understand who is using the accounts and for what purpose. We are conscious that the IFRS language is the language of investors, and that taxpayers may require other or additional information that is more important. At the same time we do want to stay true to the concepts in IFRS.

So, what we are witnessing is the birth of a new type of public accounts, which brings more transparency to the financial situation and performance of the public sector, making it easier for us to judge the governments stewardship of a countrys finances. When a government body sells an asset at a loss, this emerges in the WGA, which is concerned with the public sector as a separate entity from the private sector. The same transaction would disappear in the current national accounts, which are concerned with the entire economy of a country. What makes this historical turn in accounting and politics even more amazing, is that our guest contributor, Karen Sanderson, is leading this initiative with a smaller team than many private sector groups: a lesson of efficiency from those who look after the taxpayers money to those who look after the shareholders money?

Karen Sanderson Deputy Director, Government Financial Reporting HM Treasury Karen leads financial reporting policy for central government, acting as the standard setter for central government departments, leads on the production of whole of government accounts, and the reporting of public expenditure in the form of public expenditure statistics and to meet the requirements of Supply legislation. She qualified as a Chartered Certified Account, on an accredited programme with the former British Railways Board. On privatisation of the rail industry she joined Railtrack before moving to the private sector, where she joined Tetley GB Ltd. With her heart in the delivery of public services, she subsequently moved back to the public sector, firstly with the Strategic Rail Authority, before moving to the Department for Transport and then joining HM Treasury in 2008. She serves as a member of the Financial Reporting Advisory Board, which advises on accounting standards in the public sector.

RSM Reporting | Issue 17 | September 2013

2 | Point of view
Shlomi Shuv and Gil Rosenstock
... on investment property issues in practice

On 31 October 2012 the amendments to IFRS 10 for investment entities (Investment Entities Amendments to IFRS 10, IFRS 12 and IAS 27) were published and will be effective from 1 January 2014 (with early adoption permitted). These amendments provide an exemption for consolidation as required in IFRS 10 Consolidated Financial Statements. Instead of consolidating the controlled investments (i.e. subsidiaries), investment entities have to measure all of their investments at fair value through profit or loss. IAS40 Investment Property provides for the accounting treatment of investment property and the related disclosure requirements. It is paramount for a correct application of the Standard that the right model is adopted for the measurement of the investment property value. In light of the nature of investment property, the fair value model is, in our view, more relevant for measurement purposes than the cost model. In our view, the Standard itself seems to privilege the fair value model when it states that it is highly unlikely that a change from the fair value model to the cost model will result in a more relevant presentation. Furthermore, the Standard requires that even where the cost model is applied, the fair value must be disclosed in the notes. Under the fair value model, investment property is measured at fair value, with changes in fair value recognised in profit or loss. According to this approach, measurement of investment property using the cost method similarly, for example, to inventories would undermine relevance in the long term (as opposed to inventories, where this irrelevance is eliminated in the short term). However, for mainly practical reasons, in light of reporting entities' familiarity with the cost model and to allow time for countries with less-developed property markets and valuation professions to mature, the Standard permits the use of the cost model.

The fair value model raises many questions in practice, two of which are dealt with in the following paragraphs. The first issue deals with factors specific to the reporting entity whereas the second issue deals with factors specific to the asset being valued.

1. Factors specific to the reporting entity: fair value versus value in use The fair value of investment properties should disregard factors specific to the reporting entity. In this sense fair value differs from value in use as defined in IAS 36 Impairment of Assets. While value in use reflects the reporting entity's estimates, including the effects of entity-specific factors, fair value reflects all participants interests in the market. Therefore, in estimating the fair value of an investment property, an entity shall not include additional value created by a property portfolio containing properties in different locations, synergy between investment property and other assets held by a reporting entity, statutory rights or restrictions which are specific only to the present owner, and tax benefits or liabilities specific only to the present owner. On the other hand, fair value shall be calculated according to the optimal use (highest and best use) of the property, and not necessarily according to its present use. For example, assume that land with a golf course can be easily converted into a parking lot, which would yield higher income. While the value in use of the land reflects its current use (as a golf course), the fair value of the land should reflect its optimal use (a parking lot). This means that fair value is the highest possible value of the property evidenced by market data, taking into account each possible use - both financially feasible and legally permissible - that is sufficiently justified and expected.

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In another example, assume that a company owns investment property (a rentable warehouse) whose carrying amount is CU 10 million. The carrying amount of the property is comprised of land (CU 8 million) and the warehouse built on that land (CU 2 million). A valuer reaches the following conclusion: the fair value of the warehouse (current use) is CU 10.5 million (comprised of land value - CU 8.5 million and the value of the building - CU 2 million). On the other hand, the value of the land according to an alternative, optimal use (office building) is CU 12 million (but, in this case, the building would have to be demolished - fair value of zero). Even if the company's management does not intend to change the current use of the property, the fair value of the property should be CU 12 million. This is because the objective of a fair value measurement is to reflect the price that would be received to sell an asset in an orderly transaction between market participants. In other words, in this case it is safe to assume that a potential buyer (a market participant) would disregard the specific intentions of the reporting entity, but rather use the asset based on its highest and best use. Therefore, the fair value measurement should reflect this fact, while the exceptional intentions of the reporting entity in respect of the future use of the asset should be reflected in the results of subsequent reporting periods.

2. Factors specific to the asset being valued: accounting for prepaid or accrued operating lease income In principle, the fair value measurement should take into account factors specific to the asset being valued. This has consequences in the case of operating leasing incentives. Occasionally, when a reporting entity leases an investment property under an operating lease, it may provide the lessee with various incentives, such as a rent-free or reduced-rent period. SIC-15 Operating Leases - Incentives states that the lessor should recognise the cost of the incentives as a reduction of rental income over the lease term (usually according to the straight-line method). However, for investment property measured at fair value, the incentives provided to the lessee might already be included in the measurement of the incomeproducing property's fair value (in particular, where a similar incentive would be granted by any other market participant). For example, the fair value measurement of investment property takes into account factors such as the specific location of the asset, its age and its physical condition. Similarly, fair value measurement takes into account contractual rent cash flows in future periods, whether at, below or above market rent as of the measurement date. However, the Standard states that in determining the carrying amount of investment property under the fair value model, an entity does not double-count assets or liabilities that are recognised as separate assets or liabilities. Therefore, where the fair value has been determined based on the net rentals, since the lessor recognises a separate asset for the lease incentive as accrued operating lease income, the carrying amount of the investment property should be decreased, so as to avoid double counting. In conclusion, when valuing an investment property: (i) the model to adopt is the fair value, which must be used for the face of the accounts or in the note, (ii) factors specific to the owner of the property should be disregarded, but (iii) factors specific to the property should be considered. This is illustrated in the example, where leasing incentives are accounted for.

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Example - accrued operating lease income for lease incentive [to be framed separately if possible] On January 1, 2013, a company signs a 10-year operating lease with a lessee. Under the agreement, annual rent amounts to CU 100,000 per year, to be paid beginning from the third year onwards (i.e. the first two years are rent-free). Rent is paid at the beginning of each year. The fair value of the investment property on January 1, 2013 is CU 1,000,000, which reflects a rate of return of 8% = (100,000 X 8/10) / 1,000,000. Furthermore, the investment property's fair value on December 31, 2013 is CU 1,050,000. It should be assumed that the property's fair value takes into account the rentfree period. As the accrued operating lease income is recognised in a separate asset (other receivables) in the statement of financial position at December 31, 2013 for CU 80,000, the carrying amount for investment property is CU 970,000 (ie 1,050,000 80,000). In fact, in 2013 no rent is paid for the property. However, in accordance with the provisions of SIC-15, the company is required to average the total rent over the lease term. Accordingly, the company shall recognise rent in the amount of CU 80,000 (= 100,000 X 8/10). Furthermore, the company presents the incentive granted to the lessee as a separate asset, so the company reduces the investment property's fair value in order to avoid double counting.

In this case, loss from changes in the fair value of the investment property amounts to CU 30,000. This is because, assuming no changes occurred in all other terms, conditions and circumstances during 2013, the pure fair value (without regard to the double-counting issue) should have been CU 1,080,000. In other words, on December 31, 2013, a willing buyer would have paid CU 1,080,000 for the property, taking into account the fact that the abovemarket rent of CU 80,000 will be contractually received in the future for services supplied in the past (rent during 2013). Consequently, an actual fair value of CU 1,050,000 means that 2013 suffered a decrease in fair value of CU 30,000. The fair value of the property (CU 1,050,000) is actually split in the statement of financial position between the two assets: investment property for CU 970,000 and lease incentive (other receivables) of CU 80,000. ________________________________________
This article includes a sample of Chapter Twenty Investment Property of an IFRS Manual written by Mr Shlomi Shuv, an IFRS expert in Israel.

Gil Rosenstock, CPA, IFRS Consultant Head of Professional Practice RSM Shiff, Hazenfratz & Co., Israel T +972 (3) 791 9111 E gil_r@shifazen.co.il

Accordingly, the journal entries recorded in 2013 will read (in CU):

Dr Other receivables incentives 100,000 X 8/10 = 80,000 Dr Changes in fair value of investment property 30,000

Cr Rental income 80,000 Cr Investment property (1,050,000-1,000,000) 80,000 30,000

Shlomi Shuv, CPA, IFRS Consultant Vice Dean at the School of Business (IDC) Herzliya, Israel T +972 (9) 952 7655 E shuvs@idc.ac.il

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3 | Hot topics in accounting

Joelle Moughanni
... The newly proposed leases model in ten questions-and-answers

Entities around the world enter into leases as a means of gaining access to assets, of obtaining finance, and of reducing their exposure to the risks of asset ownership. The existing accounting models under both IFRS and US GAAP have been criticised for often providing a misleading picture about leverage and the assets that the lessee uses in its operations. As a result, many users of financial statements adjust the amounts presented in a lessees statement of financial position to reflect the assets and liabilities arising from operating leases, even though such adjustments can be incomplete or inaccurate due to missing information. Moreover, existing differences in the accounting for finance and operating leases have encouraged some companies to structure some transactions as operating leases to achieve off-balance-sheet accounting. As part of their global convergence process, the IASB and FASB (the Boards) have been working jointly since 2007 to create a single, converged, global leasing standard. The proposals in the revised exposure draft published on 16 May 2013 (with comment period ending on 13 September 2013) were developed by the Boards after considering responses to their Discussion Paper (issued in March 2009) and their initial exposure draft issued in August 2010 (the 2010 ED). However, given that two of the IASBs fourteen voting members and three of the seven FASB members voted against issuing the new ED (the dual accounting model being the main reason), the new proposals are likely to generate more debate and uncertainty about how the Boards will proceed. It is in this context that the following questions and answers provide a practical overview of the key re-exposed proposals for this long-existing project.

1. In a nutshell, what is the IASB proposing in its new exposure draft (the ED)? Overall, all leases would be brought on balance sheet unless they are short-term (i.e. less than 12 months) or not leases at all. The ED includes new guidance to distinguish a lease from a service contract, meaning that the accounting for some arrangements currently treated as leases might change. If the ED lessor model looks quite similar to the current IAS 17 model (except for some nuances in recognising revenue and discounting the residual asset), significant changes concern lessee accounting, in particular for operating leases of more than 12 months (lessee accounting for finance leases would remain unchanged). In fact, a lessee would be required to recognise assets and liabilities for all leases (of more than 12 months) on a discounted basis, with a profit or loss impact dependent on the nature of the underlying asset. Consequently, the statement of financial position, income statement and statement of cash flows would change for the majority of leases of equipment or vehicles, whereas for the majority of leases of property, only the statement of financial position would change. 2. Are there any changes to the proposed definition of a lease? The IAS 17 definition of a lease (i.e. the right to use an asset for a period of time in exchange for consideration) and the criteria in IFRIC 4 Determining whether an Arrangement contains a Lease (i.e. based on rights to control the use of specified assets) are retained in the ED (similar to the 2010 ED). However, changes to the application guidance of the definition, in particular relating to the concept of control within the definition i.e. a contract contains a lease when the lessee obtains the right to control the use of an identified asset for a period of time - are expected to narrow the population of contracts to which the proposals apply; in particular, service contracts that, under current requirements and the previous proposals, may have been considered to be leases would be excluded (e.g. some take-or-pay contracts ).

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3. Are the measurement complexities of the 2010 ED reduced in the new proposals? Yes, arguably. In particular, measurement of lease assets and liabilities would include: Variable lease payments, only if those are in-substance fixed payments or linked to an index or a rate (as opposed to including all expected variable lease payments in the 2010 ED). Lease payments payable in optional renewal periods, only if the lessee has a significant economic incentive to exercise the option (as opposed to including such payments on a more likely than not basis). In fact, the EDs proposals for variable lease payments are closer to current practice under IAS 17 than was the 2010 ED. In addition, entities could elect not to apply the proposed accounting models to short-term leases, i.e. leases with a maximum term (including renewal options) of up to 12 months; the existing operating lease accounting model could apply instead. Thus, lease length and renewal options might become key considerations in contract terms and business practices; for example, entities might be tempted with entering into very short leases to take advantage of the continued off-balancesheet treatment of short-term leases. 4. How different is the proposed lease classification from current practice? The proposed lease classification tests are fundamentally different from the current risks and rewards approach in IAS 17. Under the ED, leases would be classified at commencement date (without subsequent reassessment), by both lessees and lessors, as either Type A or Type B depending on the nature of the underlying asset and on the extent of the lessees consumption of the underlying asset. Leases of property (i.e. land and/or building) would be classified as Type B leases unless the lease term is for the major part of the underlying assets remaining economic life or the present value of the lease payments is substantially all of the fair value of the underlying asset.

Leases other than property would be classified as Type A leases unless the lease term is for an insignificant part of the total economic life of the underlying asset or the present value of the lease payments is insignificant relative to the fair value of the underlying asset. There are no bright-line quantitative thresholds on what constitutes an insignificant part of the total economic life or an insignificant amount of the fair value of the underlying asset. However, in all cases, if the lessee has a significant economic incentive to exercise an option within the lease to purchase the underlying asset, then the lease is classified as a Type A lease. The accounting models for each type of lease are discussed in Q&A 6 for lessees and Q&A 7 for lessors. 5. What is the rationale behind this introduced dual approach? In response to many comments on the 2010 proposals, the ED accounts for most equipment leases differently from most property leases in order to reflect the differing economics of the wide variety of lease contracts. The principle for determining which approach to apply is based on the amount of consumption of the underlying asset, reflecting the difference between a lease for which the lessee pays for the part of the underlying asset that it consumes during the lease term, and a lease for which the lessee merely pays for use. Typically, a lessee consumes a part of any equipment that it leases (e.g. aircrafts, ships, cars and trucks), because such equipment and vehicles are depreciating assets, whose value not only declines over their economic lives but generally declines faster in the early years of their lives than in the later years. In such leases, the lessor prices the lease to recover the value of the part of the asset consumed as well as obtaining a return on its investment in the asset. In other leases, the lessee merely uses the underlying asset without consuming more than an insignificant part of it. This is typically the case for most leases of real estate property. Property typically has a relatively long life, and a large proportion of the lease payments for some property leases relates to the land element inherent in those leases. Land has an indefinite life and the value of the land would not be expected to be consumed by a lessee. In such leases, the lessor prices the lease to obtain a return on its investment in the underlying asset (without requiring recovery of the investment itself).

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The ED simplifies this concept by making rebuttable presumptions requiring entities to classify a lease largely on the basis of the nature of the underlying asset and account for it accordingly. 6. How does the newly proposed lessee accounting model compare to the one in the 2010 ED? The core requirement for a lessee to recognise a right-of-use (ROU) asset (representing the right to use the underlying asset) and a lease liability (representing the obligation to make lease payments) is confirmed, although simplified as recognition of assets and liabilities would not be required for leases with a maximum term of 12 months or less. The more significant change is at the income statement level: whereas a lessee would have amortised the ROU asset over the lease term (typically on a straight-line basis) and recognised separately interest on the lease liability under the 2010 ED, the new ED proposes a dual approach to the recognition and presentation of lease expenses and cash flows based on classification of the lease (see Q&A 4). For a Type A lease, the ROU asset would be amortised using a systematic method with the related expense presented as amortisation expense. In addition, interest expense on the lease liability would be recognised using the effective interest method. Under this method, the interest expense would generally decrease over time whilst amortisation of the ROU asset is likely to either remain constant (under a straight-line method) or decrease over time (under a diminishing balance method). Accordingly, the total expense resulting from the lease arrangement would be front-loaded. This pattern of expense recognition is consistent with the treatment of finance leases under current lease accounting. For a Type B lease, a lessee would recognise a single lease expense that combines the unwinding of the discount on the lease liability with the amortisation of the ROU asset, calculated so that the remaining cost of the lease would be allocated on a straightline basis over the remaining lease term. Thus, the ROU asset in a Type B lease is not amortised on a straight line basis; it is instead a balancing figure arising from the difference between the amount paid, the lease expense and the amortisation of the liability.

7. How does the newly proposed lessor accounting model compare to the one in the 2010 ED? The 2010 ED proposed two different lessor accounting models, based on whether the lessor retained or transferred to the lessee the significant risks or benefits associated with the underlying asset. The ED proposes a dual model for lessors based on lease classification (see Q&A 4). A lessor in a Type A lease would derecognise the underlying asset and recognise a lease receivable (representing the right to receive lease payments and measured at the present value of the payments) and a residual asset (representing the lessors claim to the residual value of the leased asset at the end of the lease term and measured at the present value of the estimated residual value at the end of the term plus the present value of any expected variable payments). The lessor would recognise profit at lease commencement on the portion of the underlying asset that is considered to be sold to the lessee. Interest income on both the receivable and the residual asset would be recognised over the lease term using the rate the lessor charges the lessee in the lease contract. In a Type B lease, the lessor would simply continue to recognise the underlying asset and recognise lease payments as income (similar to current operating lease accounting under IAS 17). The initial proposals of recognising a lease receivable and a liability for the obligation to permit the lessee to use the asset received very little support and thus abandoned. 8. What to expect for effective date and transition? The ED does not propose an effective date for the new standard and does not specify whether early adoption would be permitted. However, it seems unlikely that entities would be required to adopt the new lease requirements before annual periods beginning on or after 1 January 2017. Under the ED, entities could choose between a full retrospective or modified retrospective transition. Under both approaches, entities would recognise lease-related assets and liabilities as of the beginning of the earliest comparative period presented. The modified retrospective approach would allow entities to use certain shortcut calculations to initially measure lease-related assets and liabilities and hindsight to determine the lease term or whether a lease exists at all. No leases would be grandfathered under either transition approach. In any case, transition is likely to be onerous.

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9. How would the new proposals improve the quality and comparability of financial reporting? For all leases with a lease term of more than 12 months, assets and liabilities would be reported in the lessees statement of financial position, thus providing a more faithful representation of the financial position of the lessee and, together with enhanced disclosures, greater transparency about the lessees leverage. The proposals require lease assets and liabilities to be measured on a discounted basis. This information is useful to users of financial statements because it provides information about future cash outflows arising from leases, which is comparable with information provided about other financial liabilities that are reported on an entitys balance sheet and measured on a discounted basis. The main concern from users of financial statements about current lessor accounting is the lack of transparency about the residual values of assets that are subject to operating leases. Those users are interested in understanding the assumptions that lessors make about significant residual values. Those who analyse the financial statements of equipment and vehicle lessors also told the Boards that it would be beneficial to distinguish credit risk (associated with receivables from lessees) from asset risk (associated with residual interests in underlying assets). The proposals would assist in providing that information for most equipment and vehicle leases by requiring a lessor to account for its residual interest in underlying assets separately from its receivables from lessees. The lessor would also be required to provide information about how it manages its exposure to that residual interest. 10. What key impacts are expected from such fundamental changes to lease accounting? The impacts would be felt across sectors. Entities that lease high-value assets (e.g. airlines and other transport companies) would see large increases in reported liabilities. Companies with large volumes of lower-value leases could face high implementation costs as they identify all leases and extract the data required to apply the new accounting models. Key financial metrics would be affected by the recognition of new assets and liabilities and by changes in the profile and presentation of lease income and expense. There could also be impacts on compliance with debt covenants, employee compensation arrangements, tax balances, and the entitys ability to pay dividends. Banks would also be concerned about the effect on regulatory capital. The proposals introduce new estimates and judgemental thresholds that would affect the identification, classification and measurement of lease transactions.

Also, in order to minimise the impact of the proposals, some entities might seek to reconsider business practices and structure lease transactions in different ways. The current focus on whether a lease is an operating lease (off-balancesheet) or a finance lease (on-balance-sheet) would be irrelevant. Instead, companies might focus more on whether a contract is a service arrangement (off-balance-sheet) or a lease (on-balance-sheet). Systems and process changes may be required to capture the data necessary to comply with the new requirements, including creating an inventory of all leases on transition. In conclusion, implementing these proposals would be a real challenge for many entities, as they would need to identify all their leases, extract key data, make new estimates and judgements, and implement new or updated systems to perform the required calculations. Since it is difficult at this stage to assess the full impact of the proposals, the Boards are holding joint round table meetings (in September and October 2013) and undertaking outreach activities to obtain additional feedback that will be considered when they finalise the Standard.

Joelle Moughanni Technical Consultant RSM Executive Office T +44 (0)207 601 1089 E joelle.moughanni@rsmi.com

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Global Contacts
Americas Richard Stuart T: +1 203 905 5027 E: richard.stuart@mcgladrey.com Europe C.M. (Kees) Roozen T: +31 (0)30 24 28 505 E: kroozen@rsmnederland.nl Asia Pacific Jane Meade T: +61 2 8226 9518 E: jane.meade@rsmi.com.au Middle East Chandra Sekaran T: +965 2245 2680 E: chandra.sekaran@albazie.com Africa Simon Fisher T: +254 20 4451747/8/9 E: sfisher@ke.rsmashvir.com RSM Global Executive Office UK Ellen Costa T: +44 (0)20 7601 1080 E: ellen.costa@rsmi.com

Editor
Dr Marco Mongiello ACA Director MSc Management and MSc Innovation, Entrepreneurship & Management Principal Teaching Fellow in Accounting Imperial College London Business School T: +44 (0)20 7594 9686 E: m.mongiello@imperial.ac.uk

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