Results of joint FASB/IASB meeting, Nov. 18

The FASB and IASB had a joint meeting via videoconference today. Among several topics of discussion was lease accounting, for both lessees and lessors. The staff’s agenda papers are available at the IASB’s web site (where you can also view an archive of the webcast). Discussion was lengthy enough that the 2-1/2 hours allocated were insufficient, and so discussion of contingent rents was postponed until a December 16-17 joint meeting.

In general, the boards agreed with the staff’s presented recommendations, some of which varied from their preliminary views as presented in the discussion paper (see previous entries in this blog); the changes were prompted by comments on the discussion paper. Some highlights of changes from the preliminary views:

• Interest rate for present valuing the rents: The preliminary views called for the lessee always to use their incremental borrowing rate. After lengthy discussion, the boards agreed to permit use of the implicit rate if it is readily determinable.
• Initial direct costs associated with a lease will be capitalized by the lessee and amortized over the lease term; a lessor will likewise add initial direct costs to the lease receivable and amortize them (using the interest method). Some members of the boards wanted to clarify that this applies only to incremental costs incurred, not to an allocation of salaries and other expenses that the company would be paying whether or not a lease was signed.
• The boards agreed that the incremental borrowing rate should not be changed during the life of the lease (as long as the lease term is not changed). This had been previously a point of disagreement between the boards.
• Impairment of leased assets will be determined based on existing impairment standards (which are different for US GAAP and IFRS). Similarly, revaluation will be based on the separate standards (US GAAP does not permit revaluation, while IFRS permits it under limited conditions).
• The initial measurement of a lessor’s lease receivable will be based on the present value of the rents, using the lease’s implicit rate (it was noted that this could be different from the explicit rate when promotional rates, like 0% interest, are being offered).
• Subsequent measurement of the receivable will be at amortized cost using the effective interest rate (like a current capital lease).
• The lessor’s performance obligation (a credit) will be equal to the receivable at lease inception (including any initial direct costs that are added to the receivable as noted above).
• The performance obligation would normally be amortized on a straight-line basis unless another method is more representative of usage (there was some discussion of whether the usage pattern would only be time-based as opposed to unit-based; I’m not sure if a conclusion on that was reached).
• For recognizing options in the lease term, the boards adopted an altered determination of the term suggested by some discussion paper respondents: rather than the “most likely lease term,” the standard is now “the longest possible lease term that is more likely than not to occur.” Thus, if there were a 40% possibility of the first option being exercised, and a 20% possibility each of exercising through options 2, 3, and 4, options 1 & 2 would be included, because the likelihood that the life will be longer is less than 50%. This applies to both lessees and lessors.
• In determining when options are to be included, the discussion paper stated that the review should include contractual, non-contractual, and business factors, but not past practice and lessee intention. That has been changed, and the boards now state that all factors, including past practice and lessee intention, should be considered. The boards are concerned that companies may use “intention” to game the results, but noted that intention will not trump other factors, but will be one of several factors to consider.
• Reassessment of whether options should be included, while in theory required each reporting date, need only be undertaken when facts and circumstances have changed, not simply due to the passage of time.

FASB/IASB joint meeting

Earlier this week, the FASB and IASB held a joint meeting in London. Among the many topics discussed was leases. According to the Summary of Board Decisions, the following important decisions were made:

* The boards reaffirmed the right-of-use approach for lessees. (IOW, the pleas of many discussion paper comments to keep operating lease accounting have been rejected.)
* The boards have decided to accept the idea of "in substance purchases" as being different from leases; they will be excluded from the scope of lease accounting. Criteria will be developed to identify which contracts should be so treated.
* The boards agreed to use a performance obligation approach for lessor accounting--the asset is not removed from the books, but a liability is set up to reflect the obligation to permit use of the asset, balancing the receivable for the rental stream.
* Lessors will no longer be permitted to recognize a profit at the beginning of the lease; everything will be recognized over the lease term.
* A lease will now need to be reflected on the balance sheet (presumably for both lessees and lessors) as soon as the contract is signed, rather than the current practice of waiting until the asset is delivered. However, until delivery it is to be recognized "net" only, which means that in most cases there will be nothing to report (assets and liabilities are equal), except in case of an impairment. Disclosures (in footnotes, not the primary financials) would be required to detail the assets and liabilities, at least when there is a significant gap in time between signing and delivery and/or the amounts are significant.

The boards will discuss further issues in November, including
* initial and subsequent measurement of the asset and obligation
* treatment of leases with options
* contingent rentals and guaranteed residuals

FASB review of comment letters

This morning, the FASB met to review the comment letters to the Preliminary Views document. No decisions were made at the meeting. The audio is available until the next meeting at http://fasb.trz.cc/archive.php.

A few notable items from the discussion:

• There is concern that more attention needs to be given to distinguishing between a service contract and a lease. Up to now, the accounting for operating leases and service contracts hasn't been significantly different, so it hasn't been a big issue. But with leases subject to capitalization, the difference becomes much more substantial, so people are much more concerned. The board plans to discuss this issue in more depth in upcoming months.
• As previously noted, many respondents disagree with including options in the capitalized value of a lease. Some members of the FASB are concerned that options are being handled inconsistently in different aspects of accounting (such as financial instruments and revenue recognition)--some are handled through recognition, others through measurement.
• There has been a background discussion of "in-substance purchases" throughout the entire lease accounting project. This reappeared, with the mention that the Leases Working Group meeting earlier this month brought up the issue as being very important to lessors, probably more important than to lessees. The definition of "in-substance purchase" seems to be confined to leases with an ownership transfer or bargain purchase option (the first two tests of capitalization under FAS 13, which currently require the leased asset to be depreciated over the economic life rather than the lease term). Lessors particularly want such leases to be treated like purchases, rather than with right-to-use accounting.
• Some respondents questioned whether appropriate due process would be followed if lessor accounting didn't go through a preliminary views document. Board members do not think that is a due process requirement; they believe it is sufficient to provide an exposure draft and respond to comments to that. The implication is that they don't want to slow down completion of the leasing project.

The FASB and IASB will have a joint meeting October 26-28. Lessor accounting is part of the agenda for that meeting.

Correction: In my August 27 blog entry, I said that the September 3 meeting of the Leases Working Group was the first in 2-1/2 years. That was incorrect. The Group also met on October 7, 2008, to discuss the proposed Preliminary Views document. A summary of the meeting is available here, but I won't take the time to review it in this blog, since it's pretty old news by now. I have not yet seen any information (or audio) posted about the September 3 meeting.

Comment letters summary

The FASB and IASB staffs have prepared a summary of 290 comment letters received on Leases: Preliminary Views, the discussion paper released in March, for which the comment period ended in July (though letters were received through mid-August; they cut off review with the letter received on August 10, while 5 more were received in the following week). The summary is available on the IASB web site. The boards plan to discuss the summary next week: The IASB's meeting will be Sep. 15, while the FASB will meet on Sep. 16. Both meetings will be broadcast on the web (IASB includes video, while the FASB is audio only; follow the links to sign up).

Some highlights from the staff's summary (you can see my less systematic review in a prior post):

* Almost half of the respondents were "preparers" (companies and other entities that need to prepare financial statements), with another 51 from industry organizations. The rest were a range of professional associations, accounting firms & standard setters, government agencies, academics, financial statement users, and individuals not claiming other affiliations. Almost half were from Europe, with a third from North America, an eighth from international organizations, and a small number from the rest of the world.

* About half supported the overall concept of a right-of-use asset and corresponding obligation for all leases; a third were opposed, and the rest did not express opinion (in most cases because they were focused on lessor rather than lessee accounting). However, most of those in support also expressed reservations about complexity, especially in dealing with options and contingent rents. Those opposed (virtually all of whom were preparers or industry organizations) largely encouraged keeping the current model with enhanced disclosure.

* "Nearly all of the respondents who commented on the boards' decision to defer consideration of lessor accounting disagree with that decision." People are concerned that the transactions will be unbalanced, and that eventual lessor accounting decisions may require further changes to lessee accounting at considerable extra cost and complexity.

* Most respondents agree with the current scope for lease accounting, though some are concerned that the new rules will lead to pressure to recharacterize leases as service contracts (which are not capitalized). Most who commented favor excluding short-term leases (generally favoring one year as the cut-off) but including "non-core" leases.

* Nearly all respondents agree with valuing the asset and obligation at the present value of the rents, though they were divided on whether lessees should attempt to determine and use the lease's implicit interest rate instead of the incremental borrowing rate.

* Respondents were divided on whether or not options (renewal and purchase), contingent rents, and residual guarantees should be included, with many of those opposed asserting that they do not fit the accounting framework definition of a liability, and also expressing concern about the complexity that would be entailed.

* If contingent rents are included, about half believe the estimates should be updated each reporting date (the boards' tentative view), to provide more accuracy. Others consider this requirement onerous, and would limit it to when a triggering event (to be defined) occurs. If changes in contingent rents happen, most prefer to see it recognized through a change in the carrying amount of the right-to-use asset, not a P&L gain/loss.

* Most who expressed an opinion on lessor accounting wish to see the transaction set up as a derecognition of (a portion of) the existing asset, rather than the performance obligation approach that the boards favored in their July meetings.

* Most who expressed an opinion believe that investment properties should be included in the scope of a lessor accounting standard. However, almost all investment property companies themselves argued against inclusion.

We'll see how significant the comments are in the boards' deliberations next week and over coming months.

Upcoming Leases Working Group meeting

When the FASB & IASB decided to revise the lease accounting standard back in 2006, they called for members of academia, public accounting, and the world of publicly held companies to volunteer to serve on an advisory panel, called the Leases Working Group. A first meeting was held in January 2007 to discuss the various issues surrounding lease accounting, and get the group's input on possible approaches to deal with the problems.

Then the boards seemed to forget the group existed. It has been over 2-1/2 years since the group met. Finally, on September 3, a second meeting of the Leases Working Group will be held in London. It's planned as an all-day event. Unlike IASB board meetings, this meeting will apparently not be available for live online listening; however, they have promised that audio will be available at a later time. Anyone who wants to attend the meetings live may do so, but needs to register in advance on the IASB website.

Agenda papers for the meeting are also available at the IASB website. They indicate that the issues to be discussed are largely issues that were not covered by the Preliminary Views discussion paper, though there will be a brief review of the 295 comment letters received. Instead, the topics to be discussed are mostly matters that the boards have discussed in their May, June, and July meetings: impairment, revaluation, initial direct costs, sale & leaseback transactions, transition, and lessor accounting, plus in-substance purchases, which some members feel should be accounted for differently than other leases. That has been mentioned at prior meetings, but there has been no in-depth discussion on the topic. Many of the topics for review are ones where the two boards have taken different positions; a number of comment letters urged the boards to come to an agreement on these topics (many respondents felt a unified standard was more important than which position was taken). More detailed information on the topics is available at the IASB's web site, among the agenda papers for prior board meetings (the appropriate papers are noted on p. 3 of the working group's agenda paper #1).

The working group will have to move at a fast pace; less than half an hour per issue has been allotted for the lessee topics, plus 90 minutes for lessor accounting and 45 minutes for in-substance purchases.

The boards plan to discuss the comment letters at meetings in September, and lessor accounting at October meetings. At this point, the schedule for the leases project still indicates an exposure draft in the second half of 2010, and a final standard in the first half of 2011. Whether the boards will stick with that after the September and October meetings, in the face of substantial public pressure for a simultaneous release of new lessee and lessor standards and a large amount of work to do on both sides of the transaction, remains to be seen.

Comment letters update, lessor accounting

The IASB continues to post comment letters to its web site. As I write this, the count stands at 272, with a notation that "Comment Letters are currently being uploaded to the website." However, fewer than 10 letters have been posted this week. It looks like these are letters received after the deadline, which they are choosing to still include (some of the cover letters have dates after July 17).

At a joint FASB/IASB meeting on July 23, the boards announced that they would review the comment letters at a meeting in September.

At the same meeting, the boards reached the following tentative decisions on lessor accounting (reported in the FASB Action Alert):

1. Initial measurement of the lessor’s right to receive rental payments would follow existing literature for the accounting for financial assets under either IFRSs or U.S. GAAP (IAS 39, Financial Instruments: Recognition and Measurement, for IFRSs and Section 310-10-30 of the FASB Accounting Standards Codification™ for U.S. GAAP).
2. Initial measurement of the lessor’s right to receive rental payments under U.S. GAAP would be discounted using the interest rate implicit in the lease.
3. Initial measurement of the lessor’s performance obligation would equal the customer consideration received (that is, on initial measurement the performance obligation would equal the lessor’s receivable).
4. Subsequent measurement of the lessor’s performance obligation would reflect decreases in the entity’s obligation to permit the lessee to use the leased item over the lease term.

However, they note that all of these decisions presuppose maintaining the overall concept of setting up a performance obligation for lessors (the original asset remains on the books, and a receivable is added to assets with a matching performance obligation as a liability). A number of comment letters have criticized that decision, in part because it seems not to mirror lessee accounting, and the boards have instructed their staffs to do additional analysis of a different model that would derecognize the asset to the extent of the lease. (This was the staff's preference presented to the boards at their May meetings, as previously mentioned on this blog.)

DP comment letters

The comment period has now closed for the discussion paper, Leases: Preliminary Views, released by the FASB & IASB in March. A flood of comment letters came in close to last Friday's deadline; as of this posting, the comment letters page lists over 200 comment letters received, with a notation that additional letters have yet to be posted.


Letters have been received from almost every conceivable type of party: accounting firms, accounting boards, lessees, lessors, associations of lessees and lessors, accounting academics, and even a few individuals. (FCS's comment letter is available here.) Interestingly, even though a major reason for the proposed revision is to provide better information to users of financial statements (i.e., investors and lenders), I see only a couple of comment letters from such entities, so we have little basis to know whether they feel the changes would help them make better investing decisions. We only have the claims of other interested parties that this or that change would or wouldn't be useful to statement users.


While I haven't had time to read all the comment letters, most of them fall in predictable ways. Accountants generally favor the overall approach, though they may have issues with some of the details. Most lessors and many lessees don't like the elimination of operating leases; many are also concerned about the increased complexity, particularly if reassessment every reporting period is required. (Some comment that lessees made their decisions to lease based on the current rules, and requiring capitalization of existing operating leases messes up their capital structures.) Some lessees are more sanguine about the general approach; JCPenney, for instance, says that it has long been internally managing its capital structure as if real estate operating leases were capitalized, so making that change on the external books is no big deal, and makes a lot of sense to them (though they'd still like to exclude small leases).

Several letters (such as the Office of Advocacy of the U.S. Small Business Administration) express concern about the impact on small businesses leasing items like computers and copiers; the impact on their financial statements, the complexity involved in calculating and amortizing present valued obligations, and the hassles of reconciling differing treatment between book and tax accounting were mentioned as issues. A number of letters suggest that small or short-term leases should be excluded to reduce the reporting burden, considering that the impact would generally be immaterial; other letters (particularly from accounting firms) oppose any exclusions, concerned that it opens the door to evasive manuvers.

Overall, it seems like virtually every question has respondents on both sides of the issue, often with very carefully thought-out reasons. Still, it's not hard to see the "whose ox is being gored" aspect of many of the comments: lessors are concerned that if all leases are capital, many companies will buy instead of lease as the off-balance-sheet benefit disappears (even as they claim that that's rarely why lessees take leases); lessees with lots of operating leases are concerned about the effect on their balance sheet of capitalizing those leases; some academics and accountants seem to be pursuing theoretical accuracy with no concern for the practical costs (while others are very aware of their clients' pain).


There are, however, some areas of general agreement. Virtually no one likes the idea of recalculating the obligation to reflect changes in a lessee's incremental borrowing rate, considering that it adds complexity and doesn't reflect a change in the actual economics of the lease. Very few like the idea of revaluing the obligation at fair value, for similar reasons. Recognizing options and contingent rent based on the most likely amount rather than probability weighting is strongly favored (though many don't want to recognize options until actually exercised or reasonably assured, or contingent rent until incurred, both of which are the current rules). Respondents generally agree with treating residual guarantees similarly to contingent rents.


There is a great deal of concern with complexity and cost, particularly the requirement to reassess at each reporting period (especially with regard to contingent rents). Many respondents suggest that contingent rents should only be capitalized if the regular rents are clearly below-market (otherwise, they would be expensed as incurred, as under current rules). Some accountants, though, believe reassessment is desirable to more accurately portray the current state of the leases. Another area of complexity mentioned by a number of American respondents is book/tax differences which would be generated by treating current operating leases as capital (when they would still be operating or "true leases" for tax purposes).

A large number of letters call for lessor lease accounting to be included in the revision, wanting to make sure that lessee and lessor accounting continue to mirror each other, rather than operate under different standards. Some are concerned, though, that the boards may rush their lessor accounting review to stay on the current lessee schedule.

CFO magazine has an article about the comment letters on their website.

EZ13 v2.3 released

FCS is delighted to announce the release of version 2.3 of EZ13(TM), the Lease Accounting solution. (The new version was actually released over a month ago, but I forgot to post this announcement.) This latest release includes a wide range of new features:

Contingent rent: EZ13 has a new tab for contingent rent, which is rent paid that is not part of the FAS 13 minimum lease payments. Contingent rent is expensed as incurred. You can enter contingent rent in the screen tab, or upload it using an Excel® spreadsheet (requires Excel installed on your computer). (Not in Mini Edition.)

Rent escalation: EZ13 can automatically create a series of rent steps based on a periodic escalation calculation (increasing by 10% every 5 years, or 5% compounded per year, etc.). This complements the existing automatic calculation of rent for leases with level principal amortization.

Expirations report: Get a list of leases scheduled to expire between two dates.

Transfer additions and terminations: A transfer addition picks up the asset and obligation midstream for the lease; a transfer termination is almost the same as an early termination, but is designed to match a transfer addition. These are useful if a lease is being moved from one department to another, and you want to recognize the expenses up to a certain date as belonging to one account and afterwards to another (using EZ13’s account numbers feature or other distinguishing codes).

Month to month extensions: Sometimes leases are renewed after expiration on a month to month basis. There is no future rent commitment; rent is expensed as incurred (using the contingent rent feature noted above). You can optionally leave the gross asset and accumulated depreciation on the books (assuming the lease is depreciated over the lease term, the gross asset and accumulated depreciation are equal, so the net asset is zero).

Capitalize leases at incremental borrowing rate (not in Lite or Mini Editions): EZ13 has had the capability to treat operating leases as capital, using their incremental borrowing rate as the capital rate. This is intended both for current indenture reporting that some lenders require, and in anticipation of the upcoming rewrite of the lease accounting standard, which plans to capitalize all operating leases at the incremental rate. The current draft of the upcoming standard calls for all leases, including those currently capital, to use the incremental rate; there would be no limitation of the asset value to the fair market value of the underlying asset, which currently causes some capital leases to have higher interest rates. This new option lets you see the effect on your capital leases of the FASB/IASB proposal. (See prior blog entries for more information on the FASB/IASB proposed rewrite of lease accounting standards.)

Some of the feature additions were in response to requests from users of EZ13. We will continue to provide updates (at least one per year) with enhanced features at no additional cost to clients who maintain a support contract. Updated CDs are being sent to all such clients. Any clients who have not maintained their support contract can get the update by reinstating support; contact us for details.

The free demo available for download on our website has been updated to v2.3, so you can try out the new features yourself.

Additional decisions on lessee accounting

At meetings held June 17 and June 18, the FASB and IASB (respectively) discussed additional lease accounting issues that were not covered in the Preliminary Views discussion paper. The following topics were discussed and conclusions reached:

Sale and leaseback transactions

An asset (most commonly real estate) may be sold and immediately leased back. FAS 98 has an extensive set of tests to determine whether the continuing involvement of both seller/lessee and buyer/lessor are such that the transaction should be recognized as a sale and a lease, or as a financing that doesn’t meaningfully transfer the asset, so that it would remain on the books of the putative seller/lessee. Sale/leasebacks are sometimes done for cash flow purposes; at other times, a major purpose under current accounting may be off-balance sheet financing. With the end of operating lease accounting under the new rules, the latter purpose would disappear.

The boards decided that in a sale/leaseback, the entire asset should be derecognized and replaced with a right-to-use asset (rather than keeping a portion of the original asset on the seller/lessee’s books). The IASB concluded that a gain should be recognized immediately; the FASB’s meeting summary doesn’t indicate their decision. The FASB thinks there may be a need for additional guidance when the sale price or rental payments aren’t at market rates.

Impairments

Existing general accounting standards for impairments should also be used for lease right-to-use assets. This means that US lessees would use FAS 144, while IFRS users would use IAS 36, consistent with their treatment of impairments of other assets.

Revaluation

The FASB holds that revaluation of the right-to-use asset would reflect amortization and impairment. Adjusting based on fair value would generally not be permitted. The IASB refers to revaluation models in IAS 16 for property, plant, & equipment, and IAS 38 for intangible assets, which do permit revaluing based on fair value.

Initial direct costs

Initial direct costs for negotiating and arranging leases are to be expensed as incurred.

Transition

This was a big hole in the preliminary views document. Both boards agreed that leases should be set up using the remaining rents as of the date of application of the new standard, valuing the obligation at the present value of the rents (using the current incremental borrowing rate), and setting the asset to the same value (the IASB notes that there could be an impairment adjustment).

Nothing, however, is said about how to handle the existing deferred liabilities on existing operating leases with scheduled rent increases, or the difference between asset and liability on existing capital leases. Will this be taken directly to retained earnings, or recognized as a gain or loss in the income statement? Most lessees would probably prefer to recognize the change in the income statement, because almost all leases (leveled operating and capital) would show a gain on removal. The argument would be that they have in effect over-expensed these leases, so they should be able to recover that excess expense as part of the changeover.

Next steps

The discussion paper comment period closes a week from Friday, July 17. The boards plan to discuss the comments at meetings in September. In July there will be another meeting to discuss additional matters related to lessor accounting (following up their May meeting); I haven’t seen a specific date yet. The two boards will be holding joint meetings on July 23 & 24, but I don’t see any indication whether they will take that time to discuss leases, or will continue their more typical practice of meeting separately to discuss the issues.

Sources for board information:
IASB meeting summary: http://www.iasb.org/Current+Projects/IASB+Projects/Leases/Meeting+Summaries+and+Observer+Notes/IASB+June+2009.htm
IASB meeting audio: http://www.iasb.org/Current+Projects/IASB+Projects/Leases/Meeting+Audio+Playback/Meeting+Audio+Playback.htm
IASB meeting agenda papers: http://www.iasb.org/Meetings/IASB+Board+Meeting+18+June+2009.htm

FASB meeting summary: http://www.fasb.org/leases.shtml
Meeting handout: http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176156247551

Proposed changes to lessor accounting

The FASB and IASB met separately on May 18 & May 20 (respectively) to discuss changes to lessor accounting consistent with the move to a right-to-use model for lease accounting. As previously discussed, the boards had decided to delay lessor accounting changes and move ahead with lessee accounting only, because they felt that the need for changes was more urgent for lessee accounting and lessor accounting had complexities that would slow the whole process down.

Now they're getting started with looking at lessor accounting directly, in part perhaps because they realized that sublease accounting is inevitably affected by lessee accounting, and sublease and lessor accounting are inextricably linked.

The boards dealt with a fundamental question in their approach to lessor accounting: Does a lease result in a transfer of a portion of the leased item from lessor to lessee, or does it create a new right and obligation for the lessor? Or as the staff puts it in their discussion paper, "What is the credit?" (Additional examples, with sample journal entries, are in a second discussion paper.) The debit in the transaction is clearly the creation of a receivable representing the discounted flow of rents. Should the credit be recognized as a reduction in the value of the asset on the lessor's books (a derecognition of part of the asset), or should the asset remain untouched and a separate performance obligation created to reflect the requirement to allow the lessee to use the asset?

The FASB staff, which wrote up the discussion paper, favored the first approach (Approach A), derecognizing a portion of the lessor's asset and keeping only the net on the lessor's books. However, the boards decided instead to recognize a performance obligation. The discussion at the IASB (available by webcast until August 19) raised a number of concerns with Approach A, one of the most compelling apparently being that it would result in a steadily diminishing asset on the books which could eventually go negative (if a building that is mostly depreciated, or land recorded at historical cost, is leased based on current market value). A separate but related issue was whether profit should be recognized at the inception of the lease. This is currently permitted for manufacturers and dealers under sales-type leases, but not for direct financing leases. A number of board members did not want to permit recognition of profit at inception, and Approach A was seen as facilitating or even demanding profit recognition. The FASB also preferred Approach B, with members stating their position in favor of no immediate profit recognition and keeping the full asset on the lessor's books as long as the lessor retains title. (A concern raised and not resolved by both boards was whether treatment should be different if the lease transfers ownership at the end of the lease term, so that no interest in the asset remains with the lessor.)

The boards remain concerned about opportunities for structuring transactions to avoid the regulations, and are trying to craft the new regulations to reduce the potential for structuring, ensuring that legal forms don't facilitate treating differently transactions of similar economic substance.

Next steps:

In meetings scheduled for July, the boards will discuss initial and subsequent measurement and presentation of the asset and liability, as well as how to recognize contingent rents and options. (The second discussion paper for the May meetings made assumptions for measurement, but these have not been decided on by the boards.) Additional items for discussion, not necessarily at the July meeting, include how to differentiate a sale of an asset from a lease, and whether the right-to-use model should apply to short-term and immaterial leases. Following that meeting, the boards will decide whether they have made enough progress on lessor accounting to include it in the Exposure Draft scheduled for mid-2010, or if the ED should remain lessee-only.

Types of EZ13 reports

This is in some ways a continuation of the prior blog entry on how to create spreadsheet output.

EZ13 provides several types of reports. Let's look at what each provides. (I'll describe specifically the spreadsheet output type #1; the text report includes basically the same information, but laid out differently.)

1) Income Statement/Balance Sheet Detail: This is our most comprehensive report of calculated information (all of the accounts involved in lease accounting for a period). We've tried to break out every account so you can see exactly what's happening. Each balance sheet account, for instance, shows five different values: beginning balance, added (for new leases), activity, removed (for terminations), and ending balance. In all, this report shows some 74 columns of calculated data, plus as many as 43 columns of descriptive information (including account numbers if you define them).

And that's just the first tab. On the second tab, we show the future minimum rent information. If you get minimum rents broken out by year for the first 5 years, then all remaining as a lump sum (as FAS 13 requires), the second tab shows 42 columns of calculated data per lease.

2) Income Statement/Balance Sheet Compact: Maybe that's overkill for you. The compact report shows 16 columns of calculated data, giving the essential highlights (just the ending balance for each balance sheet account, for instance).

3) Journal Entries: You may prefer to see each transaction a lease generates in journal entry form (each rent payment is a debit to obligation, a debit to accrued interest, and a credit to cash; etc.). Each line shows the lease number, period start and end date, account name, account number (if defined), debit or credit, and a description of the transaction so you know which lines go together and what they're for.

4) Amortization Schedule - Capital & Operating: You can view the activity for the entire life of a lease, with a separate line entry for each rent payment. Note that this report can get very large if you have many long leases; if you have several hundred leases that run 20 years or more paid monthly, you could exceed the maximum number of rows (65536) in versions of Excel before Office 2007. If that happens, you'll need to select subgroups of leases to report on (or upgrade Excel; the 2007 version permits over 1 million rows).

5) Future Minimum Rents: This report is identical to the second tab of the Income Statement/Balance Sheet Detail report. It's provided in case you only need future rent information.

6) Depreciation Over Economic Life: If you have leases that have an ownership transfer or bargain purchase option, they are depreciated over their economic life, which in most cases is longer than the lease term. Regular EZ13 reports stop reporting on a lease when it expires. This report shows the depreciation after the lease's expiration, until the end of its economic life.

7) Classification Summary: Lists how each lease fits into the four tests for capitalization; if the lease is capital, its capital rate is shown.

8) Listing: As mentioned above, this report is not available in spreadsheet format except as an export of a text report. The reason is that there is really no way to show all the input information for a lease across a single row: There can be an indeterminate number of rent steps, for instance, which can easily overwhelm the maximum number of columns in Excel.

I hope this helps you get the results most useful to you. Most accountants and financial people live in Excel, and it's also a common method of importing and exporting data (such as loading results of EZ13 into a general ledger system). Knowing the best way to get the spreadsheet information you want can make EZ13 much more useful.

EZ13 spreadsheet output

With the review of the leases discussion paper complete (see previous blog entries for a chapter by chapter review), I thought I'd take some time to review some aspects of EZ13, our lease accounting software that provides complete compliance with FAS 13 for lessee leases (and FAS 13 compliance for most lessor leases as well, in the separate lessor edition).

Based on questions we've gotten from customers, it seems there's some confusion about the ways to get output, particularly spreadsheet output. EZ13 offers two different ways to get spreadsheet output, each having a different purpose.

1) Most people wanting spreadsheet output will want a format where each lease is on a single line, with the accounts and values for that lease each in a separate column. For this type of output, you should choose output to "Spreadsheet" in the report setup page:


As soon as you click on the Spreadsheet button, EZ13 will open a dialog box for the name of the spreadsheet. Most people will create an Excel spreadsheet (.xls format). However, this requires that you have a valid installation of Excel on your computer. If you do not, you can create spreadsheet output in XML format, which can be read by Excel, OpenOffice Calc, and various other spreadsheet applications. To select XML output, go to the File menu, choose System Options, and check the box labeled "XML spreadsheet output." (XML output is also a bit faster to create, and less subject to memory limitations with very large reports.)

Once you click on Generate Report, EZ13 will build the spreadsheet. The output for an Income Statement/Balance Sheet Detail report looks something like this:

Each row shows a different lease. There is a column for the lease number, description, begin date, end date, gross asset beginning value, and so on. The last row is a totals line, which is the summation of all the columns that have value information (as opposed to descriptive information).

2) The other way to get spreadsheet output is using the Export feature of the text output. Text output is designed to be easily readable, putting all the information for a lease together on several lines so that you don't have to constantly scroll back and forth across the line. However, that makes it much less practical to manipulate (sort, select, sum, etc.) in Excel. One advantage of this method of getting spreadsheet output, however, is that the report writer can create an Excel spreadsheet without you having Excel installed on your computer. Also, this is the only way to get a spreadsheet of the listing report, which lists all the input data for a lease.

If you create a text output version of this same report, then export it to Excel, it will look something like this:


This is basically a repeat of what you see on the screen for a text report. Note that sometimes the columns won't line up correctly; the report writer is trying its best to guess what should be aligned, but it doesn't always make the right decisions, and unfortunately there's no way for us to tweak the results. In most cases, an export to PDF, HTML, or a Word .doc document is going to give better looking results. But if you really prefer to get information in Excel format, it's here.

DP Review: Overall comments

Please look at the last several blog entries for a chapter by chapter summary of the FASB/IASB joint Discussion Paper, Leases: Preliminary Views.

Change is coming. There is no question that both boards are adamant that leases need to be on the balance sheet. Operating leases will cease to exist for lessees once this standard takes effect, with only a possible exception for very short-term leases. The impact of this is expected to be substantial for many industries, particularly retail chains (including restaurants), airlines, property management firms, and others with large amounts of assets held under operating leases. We can also expect a substantial impact on lessors; one reason for leasing is off-balance-sheet financing, and with everything being on the balance sheet, one can expect that some leases will be less financial advantageous to the lessee, and so won’t get done, or at least not with the same terms.

When FAS 13 was first issued in 1976, it was the most complex standard the FASB had released (and probably more complex than standards released by its predecessors as well). The new standard is no doubt intended to be less complex, in keeping with the move to principles-based rather than rules-based accounting. But the wide variety of leasing transactions means some inherent complexity as the boards seek to develop a consistent methodology.

Another big change in the accounting is the requirement for continuous review and adjustment. FAS 13 was basically “set and forget”: the terms in effect at the inception of the lease controlled accounting for the entire lease term, unless there was an actual renegotiation. A renewal or termination option was not recognized until officially exercised. Contingent rents were expensed as incurred, with no implications on future rents (either the minimum rent disclosures or the asset & obligation of a capital lease).

With the new standard, the lessee would review all of these every reporting date (in the U.S., that generally means every quarter). Contingent rent is estimated from the very beginning of the lease, and as it changes, the rent obligation would be recalculated (though the boards can’t agree whether the balancing entry would be to asset or profit). Options to renew will be included based on factors outside the lease such as the loss of valuable leasehold improvements, relocation costs, and industry practice, not just the existence of a penalty or other factors in the lease itself, and this inclusion decision would again be reviewed quarterly, not just when the option exercise date arrives. (For U.S. lessees, the SEC Chief Accountant’s letter of Feb. 7, 2005, made leasehold improvements a reason to include renewal options, but this proposal’s wording is broader.)

This means that the calculations for capital leases are going to become more complex, particularly in handling midcourse adjustments, which are likely to become much more numerous. (Any retail store lease with a percentage of sales kicker will probably need to be adjusted every quarter to reflect actual sales; leases with CPI clauses will need adjustments at least once a year, and perhaps quarterly.) Since some changes in rents can result in a change to both the obligation and the asset, there is no certainty that the periodic depreciation charge will remain the same throughout the lease (since the asset being depreciated may change). Depending on how the boards resolve their disagreements, it’s possible that gains and losses will be recognized in the middle of the life of a lease when certain changes are recognized, rather than just at termination.

For all the work done, there is much left to accomplish. And one topic hasn’t even been discussed: transition to the new standard. How are existing leases to be recognized? Restate from inception? Grandfather? Set up as if a new lease on a specific day, or the first day of the fiscal year in which the standard takes effect? For capital leases which change, does the change hit profit or retained earnings, or is it part of the new lease’s carrying amount?

The boards welcome public input; that’s the purpose of a discussion paper. If you want to make a response, you are invited to contact either board (but not both; all comments will be shared between the two boards), by July 17, 2009.

FASB email: Send to director@fasb.org, File Reference #1680-100.
IASB online: Use their web form for comments.

Note that all comments will become part of the public record, available on the boards’ web sites.

FCS is committed to updating EZ13 to meet the new lease accounting standard once it is released. The current Standard Edition of EZ13 includes the ability to treat operating leases as capital at their incremental borrowing rate; we are adding the ability to use the incremental borrowing rate on capital leases in v2.3, which we expect to release next month.

DP Chapter 10: Lessor accounting

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 10.

Summary:

The boards list some of the issues that need to be resolved to set up lessor accounting in a right-to-use model, as well as to properly handle subleases. Subleases must be addressed with the lessee standard, but the boards have yet to discuss the alternatives available, such as using existing sublease rules with the new lessee standard, keeping leases with subleases under the existing standards, or defining a new right-to-use methodology for subleases before doing so for lessor leases.

Detailed review:

Lessor leases

In July 2008, the boards decided that rewriting lessor accounting would slow their project too much, and that the more crucial need was for a revised lessee standard. Therefore, they decided to postpone making any changes to lessor accounting, so as not to delay further the lessee standard (which has already been delayed two years from the original schedule).

This chapter describes in general how a right-to-use model might apply to lessors. The first option would convert the original asset into two assets: a receivable (a financial asset) for the rents due, plus a residual value (non-financial) asset for the remainder of the asset’s value after the end of the lease. (Alternatively, the lessor might derecognize only the portion of the original asset that matches the receivable, leaving the remaining asset portion on the books.) No obligation would be recognized.

The second possible approach to lessor accounting would create a liability to recognize the lease (the performance obligation to provide the asset to the lessee), while leaving the original asset on the lessor’s books and creating a new asset for the receivable (equal to the obligation).

The boards would need to decide when, if ever, profit (or loss) could be recognized on the lease, particularly keeping in mind that many manufacturers lease equipment as a method of sales. For such transactions, recognizing profit on the “sale” would seem more appropriate, more consistent with similar transactions, than recognizing just interest income. (This is currently done with sales-type lessor leases under FAS 13.) On the other hand, if a bank is providing the financing on the lease, one would normally expect all the income to come through interest.

Subleases

After the decision to defer lessor accounting, the boards were reminded that subleases raise many of the same issues as lessor leases. Leaving sublease accounting alone while changing lessee accounting raises issues, because current sublease accounting uses a different methodology that results in different measurements and inconsistencies in treatment. At the least, the boards would probably offer additional guidance on how to apply the current standards to subleases in the new regime. They suggest that they could also require additional disclosures.

Alternatively, the boards could exclude a head lease from the scope of the new standard, so that a lease with a sublease would continue to be accounted for as under the current standard (FAS 13/IAS 17). However, this reduces comparability because leases with subleases would be accounted for differently than other leases. It leaves those leases out of the head lessee’s balance sheet, understating its assets and obligations. And no one knows what to do if a sublease is entered into after the start of the head lease.

A third option is to develop a lessor right-to-use model for subleases only. This would be more consistent through the whole series of transactions. But it would be inconsistent with the current lessor accounting model, which means that a lessor that buys some of its assets to lease out and leases others (resulting in some lessor leases and some subleases) would account for the transactions differently, some under FAS 13/IAS 17 and others under the new standard. And the boards would have to work through many of the issues of lessor accounting, even though they wanted to defer that.

The boards note the following additional issues which need to be dealt with for lessor accounting:

(a) investment property
(b) initial and subsequent measurement
(c) leases with options
(d) contingent rentals and residual value guarantees
(e) leveraged leases (for US GAAP)
(f) presentation
(g) disclosure

Investment property is the only issue discussed in detail; the others are simply named. Investment property is treated different by US GAAP (FASB standards) and IFRSs (IASB standards); international standards exclude investment property from IAS 17 lease accounting, instead using IAS 40, Investment Property, which among other things includes an option for carrying the property at fair value rather than cost. It remains to be decided whether investment property would continue to be excluded from lease accounting, or otherwise treated differently from other lessor leases. (US GAAP does not differentiate investment property and accounts for it under FAS 13 as any other lease.)

DP Chapter 9: Other lessee issues

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 9.

Summary:

The boards have not yet discussed, but plan to make decisions on, the following topics:

• Timing of initial recognition
• Sale and leaseback transactions
• Initial direct costs
• Leases that include service arrangements
• Disclosure

Detailed review:

This is only one of a large number of accounting standards projects that are taking place simultaneously (the FASB project web page lists at least 37 different projects currently underway), and so even though the boards started this project in July 2006, they have not had enough time to discuss everything that will need to be resolved to produce a new standard. The following are issues that they recognize they need to work on:

Timing of initial recognition

There is often a gap of time between when a lease is signed and when it starts (the lessee takes possession of the asset and starts paying rent). Currently, a capital lease doesn’t hit the balance sheet until the lease starts. However, it could be argued that signing a lease results in rights and obligations that meet the standard definition of assets and liabilities. In rebuttal, some argue that before delivery, the lease agreement is an executory contract, which is not normally recognized on the balance sheet.

Therefore, the boards much decide if the assets and liabilities should be recognized at signing. If recognition is required, an appropriate measurement of value is needed, as it may not be the same as the asset/liability at the start of the lease. In addition, if construction is required during the period between signing and occupancy, there may be additional measurement issues, as rent may be subject to adjustment for construction costs, and so the exact amount is not known at signing.

Sale and leaseback transactions

A popular recent method of financing has been a sale/leaseback transaction, wherein an owner of an asset (most often real estate) sells the asset and leases it back. In some cases, FAS 98 prohibits the transaction from being recognized as a sale and a lease; instead, it must be treated as a deposit or financing, with the asset remaining on the books of the original owner and no lease shown. The continuing involvement can result in valuations that aren’t consistent with market values (there might be a below-market sales price in exchange for a below-market rent, for instance).

The boards will consider several options for sale/leaseback transactions:

1. Treating all sale/leasebacks as financings—the sale and lease would be ignored, and sales proceeds would be treated as a liability, repaid by the “lease” payments like any other loan. If this option is chosen, the boards need to decide if there are circumstances under which a gain or loss could result from the sale.
2. Treating all sale/leasebacks as sales—the asset would be sold and taken off the balance sheet, and a regular lease recognized with asset and obligation. If this option is chosen, the boards need to decide in what, if any, situations a gain on the sale would be deferred.
3. A hybrid approach, treating some transactions as financings and others as sales, depending on whether the transaction meets certain criteria (perhaps using those in current standards). This, of course, raises the potential for structuring.
   

Initial direct costs

IAS 17 currently calls for costs incurred in negotiating & arranging a lease (such as commissions, legal fees, and internal costs) to be added to the asset value of a capital lease and amortized over its life. FAS 13 has no such requirement; such costs are immediately expensed. IAS 17 is consistent with the treatment of costs associated with purchasing assets; FAS 13 is consistent with the treatment of costs in business combinations and for the acquisition of some financial instruments. The boards must decide which direction to take.

Leases that include service arrangements

Currently, costs for services associated with leases are considered executory costs, which are excluded from capitalization. Some leases clearly define the costs that are for services vs. the rent for the asset. Others, however, do not; with all leases capitalized, it becomes more important to properly separate service costs from asset costs. The boards will consider providing additional guidance.

Disclosure

The boards have not discussed disclosures; the primary current disclosure is the footnote report of future minimum lease payments. The boards will consider whether disclosures should provide additional information regarding the presence of options and contingencies.

DP Chapter 8: Presentation

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 8.

Summary:

• Lease obligations should be reported as a financial liability; the boards disagree on whether they should be reported separately from other financial liabilities.
• Lease assets should be reported according to the nature of the underlying asset (leases on vehicles with owned vehicles, etc.).
• Leases of property, plant, and equipment generate “depreciation” while those of intangible assets generate “amortization.”
• Interest expense would be separated from other interest if obligations are separated.
• For cash flows presentation, the lessee must classify the lease asset as operating or investing; the obligation and interest could be classified operating, investing, or financing.

Detailed review:

Once again, the boards have gone in slightly different directions. While they agree that the obligation and asset for a lease should be reported on the lessee’s balance sheet, they differ on how for the obligation. The IASB sees no need to separate lease obligations from other obligations; the FASB does, in part because they consider the uncertain nature of obligations related to options to change the quality of the value. For the assets, the boards agree that they should be reported according to the nature of the underlying asset, rather than grouped together as leases, though they do want to see leased assets separated from owned assets of the same type as a subledger entry.

The boards rejected options to present some or all leased assets as an intangible asset. Some FASB members want to do that for leases that are not “in substance purchases” (a concept first raised in chapter 5, but one that has not been defined by those members or the board; at the least, it would seem to include leases with an ownership transfer or bargain purchase option, but whether it covers other leases is unclear).

On the income statement, leases for property, plant, and equipment should show depreciation, while the term used for intangible assets is amortization. Interest expense would be shown separately from other interest if (as the FASB prefers) lease obligations are separated from other obligations.

The cash flows presentation is tied to the boards’ separate discussion paper, Preliminary Views on Financial Statement Presentation; the boards have not discussed it specifically as part of the lease accounting review. According to those preliminary views (which will presumably be finalized prior to finalization of the lease accounting standard), a leased asset is considered a business asset, and the lessee must decide whether to classify it as an operating or an investing asset based on the nature of the asset and its use. The obligation and interest could be classified by the lessee as an operating, investing, or financing liability.

Again, the boards will need to come to a common agreement where they differ. How they decide will depend in part on the responses they receive from the public to this discussion paper.

DP Chapter 7: Contingent rentals and residual value guarantees

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 7.

Summary:

Contingent rentals and residual guarantees would be treated the same: The expected cost is estimated and included in the asset and obligation. Estimates are reassessed each reporting period, with the change applied to the obligation. The boards disagree on how to calculate the reassessment, and whether the asset should be changed or the change should be booked immediately to profit/loss.

Detailed review:

Contingent rentals

Once again, we have a significant departure from the existing standards for capital leases. In FAS 13 and IAS 17, contingent rentals (rent that changes due to factors occurring after the inception of the lease, such as percentage rents, rebilled costs for taxes and maintenance, inflation adjustments, etc.) have no effect on the minimum lease payments or the asset and obligation. They are simply expensed as incurred. (See my March 19 blog entry for more information on the current rules on contingent rentals.)

In the new standard, the boards have concluded that contingent rentals should be included in the calculation of the asset and obligation. However, the boards differ in their approach.

The IASB prefers a probability-weighted calculation: The lessee determines the likelihood of a number of possible outcomes, the rents due under each outcome, and then the probability-weighted total. The example given is of a store with a 1% of sales kicker. The lessee considers a 10% probability of 10,000 in sales; 60% probability of 20,000 in sales; 30% probability of 35,000 in sales. The probability-weighted calculation of contingent rentals is 10% * 100 + 60% * 200 + 30% * 350 = 235.

The FASB prefers a most-likely-rental approach. With the same example, 20,000 is most likely, so the expected contingent rentals are 200.

Each approach has advantages and disadvantages:

• Probability weighting, when combined with reassessment, provides a more current view of the lessee’s obligations. It provides a reflection of various possibilities that may be realistic even if not the most likely. And it is consistent with measurement of some other uncertain liabilities, such as in IAS 37. But it is more complex, and could therefore be more costly to determine. It may be difficult to accurately determine probabilities. And it could result in a value that cannot actually happen (there might be two discrete possible outcomes, and probability weighting would give a result in the middle).
• Most likely rental is simpler, and will never provide an impossible value. But it doesn’t reflect the uncertainty of possible outcomes, so there is no difference shown between a fixed and contingent rent of the same amount.

The FASB also believes that if contingent rents are based on an index or rate, the initial estimate for the life of the lease should be based on the index or rate in effect at inception, with changes due to subsequent changes in the index recognized in profit or loss.

The boards agreed that contingent rents, like other aspects of the lease, should be remeasured at each reporting date.

However, they again disagreed on how changes due to remeasurement should be reported. Both agree that the change in rents should be reflected in the obligation. However, The IASB wants to treat changes in contingent rentals the same as changes in other rents, with a change to the carrying amount of the asset. The FASB wants to recognize the change in obligation as a profit or loss.

Residual guarantees

Here’s a rare instance where the accounting under the new standard would be less rigorous than under the existing standard. Currently, when a residual value guarantee exists on a lease (a requirement that if the value of the asset at the end of the lease, such as when sold at auction by the lessor, is less than a stipulated amount, the lessee must make up the difference), the entire amount of the guarantee must be included in the minimum lease payments, even if there is virtually no possibility that the entire amount would be paid.

Under the new standard, a residual guarantee would be treated exactly the same as contingent rentals. That means, though, that there is disagreement about how to treat it: IASB wants a probability-weighted calculation, while FASB wants the most likely outcome. Similarly, a reassessment after the start of the lease which causes the obligation to change would, according to the IASB’s preference, result in a change to the asset carrying amount, while the FASB would see it reflected in profit or loss.

DP Chapter 6: Leases With Options

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 6.

Summary:

• The lease term should be the “most likely” term, including options to renew, cancel, or purchase.
• Likelihood should be judged including contractual, non-contractual, and business factors, but not lessee-specific factors like intention and past practice.
• Lease term is reassessed at each reporting date, with any change recognized as an adjustment to the carrying amount of the asset and obligation.

Detailed review:

We’re now moving into areas where even existing capital leases are going to be face alterations in the new standard. Under FAS 13 (with IAS 17 being similar), an option to renew is recognized as part of the lease term in most cases only if there is a financial incentive or penalty that causes renewal to be “reasonably assured.” If the renewal was more or less at market rate, in general it was never included in the original lease term, even if the lessee was virtually certain to renew, until actual contractual notice of renewal had been served.

Not under the new standard. While some board members favor keeping this methodology, theirs is a minority view. The majority of both boards has determined that the lessee is to determine the probability of renewal; each possible term would be considered, and the one that management concludes has the greatest probability (even if under 50%) is the term to use.

The boards rejected three other approaches:

• Probability-weighted life: In this approach, if a lessee has a 10-year lease with a 5-year option to renew, and considers that there is an 80% chance of renewal, the lease would be set up with a life of 14 years. This, of course, results in a pro-forma term that can never actually happen.
• Probability threshold: Each option would be considered based on a threshold (virtually certain, reasonably certain, probable, or more likely than not—one of these would have to be chosen). However, the boards feared that this would result in a bright-line, arbitrary rule, when the goal is to switch to principle-based rather than rule-based standards.
• Qualitative assessment: No guidance would be provided; preparers would use their judgment on the basis of “reasonable and supportable” assumptions. But the boards feared that this could be too wide-open, and that constituents would almost inevitably ask for guidance anyway.

It was noted that the most likely lease term doesn’t distinguish between leases with and without options in the middle of the calculated term. This, however, is addressed by requiring reassessment of the lease term at each reporting date on the basis of any new facts or circumstances. If the term changes based on this reassessment, the change in rents due is recognized by adjusting the remaining asset and obligation by the present value of the rents involved. This is another change from the current standard, which alters the lease term only when a contractual exercise of an option is completed.

The boards discussed what could be appropriate factors to consider in determining which options (to extend or terminate) are likely to be exercised. They grouped the factors into four categories:

• Contractual factors (explicit terms of the lease): bargain rents, residual guarantees, penalties, costs for returning the leased asset
• Non-contractual financial factors: existence of valuable leasehold improvements, relocation costs, lost production costs, tax consequences, replacement costs
• Business factors: nature of the asset (core/non-core, specialized, potential competitor’s use), location, industry practice
• Lessee specific factors: lessee intentions, past practice

The boards considered not providing any guidance on these considerations, but concluded they should, and decided the first three categories of factors are appropriate to consider, while lessee specific factors should not be part of the determination of the lease term.

Purchase options are to be considered using the same methodology: most likely outcome, reassessed at each reporting date, any change reflected in the carrying amount of the asset and obligation (including the exercise price of the option in the rent stream if the option is going to be exercised). If the purchase option is included in the lease term, the right to use asset is amortized over the useful life of the underlying asset.

DP Review: Subsequent measurement

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today's installment covers chapter 5.

Summary:

• Assets and obligations are to be measured during the life of the lease using an amortized-cost approach.
• Assets and obligations are measured separately, so that during the life of the lease, the net asset typically will not equal the remaining obligation (just as is the case with current capital leases).
• If the cash flows change, the present value of the additional rent is added to the remaining asset and obligation.
• Board disagreement: The FASB wants to keep the interest rate as the initial incremental borrowing rate during the entire life of the lease. The IASB wants to update the rate to the current market rate during the lease’s life.

Detailed review:

The boards first dispense with one possible approach, a “linked” approach that causes the asset and obligation to be reduced by the same amount each period. Using this method, the depreciation expense would be equal to the obligation reduction; since the interest is equal to rent minus obligation, the result is that the expense recognized each period is identical to the rent paid.

The problems, in the boards’ view, are that

1. This approach is being promoted in conjunction with the idea of maintaining a distinction between leases that are currently classified as “capital” and “operating.” The proponents would apply this method only to currently operating leases. Current capital leases would be treated as purchases, with depreciation and interest calculated the way they are now. This means that similar leases (those just above and just below the threshold dividing capital and operating leases, whatever that threshold may be) would be accounted for quite differently, which is one of the problems this revision is intended to resolve.
2. This approach results in different accounting than that used for other financial liabilities, which again reduces comparability.
3. The asset and liability for a lease during its term are not always linked, since impairment and other changes in the asset value are independent of the rental obligation.

Because of these problems, the boards rejected this approach, choosing instead a “non-linked” approach to measuring assets and obligations (i.e., they are calculated independently of each other).

Obligation measurement

The boards also rejected using a fair value method of measuring the ongoing obligation to pay rentals, considering it inconsistent with other financial liabilities, inconsistent with the initial measurement of the lease based on cost, and burdensome in cost and complexity to comply with.

Instead, the obligation to pay rentals is to be valued based on the discounted present value of the rents. However, the interest rate to use is a point of disagreement between the boards. The FASB wants to use the incremental borrowing rate from the inception of the lease. The IASB, however, believes the rate should be the current incremental borrowing rate. The FASB rejected that for essentially the same reasons as they rejected fair value measurement, while the IASB believes that using market rates is consistent with IAS 37 and provides more relevant information to users of financial statements. However, the IASB did not decide whether remeasurement should happen at each reporting date or only when there is a change future cash flows (i.e., a change in rent due).

If the future rents change (such as due to the exercise of a renewal), the boards discussed how the change should be recognized. Rather than keeping the remaining or initial obligation amount the same and calculating a new interest rate needed to make the present value of the rents match that (which could result in very high interest rates), they concluded that the additional rent should be added to the obligation by present valuing it using the incremental borrowing rate (the FASB recommending the original incremental rate, with the IASB recommending the current rate).

Asset measurement

As with obligations, the boards rejected a fair value approach to valuing the asset, for basically the same reasons. Therefore, they decided that assets should be amortized over the shorter of the lease term or the economic life; if title to the asset is expected to transfer at the end of the lease, then the economic life should be the amortization term. This is basically the same as the current standard for capital leases.

Some FASB members want to call the reduction in asset value “rent expense” rather than “depreciation” or “amortization,” at least for some leases, but this option is not fully worked out, and clearly reflects a minority opinion (which apparently none of the IASB is interested in).

The asset should also be reviewed for impairment, but the boards haven’t yet considered how that will be done.

There is no reference here to how (or if) the asset should be changed if the future rents change. In the next chapter, they state that the asset should be adjusted the same way the obligation is.

Initial measurement of leases

Continuing with the review of the boards' Discussion Paper on lease accounting. Today's installment covers chapter 4.

Summary:

A lease is to be valued at the present value of the rents due, using the lessee's incremental borrowing rate as the interest rate. The asset and obligation start with the same value. There is no limitation to the asset's fair market value (unlike the current standards).

Detailed review:

Conceptually, the boards wish to determine the initial asset and obligation of the lease by determining its fair value. The boards decided that the fair value of the obligation to pay rentals is not always obvious, and therefore decided to use a discounted cash flow methodology for measurement. This is the same type of methodology used currently for capital leases, and similar to some other financial instruments.

Calculating a discounted cash flow requires deciding on an interest rate to use. The boards considered two possible rates to use:

• The interest rate implicit in the lease (the discount rate needed to make the present value of the rents plus the unguaranteed residual equal to the fair value of the leased asset plus the lessor’s initial direct costs)
• The lessee’s incremental borrowing rate (the interest rate the lessee would pay on a similar lease or to borrow a similar amount of money over a similar term to purchase the asset)

For both rates, the definition used is that of IAS 17, not FAS 13, which is slightly different (most notably, FAS 13 doesn’t refer to the lessor’s initial direct costs for the implicit rate).

The boards rejected the implicit rate because it is often difficult for lessees to determine (they may not know the residual value or the initial direct costs); it was particularly noted that for many leases currently considered operating, the unguaranteed residual can be a large percentage of the total value, and thus mistakes in valuation could significantly affect the calculation.

The boards decided to use the present value of the rents, at the incremental borrowing rate, as the value of both the asset and the obligation at the inception of the lease. They rejected a separate calculation of the fair value of the right-to-use asset, considering “measurement at cost” for the asset to be consistent with the initial measurement of other non-financial assets and less costly to determine than a fair value measurement.

This means that the current capital lease requirement of limiting the gross asset value to not more than the fair market value of the asset will be eliminated.

Those who disagree with the boards’ conclusions are asked to offer their recommended alternative and reason for the switch.

EZ13 has an option to report operating leases capitalized using their incremental borrowing rate, as contemplated by the discussion paper, so you can see today how this change would affect your reporting.

Lease Accounting: The New Approach

Continuing with the review of the boards' Discussion Paper on lease accounting:

The basic reason for the revision of lease accounting is that the boards have concluded that current accounting “fails to represent faithfully the economics of many lease contracts,” which they believe entail rights (to use property) and obligations (to pay rent) that are not recognized on the balance sheet with a current operating lease.

The boards started their analysis with a simple 5 year lease, non-cancellable, no renewal options, no purchase option, and no residual value guarantees. Based on both boards’ conceptual understanding of assets and liabilities, they conclude that the right to use the machine qualifies as an asset, and that the obligation to pay rentals is a liability. The obligation to return the property, they conclude, should not be treated as a liability (while the lessee has possession of the property, it has no right to the property once the lease term is up, and is then essentially a custodian until the property is returned).

Therefore, the boards conclude that leases should be recognized as a right-to-use asset with a matching liability for rents. This new approach, they conclude, will meet many of the criticisms of the current standard, by putting all leases on the balance sheet, improving comparability between companies and transactions, reducing the opportunities to structure transactions as “unrecognised financing,” and being more consistent with the boards’ conceptual frameworks and recent standards in other areas.

Many leases are more complex, and the boards considered options to renew, to terminate early, to purchase the asset, to pay variable or contingent rentals, and to make residual value guarantees. They considered recognizing these components separately, but decided that the problems outweighed any possible benefits, and that a single asset and obligation, encompassing all rights and obligations, should be recognized.

The boards rejected three other approaches:

“Whole asset:” The premise is that during the lease term the entire asset is under the control of the lessee, who should thus recognize the full economic value of the asset on the balance sheet, for both the term of the lease and the remaining value at lease’s end. However, the boards consider that the economic position of a lessee is quite different from a purchaser; it overstates assets and liabilities, because it considers as an asset or liability the value of the property after the end of the lease, which is not available to the lessee; and it raises definitional issues, since very short-term leases would seem inappropriate to treat this way, and defining what should and shouldn’t be included returns to the discredited capital/operating distinction.

“Executory contract:” This method would treat all leases more or less like current operating leases. The boards rejected this because they are convinced that leases do give rise to assets and obligations.

“Existing standard:” The boards consider the current approach unsuitable because 1) operating leases, which in their view do actually give rise to assets and obligations, currently are accounted for without balance sheet effect; 2) similar transactions (those just above and just below the line separating capital and operating leases) are accounted for very differently, reducing comparability and increasing structuring opportunities; and 3) They find it difficult to define a good dividing line between capital and operating leases.

Respondents are asked whether they agree with the boards’ conclusions, and if not, what analysis of leases and components they would prefer and why.

Scope of new standard

This is the first in a series of blog postings I’ll make regarding the lease accounting revision discussion paper released by the FASB and IASB on March 19. I’ll go basically chapter by chapter through the DP reviewing the issues. (FWIW, I'm looking at the FASB's edition of the DP.)

The first question that needs to be asked in the new lease accounting standard is: What transactions does it cover? There is a difference in scope between FAS 13 and IAS 17, the current standards of the FASB and IASB, respectively. FAS 13 applies to arrangements that convey a right to use property, plant, and equipment, while IAS 17 more expansively applies to rights to use an asset, including intangible assets.

Some people have suggested rebuilding the definition of a lease from the ground up. The boards have tentatively decided not to, and to base the scope on the existing standards’ scope.

The DP notes that some people would like the standard to exclude “non-core assets” and “short-term leases.” However, each of these suggestions raises serious problems. The first is again, how to define each term. What one company thinks of as non-core, another similar company may consider core, thus reducing comparability (which is one of the key reasons for the new standard). And “non-core assets” may still amount to significant assets and liabilities, which are relevant for review of financial statements no matter what their use. “Short-term leases” are typically defined as those of less than a year in length, but the boards are concerned that large numbers of short-term leases could still total up to material amounts. And the experience of the past 30 years suggests that a short-term safe harbor would result in lease structuring to evade reporting under the new regime. Both issues are still undecided, however, with not even a preliminary decision reached.

The DP notes that as with all standards, immaterial items can be excluded.

Respondents to the DP are asked whether they agree with the proposed scope. If they think non-core assets or short-term leases should be excluded, how should those be defined?

International Lease Finance in trouble

The Wall Street Journal reports that the world's biggest lessor of airplanes, International Lease Finance Corp., says in a recent filing that its financing needs could threaten its survival. ILFC is a (profitable) part of AIG, and AIG's woes have been impairing its ability to borrow money to finance its purchases of planes, which it leases to many of the world's airlines. ILFC owns 955 planes worth $50 billion. It had been using commerical paper for a lot of its financing, but with the cut in credit ratings it has suffered as part of AIG, that market is now closed.

The article speculates that ILFC is too big to fail, as it's the largest customer for both Boeing and Airbus (not to mention the prime supplier of airplanes to numerous airlines). AIG is trying to sell ILFC to raise money to repay their borrowings from the feds.

Discussion paper released

The same day (March 19) as my previous post, wondering when the discussion paper on the proposed new lease accounting standard would be released, it was actually released. It's available now from the FASB or IASB (the copies vary because of the differences between American English and British English, a reminder of George Bernard Shaw's witticism that we're two countries separated by a common language). Anyone is welcome to comment to the boards (they request that you pick one board or the other, not both, to comment to) by July 17, 2009. The FASB permits sending comments to director@fasb.org, File Reference No. 1680-100. The IASB has a web form for comments. All comments become part of the public record, available for viewing on the web. The boards also plan to have a live web presentation on the DP in May, with details to come.

The DP is over 100 pages; while the information is generally a restatement of the boards' decisions, it'll take me a day or two to look through the full text and post comments (not least because some big projects are on my plate right now). The FASB has also posted a press release about the DP. Predictably, not everyone is happy: the Equipment Leasing and Finance Association, the main US trade association for equipment lessors, issued a press release expressing concern about the complexity of the proposal and its potential to increase the cost of capital. In other words, they're afraid fewer people will lease equipment if they can't keep the transaction off the balance sheet. No doubt that's true, though I don't know how anyone can realistically estimate the magnitude of the effect.

WebCPA has an article on the DP.

Discussion Paper, when?

The FASB has released the agenda for its joint meeting with the IASB next week. The agenda does not have an item for leases, so apparently the discussion paper won't be part of the meeting. Whether it will be released without further board involvement, or has been delayed, is unclear at this time. The FASB leases project page still says the DP will be released in Q1 2009, but the page hasn't been updated since the end of January.

Contingent rent, now and future

One of the more confusing aspects of lease accounting is dealing with contingent rents. The FASB defines these as "The increases or decreases in lease payments that result from changes occurring subsequent to the inception of the lease in the factors (other than the passage of time) on which lease payments are based..." [FAS 29, para. 11] Typical causes for contingent rents are inflation adjustments, percentage of sales, a rental amount based on a floating interest rate (like LIBOR), property taxes, and maintenance fees.

Under FAS 13, contingent rents are handled in one of two ways. Both are based on the overall concept of making a one-time estimate at the beginning of the lease, and expensing the difference between the estimate and the actual payment when the payment is made.

1) If the amount to be paid is based on usage, such as a percentage of sales or machine hours of use, the up-front estimate is zero. All payments based on usage are considered contingent rent, and fall outside of the "minimum lease payments" for the lease (since if you end up not using the asset, your minimum charge is 0); they are expensed as incurred.

2) If the amount to be paid is based on a rate or index, such as LIBOR or the consumer price index, the minimum lease payments are calculated as if the rate or index will be the same over the entire life of the lease. This calculation is not changed over the entire life of the lease (unless the agreement is renegotiated). The difference between the estimate and the actual payment is expensed as incurred; note that this difference could be positive or negative.

One question that often comes up is whether to treat the CPI as a rate or as an index. Officially, CPI is an index, showing the value of a basket of goods and services. The overall value was normed to 100 in 1967; the percentage increase that is broadcast on the news is the change in that index. While some companies take the position that they should assume the current rate of increase in calculating their minimum lease payments, a strict reading of FAS 13 seems to indicate that instead one should assume that the index will not change, i.e., there will be no inflation (or deflation), and future inflation adjustments will be treated entirely as contingent rent.

Of course, if the increases in rent are specified in advance, they must be considered part of the minimum lease payments, even if they're supposedly intended to cover inflation. The key is whether the rent amount is known at inception, or dependent on future events.

The current version of EZ13, v2.2, does not track contingent rents at all, because they're not part of the minimum lease payments. However, we are currently working on a new release which will include the ability to record and report contingent rents; that will be released later this year.

The FASB/IASB revision plans to change this. According to the boards' current thinking, lessees will need to estimate their rents for all types of contingent rent. Unfortunately, the two boards have differing opinions on how to estimate: The FASB wants to use a "best estimate" approach, while the IASB wants a probability-weighted expected outcome approach. Both want lessees to remeasure their leases at each reporting date (normally every fiscal quarter), with the obligation changed by the change in present value of the remaining rents. They disagree about how to balance the change transaction: for changes caused by contingent rents, the FASB wants an immediate recognition of profit or loss, with no change to the carrying value of the asset, while the IASB wants to add or subtract the change to both the obligation and the asset. The depreciation on the asset would then be altered to depreciate the remaining asset over the remaining life.

Since the boards intend to release a united standard, some negotiation between the boards will be necessary to resolve this. Further, it remains to be seen how companies and users of financial statements will respond to this idea; clearly this is a potentially large increase in the complexity of accounting for leases, with the possibility that valuations would change every quarter with corresponding changes in interest and depreciation, along with the change in the actual rent.