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?