Friday, April 24, 2009

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.


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.

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