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.