Booking contingent rent changes and other Feb. 17/18 issues

In current lease accounting, contingent rent (rent that is uncertain at lease inception, such as that based on percentage of sales, inflation, or usage) is not counted to calculate the asset and obligation, and is simply expensed as incurred. At the extreme, this can mean that a lease has no rent commitment at all (if, for instance, a retail store lease is based solely on a percentage of sales, or a copier lease is priced entirely on copies made).

Under the proposed new lease accounting standard, contingent rents must be estimated (using an "expected outcome" probability-weighted approach) and included in the rent stream that is present valued to determine the asset and obligation. However, since contingent rents are by definition uncertain, there will inevitably be adjustments from the estimate to the actual. The question then arises, how should the adjustments be booked? In the Preliminary Views document, the FASB proposed that changes should be recognized in profit or loss, while the IASB recommended adjusting the right-of-use asset.

At a Feb. 17 & 18 joint meeting of the FASB and IASB, the boards agreed on a compromise position for lessees: changes that apply to rent in current or prior reporting periods should be recognized in profit or loss, while changes that apply to future periods (due to updated estimates) should result in an adjustment to the right-of-use asset. The same principle applies to residual value guarantees (throughout the new lease accounting standard, residual guarantees are treated as simply a variety of contingent rent).

For lessors, the decision is essentially the same, except that the dividing line is based on whether or not the associated performance obligation has been "satisfied." The boards will include guidance with the new standard to clarify how to determine when a performance obligation has been satisfied.

In substance purchases

The boards revisited the issue of "in substance purchases," and decided that a contract which is effectively the sale/purchase of the underlying asset should be treated as a sale & purchase, not as a lease. The following criteria are considered generally to be indications of an in substance purchase:

1. Contracts in which the title of the underlying asset transfers to the lessee automatically
2. Contracts that include a bargain purchase option, if it is reasonably certain that the options will be exercised
3. Contracts in which the return that the lessor receives is fixed
4. Contracts in which it is reasonably certain that the contract will cover the expected useful life of the asset and any risks or benefits associated with the underlying asset retained by the lessor at the end of the contract are expected to be not more than trivial.

It will be noted that #1 & #2 are FAS 13's 7(a) and 7(b) tests for a capital lease, and #4 is more or less a 100% economic life test (i.e., increasing FAS 13's 7(c) test of the lease term as a percentage of the economic life from 75% to 100%). However, #4 recognizes that sometimes at the end of a lease, the asset, even at the end of its useful life, may have remaining benefits or costs--for instance, an airliner has considerable scrap value, or a building could have either structural value or sizable cleanup costs. In such situations, the contract would still be recognized as a lease.

The boards are aware that sometimes land is leased for extremely long periods (hundreds of years). Since land is considered always to have value, even such long leases would still not be considered sales, though the boards asked the staffs to consider possible alternatives for such leases.

So we're back to classifying, even if everything is now on the balance sheet. A substantial number of current capital leases (particularly computer leases with $1 buyout clauses) will now be treated as purchase/sale transactions, not as leases. They are to be excluded from the scope of this standard. What standard will define how they are booked (how to calculate the asset value, etc.)?

Initial direct costs

Initial direct costs are to be added to the right-of-use asset by lessees and depreciated over the life of the lease; lessors add them to the lease receivable and amortize. At the Feb. 17 meeting, the boards clarified that initial direct costs are to be defined as "incremental costs directly attributable to negotiating and arranging a lease." The operative word is "incremental"--general overhead expenses associated with sales and marketing should not be included. Guidance will be included in the standard to illustrate, with the intention to include items such as commissions, legal fees, and employee total compensation for time spent on negotiating a lease, evaluating the lessee/lessor, preparing documents, and closing the transaction.

Transition

The boards have decided that existing simple capital/finance leases will be left unchanged if they are "simple" leases, i.e., they have no contingent rent, residual value guarantees, or option periods. For such leases, the accounting treatment is virtually unchanged (except for the possibility of a different interest rate), so it is felt that there is no benefit to requiring a recalculation at the standard implementation date. Other capital leases, however, including combined capital building/operating land leases, must be transitioned to the new standard, which means capitalizing the remaining rents at the implementation date.

Where there are large up-front or deferred "balloon" payments, adjustments will be required to avoid understating or overstating the asset. Up-front payments would be discounted and pro-rated over the life of the lease, while the overstatement from balloon payments would be addressed through impairment review.

Implicit interest rate

The new standard will permit lessees to use the implicit interest rate instead of the incremental borrowing rate if it is readily determinable. Also, the lessor is to use this rate for calculating the lease receivable. However, a new definition of implicit rate is necessary because the old definition was based on the underlying asset's fair value and the minimum lease payments; fair value is essentially being jettisoned for the new standard, and the payments used are much more than the minimum payments. The boards decided to accept as the definition: "the rate that the lessor is charging the lessee." That may sound like a tautology, but the boards will include guidance to help users determine the appropriate rate in different circumstances.

Discussions will continue in March. One item deferred to next month is separating service elements (executory costs) from the regular lease payments.

What's a lease?

The FASB & IASB had a joint meeting on Feb. 2 by videoconference. The topic of discussion was a definition of a lease. They came up with the following definition:

A lease is a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration.

This definition includes contracts which are outside the scope of the new (and current) lease accounting standard. Notably, the definition is not limited to property, plant, and equipment, but the standard is.

There will be further work on the new standard at the upcoming joint videoconference meetings Feb. 16-18.

Not your father's lease accounting

Enough of the structure of the proposed new lease accounting is set (for presentation in the exposure draft) that it's appropriate to take a step back and look at the larger picture. This rewrite, which brings an end to a 35-year-old lease accounting structure, is not just about putting leases on the balance sheet. More fundamentally, the conceptual basis of reporting has changed radically. There are two conceptual changes, each of which has significant implications.

Under FAS 13, the fundamental concept is that a lease that "transfers substantially all of the benefits and risks of ownership should be accounted for as a" capital lease, representing a sale and purchase transaction, while all other leases are treated as "operating leases, that is, the rental of property." (FASB Current Text section L10 summary) Under the new standard, a right of use is recognized as a lessee asset with a matching rent liability, and a corresponding receivable and performance obligation are recognized as lessor asset and liability; these assets and liabilities are recognized for every lease (subject only to standard materiality limitations, and for lessors, to a scope exclusion for leases of less than 12 months). Off-balance-sheet financing via leasing ceases to exist.

The second conceptual change has not been highlighted as much, but is every bit as significant. FAS 13 is concerned with minimum known lease obligations. A lessee calculates the future rent commitments and the present value of future rents, and from that the asset and obligation on capital leases, based solely on the minimum amount of rent he can be required to pay. Contingent rentals are generally excluded from these numbers (unless based on an index or rate, such as CPI or LIBOR, in which case the future rents are estimated based on the initial rate, and that estimate is never changed), with actual contingent rentals paid simply expensed as incurred. If there are renewal options, they are ignored until exercised unless it is clear at lease inception that the lessee will be economically compelled to exercise them (due to bargain rents, etc.). On the other hand, a guaranteed residual is recognized at the maximum that the lessee can be required to pay, regardless of the likelihood.

The new regime can be described as "the most likely cost of the lease." Contingent rentals of all sorts are to be estimated and included, with the estimate updated each reporting period (i.e., each quarter) if there is a material change. Options are to be included if they are deemed more likely than not to be exercised, based on expectations and past practices as well as economic compulsion. (Once they are actually exercised or not exercised, the lease will of course be updated if the result is different from what was expected.)

What's the result? Many existing capital leases will need to be recalculated under the new regime. Numerous leases will need mid-term adjustments which affect both the balance sheet and the income statement. Some leasing agreements that made a lot of sense under FAS 13 may be inadvisable, and lessees and lessors may face difficult negotiations to revise the agreements to reduce their impact on the parties without disadvantaging either. Prior estimates of the impact of revising FAS 13, based on the minimum lease term and payments, will prove substantially understated for at least some leases (likely to be most affected are real estate leases with multiple lengthy options and percentage of sale contingencies, such as many store leases). As previously noted, some companies face potentially major changes to their income statement and balance sheet due to the new rules. Almost all lessees will face a deterioration of their financial ratios; if an equal amount of asset and liability is added to one's balance sheet, debt and current ratios (for all but the most unhealthy companies) will decline.

What's the benefit? The boards clearly feel that the new methodology more accurately reflects the economic reality of leasing transactions. While they are not deaf to concerns about implementation costs, in most cases they believe those concerns must bow to providing better reporting on the huge volume of leasing (an estimated $1.25 trillion in future lease commitments in the U.S. alone, which doesn't include many of the options that will be included in the new regime). In their view, an airline without airplanes on their balance sheet doesn't reflect economic reality, and neither does a store chain with no stores, that claims all of its lease commitments end in 5 years and shows tiny future rents because percentage sales fees are excluded. In addition, having a common standard for US GAAP and IFRS will be a major step forward for the boards' convergence project to have consistent accounting worldwide.

It goes almost without saying that every company's method of accounting for leases will have to be updated (software, Excel spreadsheets, whatever). Our EZ13 is no exception, and we are currently laying the plans to make the needed changes. While we already permit treating operating leases as capital on a pro-forma basis, that is only a small part of the reporting changes that will be coming. We are committed to releasing an updated version of EZ13 as quickly as possible once the new rules are finalized.