Tuesday, February 23, 2010

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.


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.

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