Revisiting lessor assets; presentation

A major change in proposed accounting under the new lease accounting standard hits the lessor balance sheet. Under FAS 13 and IAS 17, when a lessor has a capital lease, the underlying asset is removed from the books ("derecognized"), and is replaced with a receivable. For the new standard, the boards agreed (at June, July, and October meetings) to use a "performance obligation" concept; the original asset stays on the books unchanged, a receivable for the rents is set up, and the receivable is balanced by a performance obligation that is amortized over the life of the lease.

While this resolves the problem of a disappearing asset that the lessor still owns, it raises its own complications. One of the most serious is the impact on financial ratios; since a company normally has more assets than liabilities, putting an equal new asset and liability on the balance sheet erodes a company's financial ratio, resulting in the anomaly that a lessor looks like it's in worse financial shape when it successfully leases its assets (which in the real world is a healthy situation).

At the boards' March 23 meeting, they discussed dealing with this through net presentation, showing the performance obligation as a contra asset rather than a liability. However, during the discussion, the strong majority of the IASB expressed a preference to revisit the entire performance obligation concept and possibly jettison it for the old derecognition approach. (The FASB seemed more evenly split, and as this was a physical joint meeting in London, not all the FASB members were present.)

A major concern, however, is the timetable. The boards are trying very hard to keep to releasing an Exposure Draft by June 30, 2010, with a final standard by June 30, 2011. A number of board members felt it would be difficult or impossible to properly flesh out a derecognition model by June 30 to include in the Exposure Draft. One suggestion was to separate lessee and lessor accounting, releasing an Exposure Draft for lessee accounting on time with lessor accounting following a few months later, but before the expiration of the comment period for lessees so that people would have time to review both together and comment accordingly. (Side note: for the first time that I'm aware of, a board member commented on how long it might be until the new standard must be implemented, with a comment of "2, 3, or 4 years later." However, this was an off-the-cuff comment, so I have no idea how much weight to give it.) No decision was reached.

More generally, the March 23 meeting was focused on presentation.

Lessees:

• Lease assets and obligations are to be reported separately from other assets and obligations in the statement of financial position (balance sheet).
• Lease amortization and interest expense can be separated from other amortization and interest expense either in the primary financials or in a footnote disclosure.
• Obligation and interest payments are to be listed separately in the statement of cash flows, in the financing activities section.

Lessors:

• The original leased asset, lease receivable, and performance obligation will be reported separately, then combined into a net lease asset or liability.
• Lease income and expense will be presented separately from other income and expense items. The FASB wants to combine these into a net lease income or expense; the IASB did not concur, which makes for a rare point of divergence in opinions. (Presumably a converged final standard will be reached after Exposure Draft comments are reviewed, as the boards have made a clear priority of having a converged standard.)

Service components/Executory costs; March 22 meeting

At the March 22 joint FASB/IASB board meeting (videoconference viewable here; background materials available here), the boards tackled leases that include a service component. This is what FAS 13 calls "executory costs"; the amounts are part of the future minimum rent commitments, but are excluded from capitalization, as they are considered a service contract that is simply expensed without a balance sheet impact. For operating leases, however, they were pretty unimportant to distinguish from other rent.

The boards agreed to keep the concept of separate service (executory) and lease components of the rent, with the service component not counted as part of the obligation/receivable but simply treated as an expense.

Both lessee and lessor need to evaluate whether the payments can be allocated in this way, in keeping with requirements of the Revenue Recognition project simultaneously underway. If the service component is not considered "distinct" from the lease component, they are not to be separated. Services would be considered distinct if, for example, they are available independently of the lessor, or the lessor sells them outside of leasing transactions.

If an entity is unable to determine an allocation between service and lease components, the entire rent is treated as lease. Since treating it as a service will generally be preferable financially, there's an incentive to get the numbers right.

If the total rents later change for a lease that has service and lease components, the entity should try to apportion the changes between the components. If unable to do so, they should divide the change in rents pro rata between the two components.

The new rules will apply immediately with the application of the new standard. For capital leases, it should be a non-issue; operating leases, however, will need to be analyzed to determine what portion should be considered service. (It's not clear whether the terminology is to be changed from "executory costs" to "service component.")

Disclosures and more – March 17 boards meeting

The FASB and IASB met again on March 17 (videoconference, viewable here; background materials available here) to continue working through issues related to the new lease accounting standard, still aiming to get out an exposure draft by the end of June 2010. Following are highlights of their decisions:

Lessee disclosure requirements

These are items that need to be reported in the footnotes to an entity’s financial statement, not placed in the primary financials. Both narrative and numerical disclosures will be required:

Narrative

• A general description of leasing activities, broken up by nature or function.
• Statement if simplified short-term lease accounting is being used, with the amounts involved.
• Statement if sale & leaseback transactions are entered into, along with material terms & conditions, and associated gains or losses.
• Assumptions and estimates for options, contingent rentals, residual value guarantees, discount rate, and amortization method.
• “Quantitative and qualitative financial information” to help evaluate uncertain future cash flows, and how the lessee manages those uncertainties.

Numerical

• Reconciliation between opening and closing balances for right to use assets and rental obligations (additions, activity, estimate changes, removals, etc.)
• Maturity analysis of future rent obligations, breaking out contractual minimums and additional estimated payments by year for five years, with a lump sum for remaining amounts.

The reconciliation is a completely new disclosure. The maturity analysis is an unsurprising extension of the current future minimum rent disclosure.

Lessor transitional provisions

• Like lessees, lessors will recognize the present value of the remaining rents at the implementation date on their balance sheet (as a receivable, matching the lessee’s obligation). The performance obligation will be booked for the same amount.
• The discount rate for the lease should be the rate the lessor is charging the lessee (which seems to be the same as the implicit interest rate).
• Under FAS 13, capital leased assets are derecognized. At transition, those assets will be reinstated at depreciated cost (adjusted for impairment, and for revaluation under IFRS).

Measurement at initial recognition

Assets and liabilities are to be calculated as of the inception of the lease, which can be earlier than the start date of the lease (inception is when the agreement is signed, even if possession is taken and rent starts being paid later).

Residual value guarantees – lessor accounting

• The lessor’s receivable should include guaranteed residuals when they can be measured reliably.
• Measurement uses an expected outcome technique (i.e., probability-weighted result).
• The carrying amount should be reassessed each reporting period if new facts or circumstances indicate a material change.
• Changes would be treated as an adjustment to the receivable and performance obligation just like a contingent rent change.

The boards did additional work on the new standard at their March 22 meeting, to be recapped next on this blog.