The FASB & IASB, at meetings May 18 & 19, revisited one of the fundamental decisions on lessor accounting made last year. As the staff’s agenda paper put it then, “What is the credit?” Setting up a capital lessor lease means setting up a receivable for the rent income stream. That’s a debit on the balance sheet. How should the balancing credit be characterized?
The boards considered two basic approaches. The first, which is the current methodology under FAS 13 and IAS 17, is derecognition: the owned asset is credited (reduced/eliminated). Under present accounting, the entire asset is derecognized, replaced by the receivable. Things get more complicated in the proposed new system, since many leases will be for only part of the value of the underlying asset. Crediting the asset would leave part of the owned asset on the books. More problematic is that multiple leases of a single asset could result in a sum total of receivables that is greater than the original asset value; how is that to be handled?
The solution the boards came up with was to create the concept of a performance obligation, representing the requirement to make the asset available to the lessee. This is a credit entry that is amortized over the life of the lease, based on passage of time or usage of the asset.
There have been rumblings for several months that several members of the boards are uncomfortable with the performance obligation methodology. Recent notes on lessor accounting have included explicit comment that decisions are “under the performance obligation approach.” At this week’s meetings, there was extensive discussion of going back to a derecognition approach, though this would be a “partial derecognition” approach. Described in detail in the agenda papers for the meetings, this means that the owned asset wouldn’t be completely taken off the books (unless the lease is for the entire useful life of the asset). A portion of the asset would be removed and replaced with the receivable.
The boards made decisions on how to account for various aspects of lessor activity under a partial derecognition approach, without committing to such an approach. You can read the full list of decisions in the FASB Action Alert. I’m not going to repeat all of it because it’s not clear if it will actually take effect, and I’d just be restating what they state there.
One significant implication of a partial derecognition approach is that a lessor could recognize a profit at the beginning of the lease (as is currently done with sales-type capital lessor accounting). The boards' prior decisions on lessor accounting with a performance obligation did not permit an up-front recognition of profit; instead, all income is to be recognized in the form of interest over the life of the lease. This has potentially a major impact on the reported profitability of manufacturers who lease their equipment. One can expect that they will lobby hard for a derecognition approach.
Conceptually, a derecognition approach seems to the staff to be more consistent with the lessee right-of-use approach. However, the unguaranteed residual value becomes much more significant in this approach, which can increase complexity.
The boards haven’t concluded which way to go, and significantly, there’s a difference of opinions between the boards. The FASB prefers to stick with the performance obligation methodology; the IASB prefers a hybrid model, using a performance obligation in some cases and derecognition in others. (The FASB Action Alert summary doesn't list the vote, but based on prior activity, I doubt it was unanimous with either board.) They’ve asked their staff to develop proposals to decide when to apply which model. But won’t that inevitably result in structuring opportunities, and similar transactions being accounted for differently? Eliminating that was supposed to be one of the big improvements of a new lease accounting standard. Will the two boards find a way to resolve the disagreement and keep a converged standard?
Stay tuned for more developments next month.
Friday, May 21, 2010
Tuesday, May 18, 2010
April meeting results
The FASB & IASB met again in mid-April for multiple meetings regarding the new lease accounting standard (originally supposed to be a joint meeting in London, the Icelandic volcano forced it to be a videoconference). Lessee topics included sale/leaseback transactions and rent presentation; subleasing was also discussed. Topics for lessors included: performance obligation amortization, impairment, purchase options, and disclosure requirements. Long-term leases of land affect both lessees and lessors.
Sale and leaseback transactions
Under current US GAAP, a sale and leaseback is recognized as such only if it meets criteria specified in FAS 98, which particularly prohibit “continuing involvement” by the seller-lessee in the property other than the leaseback itself. If there is continuing involvement, such as a fixed-price purchase option, nonrecourse financing, or a guaranteed residual, sale/leaseback accounting is prohibited and the transaction must be accounted for as a financing, with the asset remaining on the “seller’s” books.
The boards have decided to tie the definition of a qualifying transaction to their previous decision to account for a lease as a sale of the underlying asset. The relevant definition is “if at the end of the contract control of the underlying asset has been transferred and all but a trivial amount of the risks and benefits associated with the underlying asset have been transferred.” The interesting thing about use of this definition is that in this case, it’s being used to define the sale portion of the transaction, not the lease portion. The impact of the decision should be minimal; that is, generally transactions will get the same treatment (as far as whether they’re treated as sale/leaseback or as financing) under the new standard as the old, but it makes sense to use more consistent definitions within the new standard.
Lessee presentation of total cash rentals paid
Currently, cash rent paid under operating leases is a line item in the income statement; it is not, however, an income statement for capital leases (since the expenses recognized are interest and depreciation). The new standard includes a disclosure with a reconciliation of obligation to pay rentals, along with reporting interest and obligation repayments (separately) in the statement of cash flows; no separate presentation of total rent paid is to be included.
Subleases
As one might expect, a sublease is treated like a lessor lease by the intermediate party. Assets and liabilities for subleases will be reported gross with a net subtotal, separate from the assets and liabilities related to the head lease (the original lease of the asset that is being subleased).
Long-term leases of land
There had been some discussion of possibly treating long-term leases of land as sales (in some countries, land leases of 99 or even 999 years are common due to cultural or legal barriers to actual transfer of land ownership). The boards decided not to go that route; long-term land leases will be treated like any other lease within the new standard.
Lessor performance obligation amortization
Amortization should be in a systematic and rational manner based on the pattern of use of the underlying asset. This could be passage of time, hours of use or items produced for equipment, etc.
The boards have not decided whether or how to permit revenue recognition at the start of a lease (similar to current sales-type lessor lease accounting), and asked the staff to further analyze the issue.
Lessor accounting for purchase options
Purchase options are to be accounted for the same way as renewal and termination options, using the “more likely than not” criterion for exercise.
Lessor accounting for impairment of assets
The receivable is to be reviewed first for impairment, with an adjustment to both the receivable and the performance obligation and any difference being recorded in profit or loss. The underlying asset is also subject to impairment review; the staffs are to further consider how to apply IFRS 36 and ASC Topic 360, each board’s impairment standard.
Lessor disclosures
Descriptive
The nature of the lease arrangement(s), if leasing is a significant part of the lessor’s business activities
Restrictions placed on leased assets by the leases
Existence and terms of any residual value guarantees
Under IFRS: Information on risks surrounding the receivable (cf. IFRS 7)
Under US GAAP: Information on credit quality, the uncertainty of future cash flows, and how the lessor manages those uncertainties
Notation if simplified short-term lease accounting is being used
Quantitative
Maturity analysis, by year for five years and future years as a lump sum, showing the minimum contractual receivables and total estimated receivable
Maturity analysis, by year for three years and future years as a lump sum, of the satisfaction of performance obligations
Reconciliation between opening and closing balances for the receivable and performance obligation, showing the transactions resulting in increases and decreases
If simplified short-term accounting is being used, the gross amount so recognized
The FASB meeting notes indicate that the boards now anticipate a release of the exposure draft in August 2010, rather than the previously planned June. Obviously there’s too much yet to be completed.
This week (May 18 & 19), the boards have scheduled over 7 hours of meeting time to discuss a lessor’s accounting for the performance obligation and the alternative approach of derecognition (i.e., rather than keeping the leased asset on the books and setting up a performance obligation, the lessor would reduce reported owned assets by the amount of the lease receivable).
Sale and leaseback transactions
Under current US GAAP, a sale and leaseback is recognized as such only if it meets criteria specified in FAS 98, which particularly prohibit “continuing involvement” by the seller-lessee in the property other than the leaseback itself. If there is continuing involvement, such as a fixed-price purchase option, nonrecourse financing, or a guaranteed residual, sale/leaseback accounting is prohibited and the transaction must be accounted for as a financing, with the asset remaining on the “seller’s” books.
The boards have decided to tie the definition of a qualifying transaction to their previous decision to account for a lease as a sale of the underlying asset. The relevant definition is “if at the end of the contract control of the underlying asset has been transferred and all but a trivial amount of the risks and benefits associated with the underlying asset have been transferred.” The interesting thing about use of this definition is that in this case, it’s being used to define the sale portion of the transaction, not the lease portion. The impact of the decision should be minimal; that is, generally transactions will get the same treatment (as far as whether they’re treated as sale/leaseback or as financing) under the new standard as the old, but it makes sense to use more consistent definitions within the new standard.
Lessee presentation of total cash rentals paid
Currently, cash rent paid under operating leases is a line item in the income statement; it is not, however, an income statement for capital leases (since the expenses recognized are interest and depreciation). The new standard includes a disclosure with a reconciliation of obligation to pay rentals, along with reporting interest and obligation repayments (separately) in the statement of cash flows; no separate presentation of total rent paid is to be included.
Subleases
As one might expect, a sublease is treated like a lessor lease by the intermediate party. Assets and liabilities for subleases will be reported gross with a net subtotal, separate from the assets and liabilities related to the head lease (the original lease of the asset that is being subleased).
Long-term leases of land
There had been some discussion of possibly treating long-term leases of land as sales (in some countries, land leases of 99 or even 999 years are common due to cultural or legal barriers to actual transfer of land ownership). The boards decided not to go that route; long-term land leases will be treated like any other lease within the new standard.
Lessor performance obligation amortization
Amortization should be in a systematic and rational manner based on the pattern of use of the underlying asset. This could be passage of time, hours of use or items produced for equipment, etc.
The boards have not decided whether or how to permit revenue recognition at the start of a lease (similar to current sales-type lessor lease accounting), and asked the staff to further analyze the issue.
Lessor accounting for purchase options
Purchase options are to be accounted for the same way as renewal and termination options, using the “more likely than not” criterion for exercise.
Lessor accounting for impairment of assets
The receivable is to be reviewed first for impairment, with an adjustment to both the receivable and the performance obligation and any difference being recorded in profit or loss. The underlying asset is also subject to impairment review; the staffs are to further consider how to apply IFRS 36 and ASC Topic 360, each board’s impairment standard.
Lessor disclosures
Descriptive
The nature of the lease arrangement(s), if leasing is a significant part of the lessor’s business activities
Restrictions placed on leased assets by the leases
Existence and terms of any residual value guarantees
Under IFRS: Information on risks surrounding the receivable (cf. IFRS 7)
Under US GAAP: Information on credit quality, the uncertainty of future cash flows, and how the lessor manages those uncertainties
Notation if simplified short-term lease accounting is being used
Quantitative
Maturity analysis, by year for five years and future years as a lump sum, showing the minimum contractual receivables and total estimated receivable
Maturity analysis, by year for three years and future years as a lump sum, of the satisfaction of performance obligations
Reconciliation between opening and closing balances for the receivable and performance obligation, showing the transactions resulting in increases and decreases
If simplified short-term accounting is being used, the gross amount so recognized
The FASB meeting notes indicate that the boards now anticipate a release of the exposure draft in August 2010, rather than the previously planned June. Obviously there’s too much yet to be completed.
This week (May 18 & 19), the boards have scheduled over 7 hours of meeting time to discuss a lessor’s accounting for the performance obligation and the alternative approach of derecognition (i.e., rather than keeping the leased asset on the books and setting up a performance obligation, the lessor would reduce reported owned assets by the amount of the lease receivable).
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