Performance obligation or derecognition—or both?

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.