Friday, December 16, 2011

December meeting results

The FASB & IASB met again to discuss leases on Dec. 13 & 14. Significant decisions reached include:

Cancellable leases
If both the lessee and the lessor have the right to cancel the lease (without termination penalties) such that the minimum term, including any non-cancellable period and any notice period, is 12 months or less, it meets the definition of a short-term lease. The key here is that either side can cancel; if one side can require renewal, then normal lease accounting applies.

Investment properties
Rental income from property accounted for (under IFRS 40) as investment property will not be capitalized, as such property is out of scope of the new leasing standard. However, the boards still chose how to recognize rental income: straight line, or another systematic basis if more representative of use of the asset.

Disclosures for these lessor leases are to include:
  • Maturity analysis of future rents (at least 5 years by year, then the rest combined). This is not to be combined with the maturity analysis for capitalized leases.
  • Separate entries for minimum contractual rents and variable lease payments
  • Cost, carrying amount, and accumulated depreciation on leases
  • Narrative information about lease arrangement
Future meetings
The staff listed the following items to be redeliberated:
  • the definition of investment property (which is scoped out of this standard)
  • the "lessee accounting model"--as mentioned in a Wall Street Journal article that I commented on previously, the boards are going to discuss further a way to recognize level expense over the life of a lease, even though they rejected this earlier
  • additional disclosure items

Thursday, December 15, 2011

November meeting results

Sorry, I'm behind again. This is from a month ago; I'll post the results of December's meeting as quickly as possible. This is from the FASB & IASB joint board meetings of Nov. 15 & 16, 2011:

Leases in business combinations
An acquired lessee lease is set up as if it is a new lease at the acquisition date, except that the asset is to be adjusted for any "off-market" terms in the lease; that is, if the rent due is substantially above or below market rents, the difference between market (present valued) and contract is folded into the asset.

This is a significant change from current accounting, which calls for a fair value calculation for both the asset and the obligation at the date of acquisition, with the result that the two are normally different at the acquisition date. Now the normal case will be equal asset and liability at acquisition, unless the rent is considered off-market.

An acquired lessor lease, using the receivable & residual approach, is set up as if it is a new lease at the acquisition date for purposes of calculating the receivable. The residual is the difference between the receivable and the fair value of the asset.

An acquired lessor lease that is treated as investment property or a short-term lease (originally or according to the remaining life at acquisition) is handled according to current rules under IFRS 3 and FASB Topic 805 for acquired operating leases. (However, I don't actually see anything explicitly talking about operating leases in Topic 805 or its original source, FAS 141, so I'm not sure what that means.)

If a lessee has a previously recognized intangible asset or liability to reflect (un)favorable terms in an operating lease, that should be folded into the right-to-use asset.

Currently, the sale of operating lease receivables by a lessor cannot be treated as a sale; instead, it is accounted for as a secured borrowing (because the receivable is not recognized on the balance sheet to begin with). The boards discussed whether to permit sale treatment at transition. Requiring it was seen as onerous; permitting it as an option would reduce comparability. The boards decided to permit it on a prospective basis only.

First-time adopters of IFRS generally would apply the same transitional rules as other companies, except that they are to use fair value determinations for a right-to-use asset.

Thursday, November 17, 2011

Fighting on the expense profile

According to a Wall Street Journal article in yesterday's edition (available online only by subscription), most companies are resigned to the new lease accounting standard putting leases on the balance sheet. The primary issue they're pushing back on is the front-loading of expenses (which happens because interest is higher in the early years of a repayment schedule, while the depreciation remains straight-line throughout the lease term). The boards briefly considered, then rejected, a proposal earlier this year to make the expense profile straight-line by making the depreciation expense equal to the obligation repayment in each payment period; they didn't like the way the depreciation would look, and felt it was inconsistent with other aspects of accounting.

However, the topic hasn't died, and the article says that the FASB & IASB staff plan to revisit the issue with the boards, perhaps next month.

The article notes that the front-loaded profile is particularly problematic for retailers, who typically have lower revenues in the first years a store is open. Chains that are rapidly opening up new stores would be especially hard hit. The article indicates that investors also consider the expense front-loading unhelpful.

The article speculates that companies might shorten the life of their leases to reduce the impact of front-loading, but notes that that could cause problems for landlords who depend on long-term leases to guarantee their loans.

In other news, I realized I missed commenting on a November 1 meeting:

The boards worked through lessor disclosures, including:
  • A table of all lease related income items, listing separately profit at lease commencement, interest income on the receivable, interest income on the residual, variable payments, and short-term lease income.
  • Information about variable lease terms, renewal options, and purchase options
  • A reconciliation of the right to receive payments and residual assets (showing beginning balance, additions, payments or residual accretion, terminations, and ending balance)
  • A maturity analysis of future rent payments, by year for at least five years with the remainder as a lump sum
  • Information about how the lessor manages risks on the underlying asset
The boards decided that a lessor doesn't need to disclose:
  • Initial direct costs
  • The weighted average or range of interest rates on leases
  • "Fair values" of the receivable or residual (a term of art that requires determining a market price for sale)
Sale/leaseback transition
  • An existing sale/leaseback transaction that resulted in a capital/finance lease will continue to be accounted for with no adjustments.
  • A sale/leaseback with an operating lease or with no recognition of sale would be reevaluated based on the criteria for transfer of control of an asset in the proposed revenue standard (which presumably will be finalized no later than the leases standard; its exposure draft was put out Nov. 14). If met, the lease would transition like other operating leases.
Additionally, the FASB clarified that an exception from lease accounting under EITF 01-8, applicable to certain transactions entered into before May 2003, will not be retained, and such transactions will need to be accounted for as leases under the new standard.

Tuesday, October 25, 2011

This month's boards meeting

On Oct. 19, the FASB & IASB again met to discuss the new lease accounting standard. In a marathon session (scheduled for 5 hours), they reached a number of decisions in several areas. (Note: in the discussion below, and elsewhere in discussions about this standard, "effective date" is the date companies must start reporting under the new standard, while "date of initial application" is the date, normally two years earlier for U.S. companies, as of which leases must be treated as capital once the new standard takes effect, due to the requirement to restate years shown as comparables in the annual report.)

Lessee transition
  • All existing capital leases will be carried over with no changes required. Previously, they had planned to require restatement of capital leases with variable payments or renewal options that would be treated differently under the new standard. They decided the benefit wasn't worth the cost, because in most cases the differences would be small (particularly given recent decisions to reduce recognition of variable payments and options).
  • The incremental borrowing rate to use for operating leases to be capitalized will be a single company-wide rate, not based on the individual characteristics of each transitioning lease.
  • Operating leases can be recalculated using either a "full" or a "modified" retrospective methodology. The same methodology must be chosen for all leases. Full means going back to lease inception and calculating the lease as capital. Modified is different from what was in the original Exposure Draft; I described it last month. They have clarified that the difference between asset and liability generated by this method is to be booked to retained earnings (no P&L impact).
  • The simplifications ("reliefs") mentioned last month were all confirmed: leases that terminate before the effective date of the new standard won't have to be restated, even if they start after the date of initial application; initial direct costs are excluded during the same period; and preparers may use hindsight to set up the leases.
Lessor transition
  • Capital leases other than leveraged leases can be carried over with no adjustments.
  • Leveraged lease accounting is eliminated. Such leases will have to be restated.
  • Current operating leases will have a receivable and residual set up using the present value of the rents and expected residual value at date of initial application, the interest rate being the rate charged in the lease as of lease inception; the underlying asset is derecognized. Lessors also have the option of full retrospective application.
Lessor receivables held for sale
  • A proposal to report receivables held for sale at fair value was rejected. While this would superficially be consistent with IFRS 9 and the FASB's Accounting for Financial Instruments project, it was felt that it added complexity, was inconsistent with the rest of the leasing standard, offered opportunities for structuring, and would add more variability in profit and loss. Instead, any gain or loss would be recognized when a sale of the receivable is completed.
Variable payments for lessors
  • If the rate a lessor charges a lessee assumes "reasonably assured" variable lease payments will be made, the residual asset (which by default contains the value of those payments, since the value is not in the receivable) will be adjusted by recognizing an adjustment to the residual. The adjustment is the variable lease payment divided by the fair value of the underlying asset, times its carrying amount.
Lessor receivable and residual
  • Investment property is excluded from the lease standard scope. This keeps those properties under IAS 40 for companies using IFRS. The FASB is working on a project to create the same standard for the U.S. (which presumably will be complete by the time the lease standard takes effect).
  • Profit on the residual will not be recognized until the asset is sold or re-leased.
  • The residual is initially booked at the present value of the residual. The value is accreted, with interest income recognized for the accretion, using the same interest rate as for the receivable.

Friday, October 21, 2011

Exposure Draft delayed to 2012

The FASB & IASB have updated their project schedules to indicate that the revised exposure draft (RED) will be released in Q1 2012. That's another delay of three months from what was expected when they announced in July that a RED would be released. The Equipment Lease and Financing Association is reporting that the comment period will be a full 120 days; there had been speculation that the comment period might be shorter the second time around. That means that the comment period won't end until near the end of Q2. With time for redeliberation, that suggests that the final standard won't be out until late in 2012.

It's yet the latest delay in an oft-delayed project. When originally announced back in 2006, the boards expected to be done in 2009. The latest delay could affect the implementation date; speculation recently has focused on 2015 as the implementation date, but given the planned requirement to restate the prior two years of comparable financials, that means there could be just weeks between the release of the standard and when (1/1/2013) leases will effectively need to be reported under it. During those two years until actual implementation, bookings will be done under current standards, but companies will need to make sure they keep complete information on their leases to enable recreating their accounting under the new methodology. Of course, with the active consideration of full retrospective accounting (though probably not to be required, just optional), it would be good to be keeping information right now on any leases that you expect to remain active into 2015. (It is expected that leases that expire before implementation won't need to be recalculated.)

The boards held a lengthy meeting this week on leases, but I don't have time to review the 5 hours of recordings, and my normal sources haven't yet posted summaries of the events.

Monday, September 26, 2011

Boards get back to work, timeline slips further?

When the FASB and IASB decided in July to prepare a second Exposure Draft for the proposed new lease accounting standard, they expected to finish all the loose ends in September and release the RED (Revised Exposure Draft) soon after. Oops, here we go again. The whole history of this new standard has been one of delays: when the project was announced in 2006, it was supposed to be completed in 2009.

Even before the meeting, the boards realized they weren't going to be able to do everything this month. (There was no joint meeting in August; it's not clear whether the month off was considered in their July timeline.) But the agenda for this month included the plan to bring "all remaining redeliberation issues to the boards in the October joint board meeting." Now Asset Finance International is reporting that the boards want more time to redeliberate the remaining issues, and that it might take until next February to issue the RED, with a final standard of course being several months after that (to allow time for public comment, then redeliberation). It's not clear what their basis is for this projection; the FASB's Technical Plan still has a Q4 estimated publication date for the RED (with the notation that this was updated 9/23/11), though it doesn't list any date for the final standard. However, some decisions due this month were either completely deferred or have loose ends dangling.

Decisions made at the Sep. 19 and Sep. 21 joint board meetings:

Scope - inventory
Some people had suggested that the right-of-use asset for a lease could in some cases also meet the definition of inventory, and would be subject to potentially conflicting standards. The boards decided that the situation doesn't really seem possible, and therefore there's no need to prepare guidance to distinguish.

Financial asset guidance application to lessor's right to receive payments
A major concern of the boards is keeping accounting consistent between different types of transactions. The lessor's right to receive rent payments could be considered a financial asset. The boards decided that such standards (specifically, IFRS 9, IAS 39, and US GAAP Topic 825) should not apply to regular measurement of the receivable, but would apply to impairment. This also confirms the previous decision that fair value measurement/revision is not permitted for the receivable.

Lessor impairment
For the lessor receivable, the impairment standard for the applicable GAAP environment (Topic 310 for U.S. preparers, IAS 39 for IFRS) applies. For the residual asset, IAS 36 and Topic 360 apply; for US preparers, this indicates impairment is handled in a manner congruent with property, plant, & equipment, rather than intangibles. This is basically the same as lessee treatment.

Lessor balance sheet presentation
Lessors will be required to report all their leased assets, both receivables and residuals, as a "Lease Assets" line in PP&E. Lessors may choose whether to separate the receivables and residuals in the balance sheet, or footnote the detail. Sublease assets should be shown separately.

Subsequent adjustments of variable rents, lessor
The recalculation of variable rent payments due to changes in a rate or index (such as changes in LIBOR or the CPI) can result in a gain or loss. That is to be recognized immediately in profit & loss, rather than being rolled into the asset (as is largely the case for lessees).

Lessor accounting for residual value guarantees
The boards agreed that a residual value guarantee would not be separately recognized (whether provided by the lessee or a third party). It would be taken into account in determining the value of the residual asset, including testing for impairment.

Lessor cash flow statement
Lease payments are classified as operating (not investing) activities. An exception was made, however, for cash flows related to securitized receivables, which would be accounted for under existing guidance.

Transition, lessees
The ED called for lessees to capitalize the remaining rents on all operating leases, with an equal asset and liability set up at the date of initial application. (Note: the effective date is when the standard takes effect; the date of initial application is the date, two years prior for most US companies, as of which leases have to be treated as capital for comparison purposes.) The problem with this for the income statement is that because it treats all (formerly operating) leases as new on the date of initial application, all of those leases will be at the beginning of the interest amortization curve, when the interest recognized is highest. This means that all lessees would face considerably higher expenses than rent payment as of initial application (with expenses dropping over time, as the principal is paid down and interest correspondingly declines).

It was recognized that this results in artificial swings in expenses. For a lessee with a mix of leases starting and ending roughly evenly from year to year, the overall lease expense profile should be relatively flat, even as each individual lease shows more expense in the early years and less in the later years.

In looking for ways to mitigate this, the staffs presented to the boards two alternatives:
1) full retrospective approach
2) modified retrospective approach (distinguished from the ED's "simplified retrospective approach")

Full retrospective is seen as theoretically preferable. However, it is recognized that for some preparers, this may be difficult to execute. One particularly challenging scenario is leases that have been acquired in a business combination, where the original information for the lease may no longer be available. Long-lived leases may have similar issues. Therefore, the staffs proposed a modified methodology, where the liability would be calculated as the ED specified (present value of remaining rents, using the incremental borrowing rate at the date of initial application), and the asset would use the same calculation back to inception, then recognize the fractional amount of the lease term remaining.

Transition example (provided in Agenda Paper 2G/203):
(Please note: I calculate slightly different present values, using an HP12C or Excel, than the agenda paper presents. In the example below, I list first their calculation, then my calculation in parentheses with an asterisk.)
10 year lease, payments of 1000 CU (generic Currency Units) yearly in arrears
interest rate of 5.7%
date of initial application: beginning of 5th year (i.e., 6 years remaining)

present value of rents at inception: 7,472 (*7,466)
present value of rents at application: 4,967 (*4,964)
asset at application: 7,472 * 6 / 10 = 4,483 (*4,479)

The difference between the asset and obligation would be taken as a "cumulative catch-up adjustment." I believe this would be booked directly to retained earnings, not recognized in profit and loss. Because of the way the interest method works, every lease (except possibly a lease that has lower rents at the end of its life) will book a charge to retained earnings to be set up, so the cost of reducing the impact to the income statement is increasing the impact on the balance sheet (debt/equity ratios will balloon even further). Pick your poison.

The boards, however, didn't pick their poison. They deferred the decision to next month, asking to combine the decision with transition rules for lessors and subleases.

The staffs also suggested a few simplifications: 1) leases that terminate between the date of initial application and the effective date would not have to be restated; 2) exclude initial direct costs for leases that start before the effective date; 3) allow use of hindsight in estimating such lease characteristics as variable lease payments, renewals, and impairment. These will be considered as part of the entire transition package.

This kind of continued change is why no software publisher can claim to be compliant with the new lease accounting standard yet. It's a moving target. But we'll update EZ13 once decisions are finalized; in the meantime, EZ13 allows you to treat operating leases as capital, either from inception or as of a specified cutover date as specified in the original ED, to estimate what your exposure is.

Tuesday, July 26, 2011

Catching up on June results

June 13 meeting results:

Short-term Lessee Leases

The boards agreed to operating lease accounting for lessee leases with a maximum lease term (including renewal options) of 12 months or less. No asset or liability need be placed on the balance sheet, and rent expense is recognized on a straight-line basis over the lease term. (Lessees may choose to do full finance lease accounting if they wish. How likely is that?) Disclosure of current rent and how representative that's likely to be of the future was discussed.


A head lease and sublease are to be accounted for as separate transactions, using normal lessee accounting for the head lease and lessor accounting for the sublease (using the right-of-use asset as the fundamental asset for the transaction, not the original underlying asset).

June 1 meeting results:

Foreign Exchange Differences and Impairment

Both of these are to be recognized in accordance with existing guidance, which is somewhat different between FASB and IASB.

Residual Value Guarantees

The new standard calls for recognizing only the portion of any residual value guarantee that is expected to be payable, rather than the maximum amount. If there is a significant change in the expected RVG payable, an adjustment is required; the portion that applies to current or prior periods is recognized in profit or loss, while the right-of-use asset is adjusted for the portion applying to future periods.

Second Exposure Draft coming

I need to catch up on the boards' activity over the last two months. I've taken a summer hiatus, but they didn't...

The most important news is that at the July 21 meeting, the boards unanimously decided to release a second Exposure Draft. The changes to the proposed standard from the original Exposure Draft are so significant that they felt it important to get feedback from interested parties. Some decisions remain to be made before the new Draft can be released; they expect to complete those deliberations during Q3, with a new Draft released soon after. The wording seems to suggest that the Draft would come out in early October.

Additional decisions reached this month:

Lessor Accounting

The performance obligation model has been scrapped. All leases (except for short-term leases) will be accounted for using a "receivable and residual" model, which is essentially the same as the "derecognition approach" described in the Exposure Draft. Main points of this model:

* The lessor recognizes a right to receive lease payments (matching the lessee's obligation to make payments) and a residual asset.

* The discount rate to present value the payments is the "rate the lessor charges the lessee" (the internal rate of return, based on the asset's value).

* The residual asset accretes (increases using the interest method, same interest rate) over the lease's life.

* If the asset's carrying amount is lower than the lease's value, a profit (on the portion of the asset represented by the lease receivable) can be recognized at commencement of the lease if reasonably assured.

Short-term leases, defined as those with a maximum term of 12 months or less, will be accounted for as operating leases (no balance sheet effect, just income recognized over the lease term on a systematic basis, usually level). This will protect against needing to do convoluted accounting for things like rental cars and hotel rooms.

Operating lease accounting will also be permitted for leases of investment property measured at fair value. This is currently only available under IFRS (IAS 40). But the FASB is working on a proposed investment property standard which would be similar, with an Exposure Draft scheduled for Q3 2011.

Contingent Rents Dependent on an Index or Rate

While other contingent rents are excluded from the capitalized calculation of leases, those that depend on an index or rate have to be included. An example would be a lease whose rent is based on CPI or LIBOR. Such leases are to be initially measured based on the index/rate at the commencement of the lease, then recalculated at the end of each reporting period using the new index/rate. The change is booked to net income if it applies to the current reporting period, or as an adjustment to the right-to-use asset (for a lessee) for adjustments that relate to future periods. Lessors would recognize an adjustment in the receivable in profit or loss.

This is a potentially significant cause of recalculations on leases; many real estate leases have CPI escalators that adjust every year. The boards decided that the benefit of more accurate presentation of actual rents due outweighs the effort required.

Lessee disclosures

The boards approved a lengthy set of disclosures for lessees:

* Reconciliation of opening & closing balance of right-to-use assets, disaggregated by class of underlying asset
* Reconciliation of opening & closing balance of lease liabilities (no disaggregation required)
* Future rent commitments, similarly to current FAS 13 requirements (by year for five years, then all remaining, then subtracting interest to reconcile to the liability balance). Note that this is different from current IFRS requirements. Preparers would have the option to disclose by year for more than 5 years, if that would provide better information.
* Information about leases signed but not yet started if they create "significant" rights and obligations
* Information about contingent rentals and options
* A table of expenses: amortization, interest, variable payments, and short-term rents, plus a breakdown of principal and interest paid
* Information regarding any expected material changes in short-term rentals

However, they explicitly are not requiring disclosure of discount rates, fair value of liabilities, purchase options, or initial direct costs.

They also explicitly forbid combining interest and amortization expenses and presenting the total as lease or rent expense.

The boards split over whether or not to disclose future commitments for services and other non-lease components; the FASB wants such disclosure (which is already required by the SEC in the unaudited portion of the financial statements), while IASB does not. Presumably this will be reconciled at a later date (perhaps after the Exposure Draft is released and reviewed).

Lessee primary financial statements presentation

Lease right-of-use asssets and liabilities either must be presented separately in the Statement of Financial Position (balance sheet), or shown separately in footnote disclosures. The right-of-use asset is to be presented according to the type of underlying asset (land leases with land owned assets, etc.). They have decided not to define whether the right-of-use asset is tangible or intangible. This is a question that affects some regulated industries for tax and other purposes. The boards have decided to let the relevant regulatory bodies make the determination appropriate to their purposes.

The Statement of Cash Flows would show principal and interest payments in accordance with requirements for other financing. Variable lease payments (not capitalized) and short-term rentals are operating cash flows. New leases (creating a new asset & liability) would be an additional non-cash disclosure.

June meeting results in next post...

Wednesday, May 25, 2011

The pendulum swings again

The big news last month was that the FASB & IASB decided to reinstate a close cousin of operating lease accounting for lessees, with a level expense recognition pattern (though the leases would still be reported on the balance sheet). It was a sharply divided vote. Now, a few members of each board have switched sides, and in another divided vote, the boards have decided to ditch the "other-than-finance" lease category and account for all lessee leases the same way, as finance leases. This means a forward-leaning expense profile (depreciation is equal over the life of the lease, but interest is higher at the beginning of the lease, just like with a mortgage), which many respondents to the Exposure Draft vehemently protested. One reason given was that board members didn't like the options for how to account for the level expense recognition.

The boards also informally voted to eliminate the exemption of short-term leases (12 months or less maximum lease term, including renewal options) from the requirements of the standard that was agreed to in March. However, that will be reviewed and finalized at a later meeting.


In another backtrack that most lessees won't like, the boards have increased the likelihood that options will need to be included in the lease term. In deciding whether to include an option, one must decide if there is a "significant economic incentive" to renew. A prior meeting decided that only economic factors should be considered in this determination (including contract-based factors such as below-market rents or penalties for non-renewal, and asset-based factors such as the existence of large leasehold improvements that would normally be amortized over a longer period). The boards have now decided to include "entity-specific factors," such as historical practice of the company or industry and management intention. The boards noted that a single factor does not have to be determinative, but the door is still opened up to an increase in subjectivity and need for ongoing review.

Lessor accounting

The boards haven't decided if lessors will use one or two approaches to accounting for their leases. So they made decisions for either possibility:

One approach

If all leases are treated the same way, the partial derecognition model will be used, with the residual value accreted over the life of the lease. This is, I believe, basically the same as current finance lease accounting (sales type accounting under FAS 13).

Two approaches

If two methods of accounting are used, leases will be distinguished based on whether the lease transfers substantially all of the risks and rewards incidental to ownership of the underlying asset. This is the concept underlying both FAS 13 and IAS 17. The boards clarified that among the indicators would be comparing rent to fair value and the existence of variable rent (the latter would be an indication that risks have been transferred to the lessee). Existence of embedded or integral services would not be considered in the determination.

For leases that transfer substantially all of the risks and rewards of ownership, the entire asset would be derecognized, with the residual initially measured at its present value and accreted over the life of the lease.

For other leases, the boards could not come to an agreement. The IASB preferred derecognition, while the FASB preferred current operating lease accounting. This will be revisited at a future meeting. (Neither board, though, preferred the Performance Obligation (PO) method that was presented in the Exposure Draft. That seems to be dead.)

Lease modifications

The boards decided that a "substantive change" in a lease agreement would result in treating the modified agreement as a new contract. This applies if the new terms would change the determination of whether the contract is or contains a lease, or the determination of whether substantially all the risks & rewards of ownership are transferred to the lessee. A change in circumstances (not of the contract itself) can cause reassessment of whether the contract is or contains a lease, but not whether risks & rewards of ownership are transferred.

Discount rate

The interest rate used to present value the rents and amortize the principal (obligation or receivable, depending on whether it's the lessee or lessor) will not be reassessed if the lease payments don't change. However, if a lease is extended because an option needs to be included (either because an option is exercised, or it is deemed to be includible because of a newly recognized "significant economic incentive"), the discount rate (which is typically the incremental borrowing rate for lessees) is to be reassessed, using the current rate, and the present value of the remaining rents is then recalculated.

Thursday, April 21, 2011

Lease accounting standard delayed

The FASB & IASB have decided that they cannot complete the new lease accounting standard (as well as standards on revenue recognition and financial instruments) by their target of June 30, 2011. Instead, they will continue to work on the standard into the second half of 2011. The FASB Current Technical Plan page suggests a Q3 final standard, but notes that they expect to release a new Exposure Draft, because of the magnitude of changes from the original Exposure Draft released in August 2010. The boards have not officially committed to re-expose, but if they do not, they will do an enhanced public review, making a draft standard available for review, with outreach to interested parties.

Other decisions made this month:

Contingent (variable) payments: The boards stepped back further from their widely criticized ED proposal to capitalize contingent rents. Now the only contingent rents that are to be included are 1) those dependent on an index or rate, and 2) those that are "in-substance fixed lease payments but are structured as variable lease payments in form." This is essentially an anti-abuse provision; it is unlikely that any normal lease would be affected by this. The boards haven't yet decided whether contingent rents based on an index or rate need to be reassessed when the reference number changes; that will be decided at a future meeting. If they decide not to reassess, it would mean a complete reversion to the current standard.

Definition of a lease: There has been substantial discussion over the requirement for a "specified asset." This month's deliberations concluded that a physically distinct portion of a larger asset (like a floor of a building) qualifies, but a capacity portion (like partial usage of a pipeline) does not. The asset can be explicitly or implicitly identifiable.

Other-than-finance leases: Operating leases are back as a category, with the primary difference being that they will now be on the balance sheet. But on a divided vote (with 7 IASB members opposed, plus 1 FASB member), the boards decided to have two accounting approaches for lessees, with the distinction being basically the same as IAS 17 (the IFRS leasing standard, which is similar to FAS 13 but doesn't use the 75% and 90% "bright lines" to differentiate between operating and capital leases). They're using the awkward term "other-than-finance," presumably because they want to differentiate it from current operating lease accounting, which doesn't hit the balance sheet. Maybe somebody will come up with a better name before the standard is released. Such leases will have their expenses recognized as rent expense in the operating section of the income statement, rather than as a financing activity. The liability will still be amortized using the interest method, but the asset will be amortized so as to keep the combined periodic expense level over the life of the lease.

There will similarly be two accounting approaches for lessors, but the boards reached no conclusions on application.

Wednesday, March 30, 2011

More decisions, summarization so far

The FASB and IASB met again last week to further deliberate on leases. Among the decisions reached:

Start of accounting: A lease may be signed well in advance of when the lessee takes possession of the property (particularly with property, which may need extensive construction before occupancy). The boards have affirmed that the lease does not hit the books until the "commencement" of the lease, which is normally when possession is granted. Payments made between the "inception" (signing) and "commencement" will be accounted for as prepayments (an asset that is then folded into the ROU asset at commencement). If the lease meets the definition of an "onerous contract," it is to be accounted for during the inception to commencement period according to the Contingencies accounting standards: IAS 37 and FASB Topic 450.

Tenant incentives: Lessees are to subtract these from the right-of-use asset.

Sale & leaseback: Rather than a series of tests in the Exposure Draft to determine whether a transaction qualifies for sale and leaseback accounting, the boards have now decided that as long as the sale part of the transaction meets the existing accounting requirements (under the Revenue Recognition standard) to recognize a sale, it qualifies for SLB treatment. In general, if control of the asset has passed to the buyer/lessor, it qualifies. One change from current SLB accounting is that if the seller/lessee has a gain or loss on sale, that is to be recognized immediately, rather than amortized over the life of the lease.

Leases with service components: When the service component is not clearly identified separately in the agreement, the FASB in the ED called for capitalizing the entire contract as a lease (the IASB favored split recognition). Both boards have now decided that if the purchase price of one component (lease or service) is "observable," you can calculate the split based on that.

Discount rate: FAS 13 calls for the interest rate on lessee capital leases to be based on the lease's implicit interest rate, if known, or the lessee's incremental borrowing rate (IBR). In many cases, the lessee doesn't know the lessor's implicit rate, because the expected value of the asset at lease expiration (the "unguaranteed residual") is not stated, so the IBR tends to be used. (The rate may be higher if the present value of the rents using these rates is more than the fair market value; in that case, a rate is calculated to make the PV of the rents equal to the FMV.)

The ED introduced a new term: "the rate the lessor charges the lessee." This is to be used when available, a decision now confirmed. Finally, though, the boards have defined what they meant; this can be (from the observer summary) "the lessee's incremental borrowing rate, the rate implicit in the lease, or, for property leases, the yield on the property. When more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used." The lessor always by definition knows this rate. If the lessee does not, the IBR is to be used.

Initial direct costs: The boards defined this as "Costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made." The intent is to have a consistent definition for a series of standards (including insurance and revenue recognition, which are at similar stages of development), though there may be slight modifications to meet specific needs of the different standards. Any such differences are intended to be explained by the boards, to maintain the overall consistency.

IDCs are to be capitalized by both lessees and lessors, by adding them to the right-of-use asset and right to receive lease payments, respectively.

Summarization: The IASB staff has prepared a detailed description of the impact on the ED of the new decisions by the boards. This describes both the confirmed decisions and the changes, with links to IASB observer notes for each.

Thanks to the IASB for their podcast and to Asset Finance International for their summary.

Tuesday, March 22, 2011

Ownership transfer leases, update

In my March 17 post, I said that it wasn't clear how the scope change affected leases with an ownership transfer. Based on the IASB Update just released regarding last week's meeting, it seems clear that they are also to be considered leases. The boards have decided to simply eliminate the language that took leases with bargain purchase options and ownership transfers out of scope of the leasing standard.

Thursday, March 17, 2011

Purchase options and short-term leases

The FASB & IASB met this week for continuing discussions, on leases as well as other topics. In their meetings on March 14 & 15, they reached the following conclusions for the new lease accounting standard:
  • The ED had scoped out (excluded) leases with bargain purchase options and ownership transfers (also called "in-substance purchases") from the new lease accounting standard, stating that they should be treated as a sale & purchase and handled according to the revenue recognition standard (which is also at the ED stage). However, this decision was left over from when the boards had briefly planned to treat all lessor leases according to the "performance obligation" model, which would have been inappropriate for these transactions. With a derecognition model for lessors now in place, the need to separate out these types of leases is less evident. The boards agreed that leases with a bargain purchase option should be returned to the scope of the leases standard. It's not yet clear if leases with ownership transfer will be considered leases or sales.
  • Relatedly, the boards are adjusting the treatment of purchase options. In the ED, these did not need to be accounted for until exercised. Now, they must be accounted for if there is a "significant economic incentive" to exercise them. It remains to be determined how the accounting will work if the conclusion of a significant economic incentive changes in the middle of the life of the lease (in either direction), though the boards concluded that they would not permit a switch between the "finance" and "other than finance" categories they set up last month.
  • Short-term leases: The boards have decided that leases with a maximum lease term of 12 months or less, including renewal options, can be treated like current operating leases. They will not be shown on the balance sheet for lessees; income and expense will be shown on the income statement as currently (with rent leveling as needed). This will be an option; lessees & lessors can choose to treat short-term leases like other leases. However, the option must be chosen for all leases in an asset class, rather than lease by lease.
Thanks to Deloitte's IAS Plus and Asset Finance International for their reviews of the meetings, which were the basis for this entry.

2015 implementation?

The new leasing standard is one of several major standard revision projects the FASB & IASB have underway. Others include revenue recognition and insurance contracts, which are considered heavily interrelated with the leases, and other comprehensive income, fair value measurements, financial instruments with characteristics of equity, and financial statement presentation, which are considered more independent of other standards.

The boards put out a separate Exposure Draft asking for comments on implementation dates. While the volume of comments wasn't nearly as high as for the leases ED, the consensus response was that the impending changes are major, and financial statement preparers need substantial time to update their systems. At the boards' combined March 2 meeting, the boards didn't decide whether to implement the three linked standards (leases, revenue recognition, and insurance contracts) at the same time or in staggered order, but stated that they "will provide adequate time for stakeholders to apply the new requirements." Several members of the IASB stated a preference for 1/1/2015 as the implementation date, while most FASB members didn't want to make a commitment to a date at this time, and several expressed a preference for a staggered implementation.

Note that since U.S. companies typically report two years of comparables, and the leases ED says those comparable years will need to be restated on implementation, that means that effectively companies would need to apply the standard effective 1/1/2013, even though they wouldn't be reporting the results accordingly until later. It's not clear yet whether earlier implementation will be encouraged or permitted.

Wednesday, February 23, 2011

They hear you

Anyone who had any doubts that the FASB and IASB seriously consider responses received during their "due process" steps need only look to last week's meetings and the decisions reached on lease accounting. In addition to the previously reported complete reversal on the lease term, the boards have made an almost complete reversal on contingent rents, and are planning to substantially alter the standard to respond to the desires of those who want level recognition of expenses over the life of a lease. These three topics were probably the most strenuously argued in comment letters to the Exposure Draft.

The boards aren't backing down on putting lessee leases on the balance sheet. But they're showing that they are willing to work with preparers and accountants to make the standard more workable and less onerous.

Contingent rents

The Exposure Draft called for all contingent rents to be included in the capitalized lease payments using a probability-weighted estimate, based on a "reasonable number" of estimates. Rents based on an index or rate were to use forward rates when "readily available." Estimates would need to be revised as often as once a quarter, with changes in future rents booked as upward or downward adjustments to both the asset and the obligation (changes affecting current or prior periods would be immediately expensed).

Preparers howled. The work involved would be enormous, and would often involve forecasting well beyond normal planning horizons (a 20-year lease with a percent of sales kicker would require forecasting sales out that far, when few companies go past 5 years in their regular forecasting). The requirement for quarterly reassessment, even if softened by stating there needs to be a "significant change," would add measurably to the load of releasing statements. Much of this could not be automated, because contingent rents have immense variability in terms.

The boards have now almost completely reversed themselves. The new plan agreed to last week is that contingent rents need to be included in the capitalized rent stream in just the following cases:

* they are based on an index or rate--and in that case, the current rate is used, with no use of forward rates, though it will need to be updated each reporting period (unlike current GAAP, where the rate at lease inception is used throughout the life of the lease)
* they are "reasonably assured," with the definition to be determined later
* the base rent is below market rates

Other contingent rents will be subject to disclosure, but not capitalization.

Expense recognition pattern & placement

Many respondents to the ED complained about the income statement effect of capitalizing all leases. They didn't like two different aspects of this:

* Amortizing the obligation using the interest method, while amortizing the asset on a straight-line basis, means that expenses are greater in the early months & years of a lease, then decline over time.
* Lease payments and interest expense would classified as financing activities. Both interest and depreciation expense are excluded from EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an important measure of earnings for many companies.

Those who objected felt that level expense recognition was more reflective of economic reality, and that leasing should be considered operational rather than financing activity.

The boards concluded that there are two types of leases. Some leases truly are financing transactions (such as most current capital/finance leases). For those, the boards believe the current plan of interest and depreciation is appropriate. But others, they conclude, do not have a strong financing component, and a level expense pattern would be more appropriate.

Can you say "classification"? One of the big reasons for the new lease accounting standard was supposed to be eliminating classification of leases into two types, because of the concern that similar leases are being accounted for differently (those just on either side of the dividing line). The stories about leases with a present value of 89.9% of the fair value (just below the 90% line that makes a lease capital) have been around for a long time. Just because the bright lines are going away doesn't mean that there won't be structuring.

But the boards seem to be accepting that different reasons for leasing merit different accounting treatment. They may also be swayed by the fact that different ways of recognizing expenses can have collateral impact--companies that depend on expense reimbursement from government medical and other contracts, for instance, noted that rent expense is often reimbursable, while depreciation and interest on debt are not. They may also be concluding that the effect of possible structuring in these cases isn't as egregious as making things disappear entirely from the balance sheet.

Of course, once you say that there are two types of leases, the question becomes, how do you tell which is which? The new standard is supposed to be "principles based" rather than "rule based," so we won't have a 90% or 75% test. Instead, the boards are looking to prepare a list of factors which would be considered. Some of them are (a) residual asset, (b) potential ownership transfer, (c) length of lease term, (d) rent characteristics, (e) underlying asset, (f) embedded or integral services and (g) variable rent (thanks to Deloitte for its notes on the meeting that had this list). The boards will be discussing in the future how these factors interact, as well as proper presentation of leases considered "other than financing."

Lease vs. Service Contract

The boards spent considerable time continuing to try to differentiate between leases and service contracts (when a contract has elements of both). One conclusion they reached is that if an asset is incidental to a service, it doesn't have to be accounted for separately. (So, for instance, when you get a cable TV subscription that includes a cable box, the box doesn't have to be treated as a lease.) They also tentatively decided that the requirement for a specified asset is still met if the lessor has the right to swap out an equivalent item assuming no disruption of service (such as replacing a copier with another of the same model).

Most discussion was focused on lessee accounting. The boards have decided to discuss that primarily at this point, with the intention to get back to lessor accounting to keep things as symmetrical as possible.

A number of the decisions and issues will be reviewed with preparers, users, and accountants, with a report back to the boards at a later date.

Thursday, February 17, 2011

"More likely than not" is dead

At yesterday's meeting (Feb. 16), the IASB and FASB agreed to withdraw the proposal to include lease renewal options in the lease term when judged "more likely than not" to be exercised. This was the proposal in the Exposure Draft, which was almost universally opposed by respondents, particularly preparers of statements. Asset Finance International's summary of the meeting notes in addition to complaints of difficulty of implementation and subjectivity, another persuasive argument for board members was that real estate lease renewals frequently are not actually implemented as stated in the original option, but are subject to negotiation like a new lease, so the stated option doesn't necessarily reflect what the terms will be even if "exercised."

Rather than reinstating current terminology on when to include options (when "reasonably certain" or "reasonably assured" of exercise due to various economic factors), the boards have tentatively chosen the phrase "clear economic incentive." The boards didn't seem to think there was a substantial difference in impact, so it seems to be more a stylistic choice.

Reassessment of lease terms, which previously was required on a quarterly basis, is now to be required only when there is a significant change in circumstances, such as an addition or removal of a "clear economic incentive" on a renewal option.

Contingent rents will be discussed today.

Wednesday, February 16, 2011

ED response reviews

Deloitte & Touche has released a "Heads Up" summary of responses to the lease accounting exposure draft.

Asset Finance International (an association of lessors primarily focused on Europe) has its own summary.

Thursday, February 10, 2011

Death knell for "more likely than not"?

The IASB & FASB will be meeting next week. On the agenda on Feb. 16 meeting: the definition of the lease term. The staff briefing paper for the discussion, noting the almost universal rejection of the proposal to include lease options in the lease term if they are judged "more likely than not" to be exercised, recommends that the lease term be defined essentially the same way as it is now under both IAS 17 and FAS 13: the contractual minimum, plus options that are reasonably certain to be exercised. The staff's recommendation is that "reasonably certain" be determined solely on economic factors (such as bargain renewal options, penalties for cancellation, presence of long-lived leasehold improvements, etc.), with no weight given to past practice or management intention, which the majority of the staff considers too subjective. They do list that as an option for the boards, though, along with keeping the "more likely than not" criterion.

Given the vehement rejection of "more likely than not" in the comment letters and other outreach activities, this was, I think, expected by most observers. But assuming it comes through, it'll be a very clear indication of the significance of participating in the boards' due process.

Also on the agenda for the boards' meetings next week is variable (contingent) lease payments.

The majority staff position is that only contingent rents dependent on an index or rate should be included in the lessee's liability to make payments, with the valuation based on the prevailing (spot) rate. A minority would add all payments that are "probable" or "reasonably certain." Additional disclosures would be required, but those won't be discussed at this meeting.

This is again a pretty thorough repudiation of the Exposure Draft, which called for probability-weighted estimates of all contingent rents, including those based on usage and percentage of sales. Combined with the original proposal to include "more likely than not" options, it raised the potential of needing to estimate business and economic conditions for 50 years, an exercise that was unlikely to bear any significant connection to reality.

With these two changes, the complexity in the ED is greatly reduced. There is still the inherent complexity of capitalizing the leases, but that's far less challenging to deal with.

Tuesday, February 1, 2011

EZ13 data entry tips #2

See yesterday’s blog entry for information on how to copy a lease, create escalating rents, or create the full series of rents for level principal payments.

Date entry

While you can enter a date by typing it in with slashes, exactly as shown, there are other options.

  • Click on the down arrow next to a date to display a calendar (on the calendar, click on the month or year to change them, or the left or right arrow to go back or forward a month).
  • Click on one portion of the date (month, day, year) and press + or – to add or subtract one to that number (note: this cycles without affecting the rest of the date, so if you highlight the day on 1/31/2011 and press +, the date changes to 1/1/2011, not 2/1/2011).
  • You can enter just the last two digits of the year; EZ13 guesses the century, based on the setting for your computer. By default, the window is 1930-2029. You can change it in the Regional Options of Control Panel. (Control Panel, Regional & Language Options, click on Customize, click on the Date tab, change the end date of the window.)
  • You can use letters with the same meaning as Quicken/Quickbooks assigns to them:

Y, R - beginning or end of YeaR

M, H - beginning or end of MontH

T - Today

F - Forward one day

B - Back one day

All of these (except T) are cumulative: for instance, if you press Y when at the beginning of a year, the date moves to the beginning of the prior year.

F and B are different from Quicken, which uses + and - for the same purpose.


Context-sensitive help is available throughout EZ13. If the cursor is in a field when you press F1, you get a description of the field and what to enter there. If a different window is displayed, information about that window is provided. Virtually the entire manual is found in the help screens.

Monday, January 31, 2011

EZ13 data entry tips #1

One of my intentions for this blog has been to provide usage notes for EZ13, FCS's lease accounting software for capital and operating leases, but I’ve ended up generally more focused on what’s happening with the FASB & IASB as they revised the lease accounting standard, because so much has been happening in that regard. Today, though, I’m going to take a moment to offer some tips on using EZ13.

There are a number of features designed to make entry of leases faster and more convenient, but many of them aren’t necessarily obvious. (They're described in the documentation, but I harbor no illusions about how much documentation is read.) I’m going to go through a few of these today:

Copy a lease

You may have several leases that are the same or almost the same (several copiers leased at the same time, for instance). EZ13 allows you to copy all the data entered for a lease to create a new lease record. Use menu item Lease/Copy; all the information from the current lease is copied to the new record, except only for the lease number (since that must be unique).

Rent Escalation clauses

Many real estate leases call for an automatic increase of rent every year or every 5 years. The increase might be a percentage or a dollar amount. (Note that if the increase is based on future events, such as the change in the Consumer Price Index, that’s considered contingent rent, and only the base rent is considered minimum lease payments for FAS 13 reporting purposes; the contingent rent is simply expensed when incurred.) Rather than needing to calculate and enter each rent amount, EZ13 allows you to specify the base rent, the increment (in dollars or percent), and when the change happens. You can separately specify the executory cost, which might remain the same or change with a different increment. Use menu item Lease/Rent Escalation. Note that the rent escalation period does not have to cover the entire life of the lease.

Level Principal Rent

Relatedly, some leases are set up so that the same amount of principal is repaid with each lease payment. Since the interest is constantly decreasing as the principal decreases, this means that each rent payment is different. Entering that for a 36- or 60-month lease can be pretty tedious! EZ13 can set up the full set of payments using menu item Lease/Level Principal Rent, you just enter the initial principal, interest rate, and length of the lease (with an option for additional fixed rent, such as a service charge that's added to each payment, and executory costs).

I’ll describe some additional input convenience features tomorrow.

Friday, January 28, 2011

First redeliberation session

The IASB & FASB met in joint session last week. On the agenda, as previously noted, was the first round of reconsideration of the new lease accounting standard, reacting to the responses received on the Exposure Draft.

The separation of leases from service contracts is a major issue, including the question of service contracts that include physical assets. One example is a cable TV subscription; if the cable company gives you a cable box, does that make the whole transaction a lease rather than a service? Does the box need to be accounted for separately as a lease? Or should some small amount of physical assets be ignored in this situation? (How small?)

The boards also discussed whether all leases should be considered a form of financing (which merits the accounting proposed with delinked asset and obligation), or if some aren't really financing and should be recognized with a straight-line expense/income pattern.

Lessor accounting was also discussed in detail. Some respondents suggested putting off lessor accounting, but the boards agreed to keep discussing both sides of the transaction, particularly issues that are relevant to both. There is a wide range of views on whether there ought to be one or two kinds of lessor accounting, and if one, which one, though the boards seem to have considerable sympathy for the idea that there are two different business models for leasing that ought to be accommodated.

A number of respondents complained about the lack of symmetry between lessee and lessor accounting (sauce for the goose, sauce for the gander?); the boards directed the staffs to consider two approaches to accounting for both lessors and lessees, one based on the financing concept and the other using straight-line recognition. (One challenge, of course, will be how to differentiate.)

FASB Chairman Leslie Seidman held a webinar on Jan. 25, providing her views on what the board is doing. She noted that the count of comment letters on the lease accounting Exposure Draft is now over 750. She sees general agreement with the concept of placing lease obligations on the lessee balance sheet, but recognizes that many are concerned about the complexity of the current model, especially with regard to options and contingent rents. She also noted that there is "general disagreement" with the front-loaded expense pattern as it affects leases that are currently considered operating, and the classification of the expense in financing rather than operating activities. While she didn't officially back off from a June 30 due date for this and the other current projects, she noted that the boards have been stating that the target dates are subject to the nature and extent of the feedback received. Their goal is standards that are understandable and implementable at a reasonable cost, and "if it takes a little longer to reach that comfort level, we will take that time."

In the webinar's Q&A period, someone asked how the FASB decides when to re-expose a standard if changes are made from the exposure draft. She said their general question is: How significant are the changes from both the original exposure draft and from current accounting? The implication is that if their new plan is significantly different from both an ED and current GAAP, they would re-expose. It is, of course, too soon to tell whether that would happen to the lease accounting standard.

Friday, January 14, 2011

Redeliberations starting, comment letter summary

The FASB & IASB will have a joint meeting in London on Wednesday, January 19, when they will begin to discuss comments received on the Exposure Draft, and their plan for redeliberations. On Wednesday and Thursday, they will discuss 1) distinguishing leases from services, and 2) lessor accounting. They are not planning to make decisions on those topics.

The IASB meeting page for January has agenda papers for the leases discussions. These include a list of the major issues that the staffs feel should be thoroughly reconsidered, and a secondary list of additional possible issues for reconsideration. Five major issues are noted:

1) Definition of a lease (particularly differentiating from service/executory contracts)
2) Lessor accounting model
3) Lease term (i.e., when to include renewal options)
4) Variable lease payments (i.e., contingent rentals)
5) Profit & loss recognition pattern (whether asset amortization should be adjusted so that overall expense/income for leases is straight-line rather than front-loaded)

A laundry list of other items is listed as potentially needing reconsideration, including scope exclusions, short-term leases, foreign exchange, disclosure, fully retrospective application, lease incentives, and leasehold improvements, among numerous others.

The staffs' comment letter summary notes the "very high" number of responses (760 letters as of Jan. 12), and the fact that the boards have had contacts with several thousand people through various outreach activities. They note that very few financial statement users sent in comment letters, but outreach events included over 500 users.

The summary indicates that almost all comment letter writers disagreed with defining the lease term as the longest possible term more likely than not to occur. Respondents generally suggested either the current standard of including options that are "reasonably assured/reasonably certain" (current US GAAP/IFRS terminology), or "virtually certain" (seen as an even higher threshold), or the Alternative View listed in the IFRS Exposure Draft, to include options only when there are incentives to exercise those options.

The summary indicates likewise almost total disagreement with the contingent rent proposal. Alternative approaches suggested included 1) capitalizing only contingent rents based on an index or rate, 2) including only those that are outside an entity's control, or 3) using a different estimation approach (such as "best estimate" rather than "expected value" with multiple scenarios).

The summary is 70 pages long, so trying to fully recap it here would be tedious. Suffice to say that every question that the boards asked in the ED received lots of comment, with numerous alternatives presented.

Over half of the respondents were preparers of financial statements, with sizable numbers of industry organizations, individuals, and professional organizations. Half came from North America, a bit more than a quarter from Europe. The largest industries represented were financial services (almost 1/4), retail, real estate, and transportation.

Tuesday, January 11, 2011

Volume of comment letters

How does the volume of comment letters on the proposed lease accounting standard compare to other recent exposure drafts? The following list may be of interest:

Leases: 746 (and counting)
Fair value measurement: 95
Comprehensive Income: 72
Accounting for Financial Instruments: 2814
Derivative Instruments and Hedging Activities: 127
Amortised Cost and Impairment: 179
Revenue Recognition: 971
Troubled Debt Restructuring: 117

So leases isn't the biggest, but it's up there.

"It's not a done deal."

That was the statement of Larry Smith, FASB board member, at last Thursday's (Jan. 6) afternoon roundtable discussion on the proposed new lease accounting standard. He was responding to one participant's comment that people in the leasing industry he's talked to thought there was no point in submitting a comment letter or otherwise participating in the boards' outreach activities, because they thought the standard was "a done deal" and the process was just for show. Smith was emphatic in denying that. New FASB Chairman Leslie Seidman concurred, adding, "I've already decided that I will change my position on one or two matters," and suggesting that she may make further changes based on additional review of the comment letters and discussion with interested parties.

The count of comment letters is now up to 746 (including letters received after the deadline, which are still being posted to the FASB website). I can't possibly read them all (I need to do my real job), but members of the FASB and IASB staff are. I spoke to one of the FASB staff who is personally reading every single comment letter on lease accounting, and commented that the letters are substantive (and lengthy); they're impressed by the thoughtful responses presented. I'm sure it'll be a few more weeks before they have compiled a summary for the boards, and the boards can begin redeliberations.

I attended the Thursday afternoon roundtable as an invited participant. Other participants included representatives of KPMG and Ernst & Young, lessors Xerox and International Lease Finance (one of the largest aviation lessors in the world), the CFA Institute (financial analyst, and thus a user of financial statements), Toys R Us, Transocean (the world's largest drilling rig operator, unfortunately now infamous as the driller of the BP well that blew up last year), and consultants to the leasing industry. Also present were all five members of the FASB board, as well as two IASB members and several staff members from both boards.

We had four planned topics of discussion: the definition of a lease, the lessor accounting model, the lease term, and variable lease payments (i.e., contingent rents). Most of the discussion of the definition of a lease centered on the distinction from service contracts. It was noted that the line is sometimes fuzzy even today, but because operating leases and service contracts are accounted for relatively similarly, differentiating them isn't a significant issue. With capitalization of leases, the difference becomes much more significant. Transocean is concerned that they may be seen as lessors, which they haven't been up to now, for contracts which include use of a drilling rig, but provide full crew and other services. Airlines similarly may lease aircraft with crew & maintenance included (a "wet lease") or just the aircraft alone ("dry lease"). Aviation lessees and lessors are concerned that fully capitalizing a wet lease will reduce comparability. No consensus was reached about how or whether to divide services and leases.

We also briefly discussed whether the scope exclusion for "in-substance purchases" should be maintained, with some feeling it was a leftover in the proposal: it was set up when the boards were planning to provide only a performance obligation approach to lessor accounting, and lessors wanted a way to recognize up-front profit if they were effectively selling an asset. With the inclusion of the derecognition model, there seems to be less reason to have a separate methodology for in-substance purchases.

For the lessor accounting model, some prefer performance obligation, some prefer derecognition, and some see a place for both. But a number of participants essentially felt, "If it ain't broke, don't fix it." They don't see significant problems with current lessor accounting, and suggested essentially keeping it in place, with removal of FAS 13's "bright lines" differentiating capital and operating leases (i.e., using IAS 17 terminology of "the lease term is for the major part of the economic life" and "the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset"). The boards seemed to be willing to seriously consider that. Some participants noted that it was important to make this a long-term rather than interim decision (i.e., don't just tweak it until they can revisit it in a few years; if a change is required, do it now).

We spent long enough on these topics that our discussion leader (the FASB staff project manager for leases) decided to combine the issues of the lease term and variable payments, feeling they were in many respects similar. I agreed; in both cases, the boards are calling for capitalization of amounts that don't meet their own definition of a liability. We discussed the operational difficulty of making and updating the estimates for portfolios of thousands of leases. One FASB board member brought up a suggestion, apparently received in another venue, of doing the estimates on a whole portfolio basis rather than lease by lease. Roundtable participants felt that would not be workable, since in many cases there is wide variation in types of leases or characteristics of leases (real estate leases in particular are rarely cookie-cutter). The accountants also felt that such estimates would not be auditable.

The financial analyst expressed interest in an "expected value" approach, but other participants were extremely negative about booking, for instance, fractional lease terms (like a 7.2 year lease for a 5-year lease with several yearly renewal options). I argued that there is a qualitative difference between a 15-year lease and a 1-year lease with 14 yearly renewal options, since the lessee has the flexibility to walk away with no penalty. The current proposal makes those look identical if the renewals are judged "more likely than not," which penalizes the lessee and understates the lessor's risk of nonrenewal (and a nonrenewal would inevitably result in a substantial hit to the lessor's income statement, meaning potential for substantial earnings volatility). Options aren't "structuring;" they provide choices.

For contingent rents, a best estimate was seen as more tolerable than the current "reasonable number of estimates" (what's a reasonable number? does the norm vary from country to country?), though still all the participants in the room other than the analyst were opposed to capitalizing most contingent rents as well as the "more likely than not" threshold for including renewal options in the lease term. People were also opposed to using forward rates to estimate contingent rents that are based on an index or rate, considering it needlessly complex (do you use a different estimated rate for each monthly payment out five years or more?).

The three hours went quickly. Larry Smith of the FASB commented at the end, "We will take time." While the boards' goal has been to complete the project by June 2011, he said that has always been subject to the extent and nature of comment letters and other outreach responses, and they will extend the schedule if needed to properly respond. Their goal is a "comprehensive, converged, improved, and able to be implemented standard."

I definitely felt the board members were listening with open minds. It remains to be seen how they will balance the various perceived needs, and the varying purposes of leasing. One of the fundamental issues they're dealing with is that sometimes leasing is equivalent to purchasing an asset (a computer lease is perhaps the best example, given the short economic life of a computer), while at other times it's closer to provision of a service (a copier lease with low fixed charges and a per-page price). A methodology that provides comparability to one form doesn't work well for the other. But there are so many gradations between that it's hard to define a principle, any more than a bright line, that differentiates them.

Many people are concerned that whatever change the boards make will mess up their current business operations. Yet doing nothing means that true liabilities of a company are largely hidden (as the financial analyst put it, "Disclosure is not enough"). I don't think the boards will back down from requiring lessees to capitalize virtually all leases. But the rest of the standard is certainly in question, and the deliberations this spring are likely to be lengthy and contentious. Stay tuned!