Monday, September 17, 2012

Pushback, and pushed back

Opposition to the Revised Exposure Draft (RED) of the lease accounting standard is starting to build. Asset Finance International is reporting that the FASB's Investors Technical Advisory Committee (ITAC), at a meeting on July 24, unanimously disagreed with the boards' new approach to lease accounting, though the committee split three ways on their preferred methodology (capitalize all leases using the current methodology, use the new SLE (straight line expense) methodology for all leases, or keep current accounting but with more disclosure). "At the meeting FASB chairman Leslie Seidman acknowledged: 'I can hear that none of you think that we got it right.' "

Bill Bosco, a well-known leasing consultant and member of the boards' Leases Working Group advisory group, sent the boards a letter disagreeing with the proposals as well, though for different reasons. He is particularly concerned with the disparate treatment of equipment and real estate leases.

ELFA, the primary trade organization for equipment lessors in the U.S., has also weighed in with an unsolicited comment letter to the boards. They had been broadly in favor of the idea of revising the lease accounting standard, particularly to put leases on the lessee's balance sheet, but now are considering withdrawing support of the proposed standard, primarily because of the standard's presumption that virtually all equipment leases are essentially purchases (and thus merit finance lease accounting).

The boards are meeting this week to discuss sale/leaseback details (in particular, how to coordinate lease accounting with revenue recognition accounting to make them as consistent as possible), as well as handling impairment of SLE leases, whether to allow another systematic basis other than straight line, whether finance vs. SLE classification is subject to revision after commencement, and how to handle classification of a sublease.

The documents posted for this week's meeting indicate that the delivery date for the RED has been pushed back to first quarter 2013. It was previously expected in November.

Thursday, July 19, 2012

It's a wrap, finally

On July 17, the IASB & FASB met to make their last decisions before releasing a revised exposure draft (RED) for the new lease accounting standard. The following decisions were reached (according to meeting notes posted at IASPlus):

Lessee accounting

Statement of financial position (balance sheet)

Assets and liabilities for the two types of leases (finance, also called "interest and amortization" or I&A, and straight line expense (SLE)) will be reported separately, either on the SFP itself or in disclosure notes. Assets are to be presented based on the type of underlying asset.

Statement of cash flows

Cash paid for SLE leases will be reported as an operating activity. It was previously decided that cash paid for I&A leases will be reported as a financing activity for the principal portion, and in accordance with applicable IFRS or US GAAP standards for interest (IFRS permits it as either operating or financing, while US GAAP puts it in financing).

Several board members expressed interest in additional disclosure of cash paid for leases that would distinguish I&A, SLE, short-term leases, and variable lease payments. The staffs will review this and potentially provide a future staff paper for board action.


The maturity analysis (future rent commitments by year for at least 5 years, then combined to expiration) will not be separated between I&A and SLE leases. This was justified by the fact that the liability is calculated the same way for both types of leases. The FASB had previously decided that commitments for services and other non-lease components need to be disclosed; the FASB decided that this disclosure will also be a single report for all leases, not separated between I&A and SLE.

Reconciliation of the opening & closing balances on liabilities will be separated between I&A and SLE leases, because the liabilities themselves are being reported separately.

On the asset side, the boards disagreed. The FASB chose not to require a reconciliation at all. The IASB chose to require separate reconciliations for I&A and SLE leases.

The staff recommended a disclosure table for lease expenses, including amortization and interest for I&A leases, variable lease payments, short-term lease payments, SLE, principal & interest on I&A leases, and SLE cash paid. The boards thought this was overload, and decided only to require disclosure of variable lease payments.

Transition: SLE lease asset

The boards previously changed their approach for transitioning existing operating leases to the new regime: in the original exposure draft, they planned to make the asset and liability equal at the date of initial application, but because that would have front-loaded expenses for all leases, they decided to switch to a "modified retrospective" approach which results in an asset value largely similar to what one would have restating from inception (see my discussion of the details here). With SLE leases, however, front-loading isn't an issue, so the boards approved using the original methodology with the asset and liability equal at the date of initial application (though with an option for a fully retrospective application, which is also permitted for I&A leases). If there's a deferred rent liability/asset due to unequal lease payments, that is applied to the asset.

Lessor accounting

The boards decided that when a lease is terminated early and the lessor takes back the asset, the remaining receivable and the residual should be combined and set up as a re-recognized asset. No gain or loss would be reported on the transaction (though impairment might separately be recognized, if the remaining receivable that's being reclassified is less than the fair value of the leased portion of the asset plus any penalty payments made).

Interim disclosure

For both lessees and lessors, the boards decided that generally interim disclosures (that is, disclosures required during interim reporting periods, such as quarterly reports for US companies) should be handled consistently with existing standards (IAS 34, US GAAP Topic 270, and SEC Regulation S-X, Rule 10-01). However, an additional disclosure for lessors to detail components of lease income was approved. The FASB approved the proposal as presented by the staffs; the IASB preferred to permit a single lease income number in some cases. This leaves a rare non-convergent situation to be dealt with in the post-RED redeliberations.

Next steps

This isn't quite the end of the decision-making process. The FASB will be meeting next week to discuss a few FASB-only issues.

With these decisions complete, the staffs will now assemble all the "tentative" decisions into the form of an exposure draft. The draft will then be circulated to the boards to make sure it accurately reflects the decisions reached, then released to the public. The expectation is that it will be released during Q4, probably in November. There will be a 120-day comment period, which thus would be expected to end in March 2013 (though that might get tweaked because it falls in the middle of annual reporting for companies on a calendar year basis). Once that's complete, figure a month or so for the staffs to compile the results of the comments, so probably in May the boards will start their review and redeliberations. One can expect that there is still going to be some controversy over the decisions, so redeliberations will probably take a few months. At the meeting, two members of each board indicated an intention to dissent from the exposure draft, with an additional member of each board considering dissent; concerns included complexity and cost/benefit, exclusion of variable lease payments, insufficient disclosure, maintaining two types of leases when unified accounting was a key objective originally, and inconsistency between lessor accounting and the concurrent revenue recognition project.

If there are no significant changes, it may be possible to get the final standard approved in 2013, but it would seem to me it's not likely to be out until late in 2013. Given that, it seems almost certain that implementation would be required for 2016 (with restatement of prior years going back two years for most U.S. firms). That makes a total of just under 10 years from the time the project was announced in July 2006 to final implementation; the original plan was to have the final standard released in 2009, with implementation in 2011.... In a webinar today (July 19), the staff indicated that they expect that earlier implementation will be permitted, while non-public entities may get additional time for implementation.

Thursday, June 14, 2012

Two expense profiles

At the joint meeting of the IASB & FASB yesterday (June 13), the boards came to an agreement on the expense recognition patterns for lessee leases to be presented in the Revised Exposure Draft (RED). (My thanks to Asset Finance International for their summary of the board meeting.) If you're looking at the meeting papers prepared by the staff (available here), the choice made was for Approach 3, meaning that some leases will be accounted for using current finance/capital lease accounting (recognizing interest and depreciation expense, with the effect that expenses are higher at the beginning of the lease), while others will be accounted for with a single lease expense item which is recognized straight line over the life of the lease. If the rent payments are equal over the life of the lease, the asset and liability balances will be equal at any date. If they are unequal, the adjustment required to balance cash rent vs. accrual expense (what is shown under current operating lease accounting as a deferred rent liability) will be taken to the asset. The asset will also be adjusted for any initial direct costs or impairments, both of which are to be recognized over the life of the lease (or remaining life, for an impairment).

The second decision was where to draw the line between the two types of expense recognition. The boards opted for Option 3 (as described in agenda paper 3D/237):

(a) Leases of property (defined as land or a building – or part of a building – or both) should be accounted for using a straight-line presentation in the income statement ... unless:
(i) The lease term is for the major part of the economic life of the underlying asset; or
(ii) The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

(b) Leases of assets other than property should be accounted for under Approach 1 [finance accounting] ... unless:
(i) The lease term is an insignificant portion of the economic life of the underlying asset;
(ii) The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

The boards' push for convergence was in evidence in the voting. A solid majority of the IASB preferred a single methodology for all leases, using finance lease accounting. However, members of the FASB very strongly felt that straight line expensing was a necessary part of the standard, and the IASB agreed in the interest of having a common standard.

The implications are that virtually all equipment (except leases of 12 months or less, which have previously been excluded from the standard and will be treated like current operating leases) will use finance accounting, while the vast majority of property leases will use straight line accounting. Only when a property lease is for nearly all of an asset's useful life (or there is an ownership transfer or bargain purchase option) will finance accounting be used. We'll have to see how this sorts out in practice, but this probably means that a lease of a building for less than 30 or 40 years will use straight line unless there are very special circumstances.

Lessor accounting

Having made that decision, the boards discussed the implications for lessors. Since they previously decided that lessors of "investment property" could use operating lease accounting, and this would cover virtually all property lessors, the focus was on equipment lessors. The boards decided that they would use accounting more or less symmetrical with lessee accounting, so the "receivable and residual" model will apply to equipment leases unless the lease has an "insignificant" term or receivable. This is similar to current capital lessor accounting, but with the benefit to lessors that they are permitted to recognize a portion of profit at inception (proportional to the value of the receivable compared to the residual), whereas currently profit is recognized over the life of the lease.

Next steps

There will be some wrap-up decisions to make at the July joint boards meeting, related to the RED comment period, transition, and disclosure adjustments. After that, the staff will prepare the RED, with the expectation that it will be released in Q4 2012. (If no further hitches come up, early in the quarter would seem likely.) With an expected 4-month comment period, then time to redeliberate based on comments received, a mid-year 2013 release date of the new standard seems possible, unless there's strong pushback. However, the boards seem to have met the biggest objections, so I think any changes this time around are likely to be modest (tweaks of wording, adjustments of disclosures, etc.), not the wholesale rewrite that we got between the original ED and the RED.

At this point, I wouldn't expect an effective date before 2016, to allow companies time to update their systems and gather any needed information. However, the requirement to restate prior years remains, so U.S. companies will generally need to recalculate 2014 & 2015 when they first apply the standard in 2016. If early implementation is permitted, the recalculation period would move forward commensurately. In other words, 2016 isn't that far away.


Here at Financial Computer Systems, we're finishing up the latest update of EZ13, which will be released this summer. We won't have the new level expense capital methodology in that version, but will be working on it later this year. We'll have it in place, including transitions from current accounting, long before implementation is required. We do right now provide for pro forma capitalizing operating leases according to current capitalization rules, so you can see what your balance sheet exposure is under the RED.

Thursday, June 7, 2012

"We need to be ready to make a decision"

The FASB & IASB had separate "education sessions" on June 6, to review the materials the staffs have prepared for next week's joint meeting regarding the new lease accounting standard (and other projects). The FASB session is available here; the discussion on leases starts at about 1 hour, 30 minutes in from the beginning. You can view the IASB session by clicking on the "Register" link on this page. The discussion won't make a lot of sense without having the agenda papers available to look at; those are available here (right-click to download the zip file).

The staffs have, as directed by the boards last month, prepared three possible approaches for expense recognition:
  1. The current plan: All leases are treated using current finance lease accounting.
  2. What was called "Approach D" last month: level expense recognition, with the asset and liability linked throughout the life of the lease (if rent payments are equal throughout the lease life, asset and liability will be equal at all times).
  3. A combination of the two approaches, with the necessity to decide which leases need which treatment.
More information was provided about Approach D, now Approach 2. It hadn't been clear last month how to account for leases where the rents change over the life. I speculated that there might be a deferred rent liability, as with current operating lease accounting. Now the staff has clarified that such adjustment should be recognized in the asset, rather than in a separate account. Other adjustments to the asset could also result in assets and liabilities being unequal, such as initial direct costs (added) or impairments (subtracted).

If Approach 3 is desired, then the boards need to decide where to "draw the line" to determine which leases get which treatment. Four options were presented:
  1. Finance lease accounting when the lease transfers substantially all the risks and rewards of ownership (the language used currently in IAS 17, which is also the concept behind FAS 13; the determination, however, would be made using IAS 17 principles, rather than FAS 13's "bright lines" of 75% and 90%).
  2. Finance lease accounting when the ROU asset represents the acquisition of a more than insignificant portion of the underlying asset.
  3. Determination based on the nature of the underlying asset:
    • Property leases would use Approach 2 (straight line) unless the lease term is for the major part of the economic life of the underlying asset or the present value of the rent accounts for substantially all of the asset's fair value;
    • Equipment leases would use Approach 1 (financing) unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the rents is insignificant relative to the asset's fair value. 
  4. Determination based on the lessee’s business purpose for entering into the lease arrangement.
Most of the FASB board members (at least 5 of the 7) felt that it was appropriate to draw a line, considering that there are different purposes and intentions for different types of leasing transactions, and that it is appropriate to recognize those. Outreach indicated that virtually all property lessees see their transactions as generally not having a financing component; they see it as simply gaining use of an asset for a period of time. Equipment lessees are more split; some deny a financing component, but major aircraft lessees admit that that's part of the transaction.

Option 4 seemed to have the least support; while it seemed superficially to allow preparers to account for their actual intentions, there was substantial concern of gaming the system and a lack of comparability between different companies. Options 2 & 3 were seen as effectively the same, simply stated differently; Option 2 might be seen as more principles-based, while Option 3 is perhaps easier to put into practice. Some thought that Option 1 would be the simplest to apply, since everyone is familiar with the concept already; however, that would result in most aircraft leases getting straight-line rather than finance accounting, which was troubling. (Aircraft operating lease accounting is a poster child for the need for a new lease accounting standard.)

One board member indicated that he thought in-substance purchases were scoped out of the new lease standard. That's news to me; it had been discussed at one point, but I thought that was long since discarded. I don't see any support for that in the FASB's summary of tentative decisions to date.

During the outreach, most users of financial statements (i.e., financial analysts and investors) expressed a preference for a single approach to lessee accounting, but generally the more important issue to them was getting everything on the balance sheet. It was felt that proper disclosure could enable users who prefer to see leases a different way to make the adjustments they need.

There was some discussion regarding the implications for lessor accounting. Some board members consider symmetry important. Others consider the different business models and purposes on the two sides of the transactions sufficient that symmetry doesn't matter; at least one suggested that no change at all to lessor accounting from current practice is necessary.

The boards are concerned that their decision not seem arbitrary, recognizing that some people will be unhappy with whatever decision they make. They want to be able to defend it on a theoretical, not just practical, basis.

At the end of the session, a FASB board member asked the staff for what preferences had been expressed at the IASB education session held earlier in the day. It was reported that a majority of the IASB seems to have a first preference for Approach 1, but also that the strength of preference for that over Approach 3 would depend on where a line was to be drawn. So we have a difference of opinion between the boards; we know that they want very strongly to release a unified standard, so we'll have to see how that gets resolved.

To wrap up, though, the comment was, "We need to be ready to make a decision." The staff said a similar sentiment was expressed by the IASB. They've scheduled 5-1/2 hours of discussion for Wednesday & Thursday, June 13 & 14.

The staff expects this meeting to include the last substantive decisions on the new standard to be presented in the revised exposure draft (RED). They plan to follow up in July with wrap-up decisions, such as the comment period for the RED and interim disclosures, plus any decisions that may need to follow on from June decisions (such as adjusting disclosures if the approach to lessee accounting changes). After that, they would be ready to draft the RED and release it later in the year. The FASB Current Technical Plan is now reporting that the RED is expected to be released in Q4 2012 (that's a recent development; just a few weeks ago, it was simply "second half of 2012").

Friday, May 25, 2012

Approach D: Level expense recognition explained

As mentioned in prior posts, one of the options that the FASB & IASB are looking at for expense recognition under the new lease accounting standard is to have a single lease expense item in the income statement, which would be level over the life of the lease no matter what the cash flows. The following is my understanding of how the calculations would work.

We'll take three leases, each of which is five years long (1/1/2012 - 12/31/2016). Rent is paid monthly in advance (i.e., first payment is due the first day of the lease), and rent payments total $6,000 over the five years. All of them have an initial asset & obligation value of $5,000 (this requires different interest rates to deal with the different payment scenarios, which implies that the interest rate is the rate implicit in the lease.) Lease NoChange has rent of $100/month for the entire term. Lease Increase starts at $80/month for the first year, then increases by $10/month each year (i.e., $90/month in year 2, up to $120/month in year 5). Lease Holiday has no rent for the first year, then $125/month for the remaining 4 years.

The chart below shows the varied results for the asset and obligation with each scenario. Where the rent isn't equal over the life of the lease, there is also a deferred rent liability or asset (as with current operating leases that are leveled) and if the lease is early terminated, there will be a gain or loss.

"Straight line" is simply for reference purposes, to show what the profile would be with equal amortization each period. All of the examples would have slower amortization in the early months (the only way amortization would be faster than straight line in the early months would be if rent were higher at the beginning than at the end of the lease, which is rare; reduced rents for just a small portion of time at the end of the lease wouldn't change the overall picture).

How will the journal entries work? The following is my best guess, using the NoChange example above, for its first month (interest rate used is 7.69%):

Gross asset 5,000.00

Current obligation

Long term obligation
Setup of capital lease

Current obligation 100.00

Cash capital rent payment
Capital lease rent payment

Long term obligation 73.59

Current obligation
Reclassification of obligation from long term to current

Interest expense 31.40

Accrued interest
Interest accrual

Depreciation expense 68.60

Accumulated depreciation
Depreciation accrual

Lease expense 100.00

Interest expense (reversal)

Depreciation expense (reversal) 68.60
Reclassification to lease expense

While you might merge the last three transactions together, that's going to make it harder to see where the activity in interest and depreciation is coming from. Interest expense is calculated on the outstanding obligation after that month's payment (4900 x 7.69% / 12 = 31.40). Depreciation expense is plugged: 100 (average monthly rent) - 31.40 (interest expense) = 68.60.

Balances in the balance sheet accounts at the end of the first month:

Gross asset 5,000.00
Accumulated depreciation 68.60
Current obligation 852.85
Long term obligation 4,047.15
Accrued interest 31.40

You may notice that no interest is paid in the first rent payment. This is because with a lease that is paid in advance, as almost all leases are, the first payment is due the first day of a lease, before interest has had time to accrue. Interest expense accrues during the month and is paid the beginning of the following month. Unfortunately, while the journal entries example in FAS 13 shows this, all of the examples provided in the original exposure draft, and in all the discussion papers that I've seen generated by the staff, have used leases paid in arrears. That makes the calculations a bit simpler, but virtually no leases are written that way. I hope the staff will include a payments-in-advance example in the Revised Exposure Draft (and final standard), since this concept is often hard to get lessees and lessors to understand and accept. For leases paid in advance, the change in net asset for a period under Approach D equals the combined change in current obligation, long term obligation, and accrued interest.

The transactions wouldn't vary greatly for Increase and Holiday, but in those cases the Lease Expense won't match the current month's Cash Capital Rent Payment, and the depreciation expense will be smaller or even negative (for Holiday). The balancing entry would be booked to deferred rent liability.

I hope we'll see a more official presentation of how to account for leases using Approach D next month.

Thursday, May 24, 2012

Today's board meeting: Setting the stage

This morning the FASB and IASB held a joint meeting at the FASB offices in Norwalk (part of a series of joint meetings all week long). The first item on today's agenda was a review of the outreach done on expense recognition options for the new lease accounting standard. As reported in my prior blog entry, the staff (and board members) held a number of outreach events with financial statement preparers, users, and auditors, and summarized the results in a paper available online.

Board members discussed their reactions to the responses received. They heard a strong plea for simplicity from the various constituents. Essentially all board members agreed that Approaches B & C were not practicable, even though several of them expressed that they felt one or the other was conceptually the best choice. That leaves Approach A (capital/finance lease accounting), Approach D (straight-line expense recognition), or a combination of the two, with the need to define some dividing line between them. (And, as one board member noted, there is a third model that they've already agreed to: operating lease accounting, off balance sheet, for leases of 12 months or less.)

In the discussion, calculation of the balance sheet with Approach D was clarified:  I'm going to make another post that looks at the calculations under Approach D a bit more. In essence, it's a plugged number, though the staff person didn't like the use of that word. But some board members are concerned about the conceptual basis for the calculation, considering that it doesn't fit the normal definition of amortization and depreciation. They want lease accounting to be consistent with the overall Conceptual Framework of accounting that they've been working on for years.

They noted that in outreach, real estate lessees almost unanimously preferred Approach D. Equipment lessees generally preferred Approach A. However, there are many permutations on leasing, and board members noted that it won't be possible to make the accounting fit every different motivation that management has for entering into a lease.

Some board members would prefer symmetry between lessee and lessor accounting, in part because it seems easier to defend conceptually. Others noted that lessor accounting is generally not considered broken, and that leasing of investment property is already being scoped out of the project, so they were less concerned about symmetry.

While IASB Chairman Hans Hoogervorst noted that some European standard-setters don't agree with putting leases on the balance sheet, he noted that support for that move was almost universal among the preparers and especially users of financial statements. It seems clear that that decision will not be revisited.

The boards plan to vote in June on the expense recognition profile. The staffs were directed to present as options Approach A, Approach D, and a combination, with several alternatives for how to draw the line between A & D (similar to current IAS 17; real estate vs. equipment; and others). The staff stated that they expect to have a few wrap-up questions to deal with at the July meeting, and they would then prepare the Revised Exposure Draft.

Wednesday, May 23, 2012

WSJ Article: Leases Suffer Identity Crisis

Yesterday's Wall Street Journal (May 22) had a sizable article produced by CFO Journal, titled "Leases Suffer Identity Crisis," reviewing the controversy over expense recognition in the new lease accounting standard. Most of what's discussed there we've already seen, though a few items are worthy of note:

  • They expect the revised exposure draft to be released in "mid-2013"
  • IASB Chairman Hans Hoogervorst is quoted as saying that leases “are somewhere in between a purchase and a service, so our traditional answers in accounting don’t give a simple way to do this. ... The only clear signal we have from investors is to get them on the balance sheet and to keep it as simple as possible.”
The article quotes both a preparer and an accountant as considering many of the proposals overly complex ("over-engineered") and not useful.

The Journal often doesn't make CFO Journal articles available on the web (see, for instance, the article noted in this post), but at least for now, it's available without a subscription.

Tomorrow's meeting will discuss expense recognition. I intend to listen live, and will report once it's complete.

Thursday, May 17, 2012

Outreach results on expense recognition

At their February meeting, as previously reported, the FASB & IASB were split regarding the proper approach to expense recognition for leases under the new standard. They directed the staffs to do outreach, meeting with a total of nearly 200 preparers (companies and organizations that prepare financial statements), users (banks and analysts that use financial statements for investing and lending decisions), lessors, and auditors.

That work is now complete, and the boards will review the results at a meeting next Thursday, May 24. The summary is available online. Highlights:

The staff presented four options for reporting expenses:
Approach A: Identical to current capital/finance lease accounting: Interest expense calculated on the remaining liability balance, with depreciation expense recognized usually straight line.
Approach B:  Interest expense as in Approach A. Officially the remaining asset would be the present value of the remaining benefits, with depreciation the difference between the remaining asset at the beginning and end of the period. If remaining benefits are considered to be equal throughout the life of the lease, and rent payments are also equal, depreciation plus interest in any given period would be equal to the rent (and equal over the life of the lease). This was described as "interest-based amortization" at the February meeting.
Approach C:  Interest expense as in Approach A. Depreciation is based on considering the estimated consumption of the underlying asset over the lease term. For a real estate lease whose property is expected to be worth as much or more at the end of the lease, depreciation would equal principal repayment, and the total expense would give a result similar to operating lease accounting. For an equipment lease whose property is completely used up during the lease, the result would be the same as Approach A. A lease in between would get a proportionate result. This was described as the "underlying asset approach" at the February meeting.
Approach D: This was not discussed at the February meeting. A single lease expense item would be reported, equal to the straight-line rent. It is not clear how the asset and liability would be calculated for balance sheet purposes (I believe liability would be the same as for other approaches, but I've seen no indication of how the journal entries would work for it or for the asset amortization).

Nearly all users reported that they attempt to capitalize lessees' operating leases currently to get a better picture of a company's financial situation. However, they had a variety of methods of doing so, on both the balance sheet and the income statement sides. There's no way to provide matching results for everyone.

Most users thought a single model for all leases would be best, though they recognize that people lease for different reasons. Most preferred either Approach A or Approach D.

Most thought Approaches A & D would be least costly and difficult to apply. Some thought that C would be prohibitively costly; some retail lessees reported having over 15,000 leases that are regularly renegotiated, which they considered would make reassessing the consumption pattern impracticable. Preferences were often influenced by the type of leasing a preparer did: retail lessees tended to prefer D while oil & gas lessees preferred A. Some argued, though, that D would call into question recognizing the leases on the balance sheet.

There was no agreement on whether symmetry between lessee and lessor accounting was critical, though it was noted that a lack of symmetry could make sublease accounting "anomalous." Lessors said they would not always be able to provide information to lessees regarding valuations (residual values, etc.), because that is sometimes confidential for competitive reasons. While they find the receivable and residual model proposed for lessors to be appropriate for assets that are leased just once or twice, they find it less appropriate for longer-lived assets that are leased multiple times to different lessees, and would prefer current operating lease accounting for such transactions.

Some have questioned whether Approach C in particular is auditable. Auditors believe it is, but that it would be the most costly approach to audit (and for preparers to implement). They also question how to test and account for impairments under B and D because of the unusual method of calculating the net asset.

We'll see if the boards can reach a consensus at next week's meeting. It's not outside the realm of possibility that they'll punt the issue, offering more than one alternative in the revised exposure draft and asking for responses, making the final decision during redeliberation.

Thursday, May 10, 2012

FASB meets with Small Business Advisory Committee

This morning the FASB met with the Small Business Advisory Committee. The meeting is continuing as I write this, but discussion on leases was near the beginning of the agenda, and that's what I'm concerned with.

A FASB staff member gave a bit of an update of the outreach they've been doing since the February meeting, when the FASB and IASB considered some options for expense recognition on leases in the new standard. They've been meeting both with companies that would apply the standard ("preparers") and analysts ("users"). They've found that among users, there is near unanimity in agreement on the balance sheet approach planned for the new standard (i.e., capitalizing essentially all leases). There is, however, considerable diversity on the income statement side, selecting from among the options that the board is considering.

The presentation at this meeting included three alternatives to the current capital/finance lease model, rather than the two discussed at the February meeting. In addition to February's interest-based amortization and underlying asset approaches (see my prior summary of these), they showed an "Approach D," which is straight-line rent expense, like current operating lease accounting. It wasn't clear how the balance sheet balances would be amortized in such a situation: Would the asset and liability be shown undiscounted, and then amortized straight-line, or would they be shown as the present value of remaining rents (either based on cash rents or the straight-line equivalent), or something else?

In general, the committee expressed strong support for level expense recognition, considering that capital lease accounting provides unhelpful information in their environment. Some still want to make the case for it being off the balance sheet ("If I can't sublet, do I really have an asset, since I can't transfer it?") I don't see any likelihood of that prevailing.

Some expressed support for handling real estate differently from equipment, making the argument that real estate leasing is more about reducing risk (knowing what your rent will be into the future) while equipment has more of a financing approach (I can't afford to buy it up front; though often an equipment lease is related to wanting the equipment for a limited time, wanting quicker upgrades, etc.). This was in support of level expense recognition for real estate even if equipment used the standard financing model.

A FASB board member, however, said he didn't like the idea of basing the accounting on the type of underlying asset. He wondered if they could define characteristics that justified the different treatment. One that he mentioned is that in a real estate lease, the asset is expected to have little or no reduction in value (a land lease particularly exemplifying this concept).

Another committee member suggested that if the present value of the rents is less than "about" half the value of the underlying asset, operating lease accounting should be acceptable. But he didn't have a good answer for how to draw the line between leases that would and wouldn't qualify. A major issue driving the revision of lease accounting is that similar leases (those just barely on opposite sides of the capital vs. operating dividing line) are accounted for very differently.

A banker commented that many leases are written to game the accounting rules, and she fully expects the same thing to happen under the new rules. A particular area of potential vulnerability that several people saw is the issue of substitutability--according to the current draft, a lease requires a specific asset to be named, and if the asset can be freely substituted (so that it's the output of the asset, rather than the asset itself, that the lessee is controlling), it's a service contract rather than a lease. It was suggested that lessors may start writing leases so that all kinds of equipment are officially subject to substitution. Whether "substance over form" principles will protect against that is unclear.

Friday, April 13, 2012

No lease accounting discussion this month

At the February meeting, the FASB & IASB directed the staffs to conduct outreach on the alternative expense recognition possibilities considered. The plan at the time was for results of the outreach to be discussed at the boards' combined meeting in April. The agenda for April has now been released, and leases are not on the list. So yet another month of delay for finalizing the revised exposure draft...

Thursday, March 15, 2012

Into the second half of 2012

The FASB recently updated their project timeline for the new lease accounting standard, and they've now officially pushed back the date for release of the revised exposure draft (RED) to the second half of 2012. This is at least a 9-month delay from the original plan: last July they expected to finish the redeliberations in September 2011 with the RED to come shortly thereafter. But, of course, the whole project has been a story of delays; it's mind-boggling to think that when they announced the project in 2006, they expected to be finished in 2008.

Wednesday, March 14, 2012

Yet another delay

As previously mentioned, the last substantive issue the boards are discussing is the expense profile of lessee leases. Capital lease accounting under FAS 13/IAS 17 results in more expense in the early months/years of the lease than at the end, because interest expense is accrued on the remaining obligation, which declines over the life of the lease, while depreciation expense is usually equal through the lease's life. Operating leases, on the other hand, show level rent expense throughout their life (even if the rent increases).

There has been a great deal of pushback from lessees about applying this expense profile to all leases. They argue that front-loading the expense doesn't reflect actual usage and costs; it also means a mismatch with likely benefits, since income tends to rise over time. If managers are reviewed based on profitability, front-loaded expenses may skew the view of how well or poorly they're actually doing.

At the FASB/IASB meeting Feb. 27-29, the boards considered two alternatives to current capital lease accounting, each of which would reduce or eliminate the front-loading of expenses. The alternatives are:
  • Interest-based amortization: Depreciation would be based on the "present value of remaining economic benefits." As a practical matter, unless there's a reason to think the benefits provided by the asset will dramatically change in value during the lease, the depreciation recognized will be equal to the reduction in the obligation balance if the rent is equal over the life of the lease. If rents are unequal, the depreciation will be equal to what the reduction in obligation would be if the rents were leveled.

    The expectation is that if this method is chosen, it would not apply to all leases. More or less all leases that currently are considered capital would be accounted for the same way as they are now, to keep their accounting more consistent with purchase accounting.

  • Underlying asset approach: Depreciation would be based on a combination of the portion of the underlying asset expected to be consumed during the lease term plus unwinding the discount on the expected residual value. The effect is that for a real estate lease, where the expected future value is the same as or more than the current value, depreciation would be the same as for interest-based amortization, and the expense profile would be flat. For an asset expected to be fully consumed by the end of the lease term (zero residual), the expense profile would be the same as current capital lease accounting. A residual value in between would give a proportionally interim result.
Each approach has advantages and disadvantages, both practically and conceptually. Interest-based amortization is simpler in most cases, but is different from typical amortization of PPE (property, plant, & equipment). The underlying asset approach in some ways seems more conceptually correct, but is dependent on determining the expected consumption of the asset at the end of the lease term, which many lessees will have no simple way to determine, and there is concern that trying to determine it will be 1) an expense that serves no other purpose, and 2) a subjective exercise that is difficult to audit.

The boards split in their positions. Some board members want to maintain capital lease accounting for all leases, but a majority of the FASB favors interest-based amortization, while a majority of the IASB favors the underlying asset approach. However, the overall conclusion was that more "outreach" is needed, discussing the options with both statement preparers and users; the underlying asset approach in particular is a very new concept which has received little review. Therefore, the boards are going to take two months to meet with interested parties, and plan to continue discussions in April with the results of their outreach.

Given that once this is settled, the boards need to decide if there is any impact on lessor accounting, and then they need to talk about final details such as the comment period and interim disclosures, it looks like we're not going to get a revised exposure draft before June.

IASB/EFRAG meeting
The IASB met March 9 with EFRAG, the European Financial Reporting Advisory Group, to discuss several current IASB projects. EFRAG wants to keep the current distinction between capital and operating leases, with just minor improvements to determining when leases ought to be considered financing transactions and therefore capitalized. That seems unlikely.

Thursday, February 23, 2012

Schedule for wrapping up the redeliberations

The IASB has posted on its web site the agenda papers for next week's combined IASB/FASB board meeting, which will include discussion of lease accounting. One of the agenda papers details the schedule from here out:

February boards meeting: last substantive discussions
March boards meeting: "sweep issues" such as comment period and any interim disclosures
Following: Second Exposure Draft is drafted. They don't say anything more than "later in 2012" for when it will be released, though the IASB Work Plan page indicates Q2 2012 (the equivalent FASB Project Updates page says the same thing).

Tuesday, January 31, 2012

EZ13 and Asset Retirement Obligations (ARO)

We are delighted to announce the release of a new module for our EZ13 Lease Accounting software. The new module tracks Asset Retirement Obligations. While primarily intended to be used for AROs tied to leases, it can also be used for AROs independently.

Asset Retirement Obligations are legal obligations of a company that take effect at the retirement of an asset. Most commonly, they are involved with restoring the asset to its original (pre-use) condition. One common example is cleanup of a drilling site by an oil/gas driller. Another applies to gas stations, which are required to dig up their underground fuel tanks when the station closes (or when the tank reaches the end of its useful life).

Under FAS 143, now called ASC Topic 410-20, a company must estimate the cost of the asset's retirement, most commonly by determining the current cost and applying an inflation factor to get the future cost. (Even if you expect to take care of the work using internal resources, the ARO must be priced based on hiring the work to be done; if you end up actually using internal resources, you will book a gain at that time.) It then books the present value of that cost (using its "credit-adjusted risk-free rate" for borrowing); the asset is called the Asset Retirement Cost, while the liability is the Asset Retirement Obligation. The ARC is depreciated over the remaining life of the asset, while the ARO is accreted over the same life; that is, an interest-type calculation is made on the liability using the same credit-adjusted risk-free rate, and the accretion expense is added to the liability, so that at the end of the asset's life, the ARO is equal to the expected (after-inflation) cost of retirement.

If you have a lease, the ARO's life is normally the same as the lease life. For an owned asset, the ARO life is typically the useful life of the asset itself.

EZ13 now offers complete ARO accounting as an extra-cost module. Reporting available includes showing ARO information on the income statement/balance sheet detail report, ARO accretion/depreciation tables, and rollforward reports (showing beginning balance, additions, accretion/depreciation, terminations, and ending balance, by lease). ARO components with varying levels of probability are accepted. For more details, including an example of an ARO calculation, please see our ARO page.

Thursday, January 26, 2012

LWG favors level expense

Asset Finance International, a European website focused on equipment lessors, is reporting that yesterday's Leases Working Group meeting produced a strong consensus in favor of providing a level expense profile for most leases, as is currently the case for operating leases. While one of the arguments of IASB and FASB board members against this has been that it would mean a different depreciation methodology from owned property, plant, & equipment (PPE), one working group member turned that argument on its head, arguing that this profile would be more appropriate for both leases and owned assets. Obviously, rewriting depreciation rules for owned PPE is out of topic bounds, but changing the rules for leases could be a first step to "start getting it right."

As mentioned in my previous post, the staff presented five alternatives for lease expense profiles. Most LWG members preferred "interest based amortization," which basically subtracts the normally calculated interest expense from what level total expense for that period would be (total expense is generally equal to all rent paid over the life of the lease, which is then equally apportioned over the lease life). For a lease with a single rent step, this would mean that the depreciation per rent payment period would be essentially the same as the principal paid, so asset and liability would be equal throughout the life of the lease. If a lease has multiple rent steps, the difference between asset and liability would be the same as the deferred rent liability currently recognized on leveled operating leases. (The staff document only talks about a simple lease with one rent step; I'm not aware of anyone else pointing out this congruence with current operating lease accounting for multiple rent steps.)

Level expense recognition would not be applied to all leases. The LWG favored defining the dividing line between that and current finance/capital lease expense recognition more or less at the same point that current operating and capital leases are divided: a transfer of control or the lessee's control of "substantially all the remaining benefits" of the leased asset. The wording would be made as consistent as possible with another draft accounting standard on Revenue Recognition.

Level expense recognition would make transition to the new system easier. If all current operating leases are assumed to qualify, there would be no hit either to the income statement or to equity. However, the transition rules would need to be rewritten to specify how the balance sheet should be set up.

The next joint boards meeting is at the end of February, at which the expense profile will be on the agenda. Asset Finance International thinks that the new exposure draft can't come out before May even if the boards don't change the expense profile. If they do, it would likely take a few more months as they review the consequential changes to other parts of the standard. Add a four-month comment period and then time for the boards to redeliberate, and it's likely to be Q4 2012 or even 2013 before the final standard is finally released.

Monday, January 23, 2012

Leases Working Group meeting on expense profile

As previously noted, the FASB & IASB are reviewing whether a different expense profile would be appropriate for capitalized leases under the new proposed lease accounting standard. The current plan is for the same profile as for existing capital leases, which has more expense in the early months/years of a lease than at the end, because interest is recognized on the remaining principal balance, which declines over the life of the lease, while depreciation is normally recognized straight-line.

There is no joint FASB/IASB board meeting this month. However, tomorrow (Jan. 24) the Leases Working Group will meet with members of the boards. The LWG is a group of individuals from business, academia, and accounting firms who have an interest/specialty in lease accounting, who meet occasionally to provide feedback to the boards. Tomorrow's meeting will be primarily focused on the issue of the expense profile on lessee leases. Meeting papers are available here.

The boards' staffs have identified five alternatives for expense recognition:

(A) current approach
(B) modified interest-based amortization for the ROU (right of use) asset
(C) modified whole-asset
(D) use "other comprehensive income" to level the expense recognition
(E) allow current operating lease accounting for more leases

A brief description of each:

(A) As with current capital leases, interest expense is recognized on the outstanding liability (the "interest method") and depreciation is normally straight-line (officially, "reflecting the pattern of consumption of expected future economic benefits from use of the leased asset")

(B) Interest expense is the same; amortization is such that the interest plus amortization is equal for each reporting period. (For a lease with equal rent paid over its life, amortization each period would be equal to the reduction in principal.)

(C) Interest expense is the same; amortization is calculated by determining the net asset. The initial net asset is the fair value of the leased asset minus the present value of the expected residual value. The asset is depreciated and the residual value accreted over the life of the lease so that at expiration the two are equal.

(D) Interest and amortization are calculated like (A). Then the difference between that and the straight-line value is recognized in OCI (over the life of the lease, the OCI activity will net to zero).

(E) Current straight-line operating lease accounting would be used, with no ROU asset or lease liability recognized (though there would be a potential asset/liability for prepaid/accrued rent).

In addition to the question of whether any of the alternatives to (A) is preferable, there is the question of whether they should apply to all leases, or just a subset; if the latter, how should the target set be identified?

The working papers identify advantages and disadvantages to each approach, and show examples for simple equipment and land leases. (Some of them get much trickier to calculate with leases that have scheduled changes to the rent; no such examples are provided.)

The LWG will also discuss issues of investment property for lessors.

The boards will have their next joint meeting Feb. 27-29, and will presumably review these topics at that time.