Tuesday, November 18, 2014

Misinformed congressmen in WSJ

In the Nov. 10, 2014, issue of the Wall Street Journal, congressmen Brad Sherman and Peter King attacked the planned new lease accounting standard, claiming that it will "fabricate trillions in new debt" and thereby crush the economy. They reference a study that foresees a loss of at least 190,000 U.S. jobs, and $27.5 billion in economic activity (up to a worst-case scenario of 3.3 million lost jobs and $400 billion in lost GDP!). All for an accounting change?

There are several problems with this attack. The most significant is that the study forecasts the effect of a standard that is no longer being proposed. The study was written in early 2012, when the proposal was to treat all leases as capital, including all optional renewal periods deemed "more likely than not" to be exercised. This proposal was eventually recognized as onerous by the boards, and substantially scaled back. While the IASB has retained the plan to treat all leases as capital with a one-size-fits-all calculation process, it eliminated including options unless exercise is "reasonably certain." The FASB has made the same adjustment to options, has chosen to keep a separate accounting model for operating leases, and is now saying that the liability to be shown on the balance sheet should be considered a "non-debt liability," meaning it will not affect debt covenants in loans, bonds, and the like.

The op-ed contains other inaccuracies. It suggests that under the new proposal, businesses would be burdened with "constantly tracking and remeasuring the 'fair value' of leases of every kind, from a business's office space to the photocopier down the hall." This is ridiculous, and was never part of any proposal coming from the boards. A fundamental concept of lease accounting is that fair value is not remeasured during the life of the lease, except by algorithm; the fair value is assumed to be the amortized net asset value, unless a material impairment needs to be recognized. This is true under FAS 13, and has not changed in the slightest as part of the new proposals. The op-ed also talks about accelerating expense recognition; that will happen to companies covered by international IFRS rules, but not under the current FASB proposal.

The op-ed notes that Congressman Sherman is an accountant. But obviously he doesn't have enough time to keep up on what's really happening in accounting. He should be embarrassed to have put his name on a column that misstates accounting principles and proposals so badly. (So should Rep. King, though he doesn't claim an accountant's credentials.) They darkly warn that Congress will have to act to rein in the FASB if the SEC doesn't. One hopes that they'll learn the actual facts before they try to politicize accounting standards.

The Nov. 17 issue of the Journal includes several letters to the editor, most of which point out the value of capitalizing lease obligations, and noting that banks often require doing this pro forma already. The new proposal, they argue, will simply reflect economic reality. I'm surprised that none of them note that Sherman and King are attacking a straw man.

Friday, August 8, 2014

July meeting update, project update

The joint IASB/FASB meeting of July 22-24, 2014, included leases on its agenda (on July 23). There were two main topics of conversation: sale/leaseback transactions and lessor disclosure requirements. The IASB summary is available online, with more discussion detail provided by Deloitte's IASPlus.

Sale/leaseback transactions

The boards reaffirmed that for a transaction to be considered a sale/leaseback, the sale must meet the requirements of the new Revenue Recognition joint standard (ASU 2014-09/ASC 606/IFRS 15). However, "continuing involvement" generally precludes sale recognition under that standard, and the boards clarified that an ordinary leaseback does not trigger that clause and preclude sale/leaseback accounting.
   The FASB decided, however, that if the leaseback meets "type A" criteria (i.e., it's a capital lease), the transaction would not be considered a sale. In other words, if the risks and rewards of ownership are being transferred back to the seller-lessee, no sale really happened.
   The IASB concluded that a "substantive repurchase option" precludes sale recognition while the FASB will explore further the effect of repurchase options at fair value.
   The buyer-lessor accounts for the purchase like that of any other nonfinancial asset.(ignoring the leaseback).
   The seller-lessee accounts for any loss on sale like that of any other sale.
   Both parties treat the lease like any other lease.
   For the gain, the two boards split: the FASB concluded that the full gain should be recognized just as with any other sale. The IASB held that only the portion of the gain applicable to the residual asset can be recognized at sale.
   If the official sale price is higher or lower than the market price ("off-market"), a reduced sale price is treated as a prepayment of rent; a higher sale price is treated as additional financing by the buyer-lessor to the seller-lessee.
   In the case of a "failed" transaction (i.e., a transaction that cannot be considered a sale/leaseback), the IASB voted to treat it as a financing transaction. The FASB voted to study the situation further.

Lessor disclosure requirements

   A lessor must disclose descriptions of the nature of its leases, assumptions and judgments made in applying the lease accounting standard, and how it manages risks related to residuals.
   A lessor must provide a table of lease income, comprising:
  • For type A leases: profit or loss recognized at lease inception, and interest income
  • For type B leases: lease income from lease payments
  • Variable lease payments
   Assets used for type B leases should be separated from other assets owned and used by the lessor, with disclosures for the type of asset.
   Separate maturity analysis tables are required for Type A and Type B leases, showing the amount of (undiscounted) lease payments by year for the next five years, then all remaining years. Type A leases need a further reconciliation to the receivable balance, as is done in current accounting, as well as an explanation of significant changes in net investment during the reporting period, with the FASB reserving the possibility of adjustments to this requirement based on the concurrently running project on impairments.


Remaining topics to be discussed in upcoming months include lessee disclosure and transition requirements. They also have said they will consider a possible exclusion of "small ticket" items, to make implementation less onerous.

Project update

The IASB released on August 7 an update describing major decisions reached, with an accompanying podcast; it doesn't go into detail on the different decisions reached by the FASB. It notes that the boards expect to complete their deliberations in 2015 (no more specific). This raises the question of whether implementation will get pushed off to 2018.
    The update restates the boards' insistence that improving disclosure alone is insufficient, that it is vital to have lease contract commitments on the balance sheet. It provides an example of two actual companies, one of which does little leasing while the other gets most of its assets through leasing. With leases off the balance sheet, the heavy lessee looks to be less leveraged; once adjusted for the effect of leasing, the heavy lessee is revealed to be considerably more leveraged. It shows that "rule of thumb" estimates, like multiplying rent expense by 8 to calculate liability, are too inexact. And it emphasizes that even if sophisticated analysts, doing in-depth research on individual companies, can reach reasonable approximations (though lacking all the desirable data), this doesn't serve less sophisticated investors, or those who are looking at large groups of companies, who must rely on the basic financial statements. Thus, while the boards have been willing to consider adjustments to the details, the fundamental concept of putting leases on the balance sheet is fixed.

Wednesday, July 2, 2014

Type B lease accounting

Since it seems highly likely that Type B lease accounting will survive for current lessee operating leases in the U.S. (with perhaps a few leases at the margins moving in and out of such treatment), I thought it might be worthwhile to look in more detail at some examples of how Type B accounting will work. (Let's hope they come up with a nicer name for it; "type A" and "type B" are totally arbitrary, and don't at all describe the accounting involved.)

With simple leases (no initial direct costs, the same rent paid throughout the life of the lease), the calculations are pretty simple: both the asset and liability are, at any given moment, equal to the present value of the remaining rent (excluding service components, of course). But life is rarely simple. So let's look at a few variations on a theme.

Example #1: We'll start with a simple lease of five years, starting 1/1/2014, paid yearly in advance (i.e., first payment due first day of the lease), rent 10,000 per year, and an incremental borrowing rate of 6%. There are no initial direct costs.

The present value of the rents at inception is 44,651.06. Both the initial liability and asset are set to that amount. The balances at the end of each year, and the effective interest calculated (not expensed, but used to determine the drawdown on the balance sheet accounts), are as follows:

End DateLiability Asset Effective
Initial (44,651.06) 44,651.06
12/31/2014 (36,730.12) 36,730.12 2,079.06
12/31/2015 (28,333.93) 28,333.93    1,603.81
12/31/2016 (19,433.96) 19,433.96    1,100.04
12/31/2017 (10,000.00) 10,000.00 566.04
12/31/2018 (0.00) 0.00 0.00

As you can see, the liability and asset are identical at all times. The reduction in each is the rent (10,000) less the effective interest (for 2014, 10,000 - 2,079.06 = 7,920.94). The yearly expense is the 10,000 rent.

Example #2: Many leases have changes in rent during the life of the lease. Let's say that for this lease, the rent increases to 11,000 per year starting 1/1/2016 (start of 3rd year).

End DateLiability Asset Effective
Initial (47,172.77) 47,172.77
12/31/2014 (39,403.13) 38,803.13 2,230.37
12/31/2015 (31,167.32) 29,967.32    1,764.19
12/31/2016 (21,377.36) 20,577.36    1,210.04
12/31/2017 (11,000.00) 10,600.00 622.64
12/31/2018 (0.00) 0.00 0.00

The yearly expense is 10,600 (the average of the rent over the lease term). Effectively, the difference between the cash and level rent is recognized in the asset, instead of the FAS 13 practice of setting up a deferred rent liability.

Example #3: Going back to the simple lease of 10,000 rent per year. This time we add initial direct costs of 2,000, which is added to the asset but not the liability.

End DateLiability Asset Effective
Initial (44,651.06) 46,651.06
12/31/2014 (36,730.12) 38,330.12 2,079.06
12/31/2015 (28,333.93) 29,533.93 1,603.81
12/31/2016 (19,433.96) 20,233.96 1,100.04
12/31/2017 (10,000.00) 10,400.00 566.04
12/31/2018 (0.00) 0.00 0.00

The yearly expense is 10,400 (rent plus a straight-line portion of the initial direct costs).

Example #4: No initial direct costs. Payments are made in arrears (that is, the first payment is made at the end of the first year).

End DateLiability Asset Effective
Initial (42,123.64) 42,123.64
12/31/2014 (34,651.06) 34,651.06 2,527.42
12/31/2015 (26,730.12) 26,730.12 2,079.06
12/31/2016 (18,333.93) 18,333.93 1,603.81
12/31/2017 (9,433.96) 9,433.96 1,100.04
12/31/2018 (0.00) 0.00 566.04

The yearly expense is 10,000 (the yearly rent, same as example #1). You may notice that the effective interest for years 2-5 is identical to the interest for years 1-4 in examples 1 & 3.

Tuesday, July 1, 2014

Subleases, balance sheet, cash flow

The FASB/IASB joint meeting for June was held June 17-19, 2014. The boards discussed subleases, lessee balance sheet presentation, and cash flow statement presentation. Discussions were made in the context of  the FASB's tentative decision to permit two different types of lessee presentation (Type A leases, essentially the same as current capital leases, and Type B leases, similar to current operating leases but with an asset and liability on the balance sheet) and the IASB's tentative decision to treat all lessee leases as Type A capital leases.


Both boards agreed that the intermediate lessor (who leases the underlying asset from its owner, and subleases it out to the sublessee) should account for the head lease and the sublease as two separate contracts, unless the contracts meet contract combinations guidance that the boards adopted in April. (This guidance indicated that they should be combined "if either of the following criteria are met: (a) The contracts are negotiated as a package with a single commercial objective; or (b) The amount of consideration to be paid in one contract depends on the price or performance of the other contract.")

In keeping with this, the assets and liabilities of the two contracts should not be offset (unless them meet financial instruments requirements for offsetting). Likewise, lease income and lease expense should not be offset unless the intermediate lessor meets the "principal-agent" guidance in the newly released revenue recognition standard (ASC 606, IFRS 15).

The FASB held that a sublease should be classified with reference to the underlying asset, while the IASB calls for classifying it with reference to the right-of-use (ROU) asset arising from the head lease.

Since the IASB has decided to have a single lessee accounting model, while maintaining the existing capital vs. operating separation for lessors, subleases will end up with accounting that is not in sync between the two sides of the transaction.

Balance sheet presentation

Both boards agreed that Type A lessee lease assets should either be presented as a separate line item, or combined with the same type of assets as the underlying leased assets and then disclosed separately in the notes (the latter treatment is not permitted if the amounts are material). The FASB concluded that Type B assets should be treated likewise, and should be separated from Type A assets. This will facilitate analysis that depends on distinguishing lease types, such as bankruptcy analysis, bank regulatory capital tests, and possibly loan covenants.

Likewise, liabilities can be reported as a separate line item or disclosed in the footnotes, with Type A and Type B liabilities reported separately. If liabilities are combined in the primary statement, the footnote should indicate which line item contains the lease liabilities.

Cash flow presentation

Lessors: Confirming the 2013 Revised Exposure Draft (RED), lease cash receipts are classified within operating activities.
Lessees: Confirming the RED, cash payments for the principal portion of a Type A lease are financing; cash payments for the interest portion of a Type A lease are operating (FASB), or either operating or financing based on a lessee's accounting policy choice (IASB); cash payments for a Type B lease are operating.

The IASB also decided to require a separate presentation of total lease payments, so that statement users can find a single number for the cash outflow.

Monday, June 9, 2014

May redeliberations

The FASB/IASB joint meeting on May 20-22, 2014, reached the following additional decisions for the new lease accounting standard, reviewing the Revised Exposure Draft (RED) and redeliberating on user reactions:
  • Allocating consideration between lease and non-lease components should be based on observable standalone prices, if available, or the best estimate. If the lease term or an option is reassessed, the allocation should also be reassessed.

  • Lessors may choose to make an accounting policy by class of underlying asset not to separate lease & non-lease components, and instead treat as a single lease component.
Other decisions were made basically reaffirming and clarifying the RED on the definition of a lease, separating lease and non-lease components (other than discussed above), and initial direct costs. Of note is the reaffirmation that initial direct costs include only incremental costs associated with starting a lease. Current US GAAP permits lessors to allocate overhead costs to a lease, which would now be prohibited.

For more details, see the FASB board meeting minutes or IAS Plus.

It's also worth noting that the boards on May 28 released the new converged standard on revenue recognition (RevRec). This standard will be referenced in the new lease accounting standard for some aspects of lessor accounting, as previously noted. It is also notable for its implementation schedule: required in 2017. Multiple observers of the boards think that the same implementation schedule will apply to leases, though obviously the final standard has not been released, and won't be for several months. The boards haven't yet posted a timetable for final release, but some observers think it will be this year.

On May 29, Hans Hoogervorst, chairman of the IASB, spoke to the IFRS Conference in Singapore. Among his comments, he said he expected to complete work on the lease accounting standard "in the next couple of months," while saying they're still looking at ways to make implementation less costly but suggesting that most companies will not be significantly affected.

Monday, May 19, 2014

Status of redeliberations: lessors

(See prior post for information on lessees and the general redeliberation process)

Lessor accounting update:

In response to a large chorus of, "It ain't broke, don't fix it," the boards in March decided that lessor accounting should be generally left unchanged.

How many models? Both boards agreed with a Type A/Type B separation, though changing the dividing line between them from the RED proposal back to the current FAS 13/IAS 17 of determining whether a lease is effectively an installment purchase that transfers the risks & benefits of ownership. Thus, substantially all current operating leases would become Type B leases; substantially all current capital leases would become Type A leases. However, the standard would be worded as a "principle" rather than a "rule", so the 90% and 75% tests would no longer be bright lines. The FASB further concluded, consistent with the forthcoming revenue recognition standard, that profit could only be recognized at commencement if control of the underlying asset is transferred (that is, there is an ownership transfer or bargain purchase option in the lease).

Finance accounting: The boards scrapped the "receivable and residual" methodology, and will leave the existing finance lease accounting in place (except that leveraged lease accounting seems still to be excluded).

Discount rate: Reference to property yield will be removed, and the rate the lessor charges the lessee is defined as the rate implicit in the lease, including initial direct costs. The discount rate is not to be reassessed even if a lease is modified.

Modifications: The April meeting dealt with issues not specifically addressed by the RED. As for lessees, if a lease is modified with the addition of new rights-of-use (such as additional square footage in a building, or additional equipment), and the increase in price is commensurate with that the cost would be to get the new assets on their own, the additional asset and rent should be recognized as a new lease. Otherwise, when a Type B lease is modified, the modified lease is in effect treated as a new lease (as is pretty much the case now), while a modification to a Type A lease is handled using IFRS 9 or FASB Topic 310. This is largely consistent with current IFRS practice; however, it represents a change for U.S. companies, which they think will be simpler to apply. In effect, when the criteria for derecognition of the asset are met, the modified lease is treated as a new lease; otherwise, the carrying value is recalculated using the original discount rate, with the offset recognized in profit or loss.

Variable lease payments: The RED called for recalculating variable lease payments (VLPs) based on an index or rate, and the lease as a whole, when the rate changes. At the April meeting, the boards decided that lessors would not be required to reassess VLPs at all. Instead, any differences between the original estimate and actual payment are recognized in profit and loss as incurred, the same as FAS 13/IAS 17 call for now.

Short term leases: See lessee update.
Purchase & renewal options: See lessee update.
Timeline: See lessee update.

Status of redeliberations: lessees

The FASB and IASB are underway with their redeliberations on the lease accounting standard, in the wake of the 641 letters received, plus additional outreach the staff and boards have undertaken since releasing the 2013 Exposure Draft. The deliberations are taking somewhat different turns for lessees and lessors, so I'm going to put up two separate posts to deal with them.

Lessee accounting:

This is by far the more contentious side of the discussions. Fundamentally, the problem is that different leases are viewed by lessees and investors in different ways. Lessees of real estate and of relatively short-term equipment leases don't see their leases as acquisitions, but as usage contracts. They are pushing back strongly against the idea of front-loaded expenses, as is inherent in finance lease accounting (where the expenses are interest and straight-line depreciation, as is typical with current capital leases). Many of them also are objecting to putting the value on the balance sheet at all, even though that is the primary reason for the entire rewrite of the lease accounting standard.

Some investors and lenders agree with these lessees. Others want all leases fully hitting the financial statements, just as current capital leases do. Others want to be able to do their own massaging of the numbers.

The first exposure draft in 2010 strongly supported the "capitalize everything" mantra. It was buried under criticism. The 2013 revised exposure draft (RED) sought to mollify those of the "usage" persuasion by allowing a straight-line expense recognition for real estate and certain short-term equipment leases, which it calls "Type B" leases. But it faces fire from both sides: it doesn't permit as many leases to be Type B as are currently operating, which upsets lessees, but by having two accounting methods, it presents opportunities for similar leases to be treated differently (one of the complaints with FAS 13/IAS 17), and the depreciation methodology for the asset is a plugged number, which offends many accounting purists and raises issues for how to deal with impairments. Others complain that assets and liabilities are recognized which have no standing in bankruptcy (leases can be rejected wholesale).

With all that as preamble, let's look at what's happened in the last few months since the boards started substantive redeliberations:

How many models? We have a split between the boards on this fundamental issue. The FASB wants to keep the Type A/Type B separation, though changing the dividing line between them to the current FAS 13/IAS 17 of determining whether a lease is effectively an installment purchase that transfers the risks & benefits of ownership. Thus, substantially all current operating leases would become Type B leases; substantially all current capital leases would become Type A leases. However, the standard would be worded as a "principle" rather than a "rule", so the 90% and 75% tests would no longer be bright lines. On the other hand, the IASB prefers to treat all leases as Type A. It remains to be seen whether convergence will be possible, or if the different constituency pressures of the two boards will result in an unconverged standard.

Modifications: The April meeting dealt with issues not specifically addressed by the RED. If a lease is modified with the addition of new rights-of-use (such as additional square footage in a building, or additional equipment), and the increase in price is commensurate with that the cost would be to get the new assets on their own, the additional asset and rent should be recognized as a new lease. Otherwise, the lease is recalculated, including a new discount rate, as of the date of modification. If the liability increases, the asset increases by the same amount. If the liability decreases, a proportional amount of asset should be removed (remember that the asset and liability aren't the same for a Type A lease during the lease life), and a gain or loss recognized for the difference between the asset and liability removed.

Variable lease payments: The RED called for recalculating variable lease payments (VLPs) based on an index or rate, and the lease as a whole, when the rate changes. At the April meeting, the FASB decided for lessees to reassess VLPs only when the lessee remeasures the lease liability for other reasons (for instance, because the lease term is changing). The IASB voted to reassess for that reason or if the cash flows change due to a change in the reference index or rate. There is no change to the exclusion of VLPs that are based on other factors, such as usage, nor to the reqirement to include VLPs that are in-substance fixed (that is, payments that are written as if they are variable merely to game the system). This leaves a substantial difference between the boards; the FASB's exclusion of remeasurement for changes in rates matches what is done currently under FAS 13, and considerably simplifies compliance. It has not been discussed whether future rent commitments would need to be adjusted for changes in rates, or would also stay fixed at the initial values.

Discount rate: The boards decided to tighten the definition of the "rate the lessor charges the lessee" to be specifically the implicit interest rate, not the yield, to avoid lessees being able to choose from multiple rates.

Short term leases: The exemption for leases of 12 months or less is maintained. The boards now define the 12 months the way the lease term is defined, excluding arms-length options, so a 12-month lease with a renewal option (without an economic incentive to renew) can now be treated as short-term, contrary to the RED proposal.

Purchase & renewal options: A lessee should reassess whether exercise of an option is "reasonably certain" (and thus must be recognized) only upon the occurrence of a significant event or a significant change in circumstances that are within the control of the lessee.  The boards explicitly agreed that the term "reasonably certain" is a high hurdle, meant to be essentially the same as the current "reasonably assured." (Why they didn't want to keep the current terminology is unclear.) The original exposure draft's contemplation of reassessing every year or every reporting period has been definitively eliminated.

Contract combinations: If two or more leases are entered into at or about the same time between the same lessee and lessor, and either they were negotiated as a package, or the amount paid for one contract depends on the price or performance of the other (such as a volume discount), then they should be considered a single transaction.

Timeline: The Current Technical Plan on the FASB web site shows no expected date for completion in 2014. (Revenue Recognition, no the other hand, is expected to be finalized this quarter.) However, observers such as Bill Bosco of Leasing 101 think the boards are pushing hard to finish in 2014, with no new exposure draft.

The boards meet again this week to discuss:
• Definition of a lease
• Separating lease and nonlease components
• Initial direct costs and lease incentives
Discussion papers are available at the IASB web site.