(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.
Monday, May 19, 2014
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.
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.
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