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.