Monday, December 14, 2015

Overview of the new standard

With the final decisions made, and just waiting for the official final document, what is the new regime for lease accounting? Most importantly, what is changing from the current standards?

US GAAP: FAS 13/ASC 840 to ASC 842

Lessee leasing: The most significant change, of course, is that all leases (except for those with a term of 12 months or less) must be put on the balance sheet. This was the primary reason for the whole project, and despite complaints from some quarters, there was never any real question that it would be implemented. However, the FASB chose to largely leave the distinction between capital and operating leases in place. (While for much of the deliberations the boards used the terms Type A and Type B, that nomenclature has fortunately been jettisoned; however, perhaps for convergence reasons, capital leases will now be called finance leases, while operating leases keep that name.)

One modest difference for classification is that the FASB added a capitalization criterion that was previously in IAS 17: whether the asset is so specialized that it cannot reasonably be repurposed. An example would be equipment installed at a remote mine which would be cost-prohibitive to move.

An operating lease is capitalized using the present value of the rents; the interest rate used is the implicit rate if known, otherwise the lessee’s incremental borrowing rate. (This is a change from FAS 13, which uses whichever rate is lower.) Since accurately knowing the implicit rate requires knowing the lessor’s unguaranteed residual, it’s most likely to apply only with leases that specify a purchase option. For simple leases, the asset and liability will be the same at any point during the life of the lease. If there are scheduled rent increases, the rent leveling effect will be reflected in the asset. Initial direct costs are added to the asset and amortized over the lease life.

While operating leases go on the balance sheet, the FASB specified that it should be treated as a “non-debt liability.” Thus, debt covenants should be unaffected by the change. It is nonetheless true, though, that certain financial ratios (current ratio, quick ratio, and return on assets) will be depressed by the addition of both assets and liabilities. (Terminology has changed from “obligation” to “liability.”) A second benefit to the separate accounting for operating leases is that expenses will generally be recognized straight line, rather than front-loaded as the depreciation + interest expense profile for a capital/finance lease works. This was a big deal to many lessees, virtually eliminating the impact of accounting on profit and loss calculations, equity, and tax vs. book timing differences.

Initial direct costs are no longer expensed as incurred. Instead, they are amortized straight-line over the lease life. However, this is limited to incremental costs, which effectively means only externally billed costs (commissions, legal fees, etc.), rather than rebilling internal costs.

Variable lease payments: Changes to rent due to future events (such as a change in an index or rate, or charges for excess use) remain contingent rents that are expensed as incurred. These can be positive or negative. If a lease must be recalculated due to other changes, though (such as a term extension or a revision to the base rent), the new variable lease payment level must be used for recalculation.

Lessor leasing: Almost unchanged, except that leveraged leasing (U.S. only) is being eliminated. Existing leveraged leases, however, will be grandfathered, including deals completed up to the implementation date.

Initial direct costs on sales type leases are recognized over the life of the lease unless the lease contains sales profit or loss.


The IASB decided that all leases should be recognized using finance lease accounting. Thus, the present value of the rents must be capitalized; the liability is amortized using the interest method, while the right of use asset is depreciated, usually straight-line. This means that current operating leases will have a new front-loaded expense profile (because interest expense in a mortgage-style amortization is more at the beginning than at the end). However, short term leases (12 months or less) and low-value leases are considered out of scope. The IASB also scoped out “small ticket leases,” defined as having a value of $5,000 or less. (It’s interesting that a dollar amount is used for a standard that doesn’t apply in the U.S.)

The impact of front-loaded expenses will be the most significant for rapidly growing organizations; if the leasing portfolio is rolling over fairly consistently, the aggregate impact on P&L will be small, though individual cost centers may face significant impacts depending on where in the lease’s life they are. However, all entities will see an equity impact that grows fairly quickly after implementation until it potentially reaches equilibrium when leases start expiring at the end of a full term under the new regime. From the very beginning, though, most financial ratios will take potentially significant hits, due to adding equal amounts of assets and liabilities. (EBITDA is one exception; since expenses will now be reported as interest and depreciation, they will be absent from EBITDA.) Some companies will double their reported liabilities, which (even with a substantial equity balance) will make them look percentage-wise much closer to the margin. Many lessees with substantial portfolios will need to talk to their lenders about revising the debt covenants on loans.

Variable lease payments: If a lease has variable rents based on an index or rate (such as interest based on LIBOR), its liability must be recalculated whenever the rent changes. However, since the index rate is also usually used for the PV calculation, in most cases the liability won’t substantially change, though the expense reported as interest will increase.

Retirement obligations associated with leases are reported in accordance with IAS 37. The asset side of the provision (equivalent to what US GAAP, in FAS 143, calls an asset retirement obligation) is added to the right of use asset for the lease; subsequent changes to the provision result in adjustments to the ROU asset, which cannot be reduced below zero (if further adjustments are required because the liability is reduced, a gain is recorded).

Lessor leasing: Almost unchanged, except that determining the finance vs. operating classification will explicitly use the bright line tests of FAS 13: whether the lease term is 75% or more of the economic life, and whether the present value of the rents is 90% or more of the fair value of the underlying asset.

Shared by ASC 842 and IAS 17

The definition of a lease is “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.” This includes a requirement of a specified asset; if the lessor can swap assets at will, for its own benefit (not counting the replacement of a non-functioning asset), the agreement is considered a service contract, not a lease.

All lease/rental agreements are out of scope (i.e., do not need to be reported according to the standard; you can simply expense the rent as paid, with no balance sheet impact nor footnote disclosure of future rents) if they are for a term of 12 months or less. In a change from the current standards, the definition of the lease term can include business practice as well as contractual obligations in determining whether options should be included, though the new standard of “reasonably certain” that the option will be exercised is considered functionally equivalent to the current “reasonably assured” term.

If the rent contains non-lease components, a lessee should allocate the rent to lease and non-lease expenses, using observable standalone prices for the services, if available, or estimating if necessary. ("Non-lease components" is a subset of "executory costs" in current accounting; passthrough costs such as taxes and insurance are now lease expenses and are capitalized with the base rent.)
Residual guarantees are capitalized at their expected, rather than maximum, value. Since this amount is usually zero, it will significantly reduce the likelihood that TRAC leases will be considered capital for US GAAP.

Sale/leaseback accounting has been tightened. The transaction must meet the requirements for a sale in FASB Topic 606 (IAS 15), the revenue recognition standard. If there is a fixed-price purchase option, sale/leaseback treatment is not permitted unless the lessee does not control the asset at the time of the transaction and is acting as an agent for the original owner. If the leaseback qualifies as a finance lease, then no sale/leaseback has occurred. A failed sale/leaseback remains on the lessee’s books as an asset with the leaseback accounted for as debt.

Subleases: The “head lease” (intermediary’s lessee lease) is accounted for separately from the sublease unless the transactions meet specific contract combinations guidance. Rent income and expense should not be offset, unless the intermediary serves as an agent under Revenue Recognition rules.

A modification of a lease is treated as a new lease if the lessee receives an additional right-of-use (i.e., additional assets), which is priced commensurately with a standalone price. Otherwise, a modification is treated as an adjustment to the existing lease, including an extension of the term. If the scope of the lease increases or stays the same, the current methodology of adjusting the asset and liability by the change in the present value of the rents still applies. If the scope of the lease decreases, a gain or loss is recognized in proportion to the decrease in scope. So if you have a lease covering ten trucks and you return one, you would recognize 1/10 of the current difference between asset and liability (if any) as a gain.

A lessor modifying a finance lease adjusts the discount rate to keep the net investment the same with the new terms.

Implementation: The new standard must be implemented effective January 2019 (the FASB styles it as “fiscal years starting after Dec. 15, 2018,” since some companies use fiscal calendars that start the same day of the week each year, which might be in the last week of December). Privately held companies have an additional year to comply. Earlier implementation is permitted, though the IASB requires implementation of the new revenue recognition standard, IFRS 15, no later than the same time.

The plan is for the final official documents to be released in January. Then the work of implementation begins. 

Obviously, there are more details, some of which are not yet explicitly stated. But there shouldn't be any significant surprises when the final document is released. More details are available on the FASB project page.

FCS is working on updating our EZ13 software to meet the new requirements. We will provide a fully compliant update for all current users with active support contracts, so you can implement the software now and be confident of a smooth path to upgrading. We've been at this for forty years, longer than almost anyone else offering lease accounting software, so you know that our solution will be thorough, well tested, and comprehensive.

(This post was updated 3/10/16 to correct the relationship of non-lease components and executory costs.)

Wednesday, November 11, 2015

FASB: New leases standard implementation in 2019

As I think most observers expected, the FASB at today's meeting set the implementation deadline as fiscal years starting after Dec. 15, 2018, i.e., calendar year 2019. This matches the IASB decision from last month. The FASB will permit early implementation; they seem to think it most likely that lessors will be early adopters. Given the potential impact on financial ratios, lessees are less likely to want to adopt early. Unlike the IASB, the FASB is not tying early adoption of the new leases standard (ASC Topic 842) to the recently adopted revenue recognition standard. Non-public entities will be given an extra year to comply (i.e., effective 2020).

One more substantive issue came up at the meeting. FAS 13 includes a provision that, if a leased asset is in the last 25% of its economic life, the lease is operating unless there is an ownership transfer or bargain purchase option. The new standard as written lacked any such bypass. Some constituents, particularly lessors, objected to this change, arguing that for lessors whose business model is based on repeated rentals of the same equipment, they could find the anomalous situation of a series of operating leases, followed by a capital lease near the end of the asset's life. Lessees would be potentially caught by the same situation. While there was some concern that this might not properly recognize lessors who are intentionally selling off old assets via lease, the proposed solution for the situation was to skip the economic life test if a lease starts near the end of the asset's life, but to leave the present value/fair value test in place.

With this complete, the deliberations are supposed to be finished. The FASB's news release for today's meeting says the final Accounting Standards Update should be published in early 2016.

Here at FCS, we are working on updating EZ13 to meet the new standard. The current version allows you to treat operating leases as capital, so you can anticipate the effect of putting operating leases on the balance sheet. Complete compliance with the new ASC 842 (and the update to IAS 17 for international entities) will be released next year. We are looking forward to assisting corporations and other reporting entities, both in the United States and throughout the world, in meeting the challenge of the biggest change to lease accounting in 40 years. FCS has been specialists in lease accounting since even before the initial release of FAS 13, and we are happy to put our accumulated expertise to work for customers ranging from Fortune 500 corporations to solo CPAs. Please contact us for more information about how we can help you.

Wednesday, October 21, 2015

IASB: New leases standard implementation in 2019

At the IASB's October 20 meeting, the board had its final deliberations on the new lease accounting standard. The headline decision is that the board decided that the new standard would be required starting with fiscal years beginning on or after January 1, 2019. Earlier implementation is permitted if an entity also implements IFRS 15, Revenue from Contracts with Customers, on or before the date the leases standard is implemented. While the FASB will make its decision independently, it is highly likely they will choose the same implementation date.

Other items discussed:

a. A lessee, and a lessor with a finance lease, will account for a lease modification that extends the life as a continuation of a lease, rather than a new lease agreement. This means that the impact of the modification is recognized immediately, rather than at the end of the existing lease. The FASB has made the same change.
b. If a lease's rent is based on a floating interest rate, the lease's discount rate should change whenever the rents are updated due to an interest rate change. (In other words, the discount rate for calculating the obligation will track the rate used to calculate the payments, which means that the obligation and asset won't change.)
c. End of lease restoration obligations should be accounted for in accordance with IAS 37, Provisions, Contingent Liabilities, and Contingent Assets. (This is virtually the same as FAS 143, Asset Retirement Obligations.) The asset side of the transaction is added to the right-of-use asset for the lease; subsequent changes in the provision obligation result in adjustments to the right-of-use asset as well.
d. Short-term (12 months or less) and low-value asset leases that are not capitalized can remain uncapitalized in a business combination. The FASB has made the same determination for short-term leases, but does not have a low-value asset exemption from lease accounting.
e. Any leases that are considered within scope of IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, do not require additional disclosures beyond those specified in IFRS 5. (In other words, they are not included in regular lease reporting.)

The IASB says they are finished with all deliberations on leases, and will have a final ballot on the proposed standard before the end of the year.

Wednesday, March 18, 2015

IASB: It's a wrap

At the IASB's March 17, 2015, meeting, the board unanimously agreed that it is done with the new lease accounting standard, and committed their work to the drafting process. They considered whether or not another exposure draft was necessary, and concluded it was not, because all the substantive changes from the 2013 exposure draft either a) have been previously exposed (the single lease model was proposed in the 2010 exposure draft), b) are changes to retain existing accounting (lessor accounting), or c) are simplifications or clarifications responding to feedback received (such as excluding "small assets").

One IASB member stated an intention to dissent from the new standard. Presumably the others are on board.

The FASB is at essentially the same position. Neither board has stated a timeline more specific than "later in 2015" for when the final standard will be fully drafted and voted on. Neither have they set an effective date, though generally discussion has suggested two full years to prepare, which would suggest a January 1, 2018, effective date.

The IASB has released a summary document, Leases: Practical implications of the new Leases Standard, which describes the most important characteristics of the upcoming standard, with a comparison between current accounting and the two different standards that the IASB and FASB will be releasing.

It's been a slow train coming. The project was announced in July 2006. Maybe it'll be done for its ninth birthday, maybe not.

Friday, January 9, 2015

Standard release schedule update

The IASB has updated their project schedule with a target date for release of the new lease accounting standard: sometime in the second half of 2015. (The FASB's Current Technical Plan page has had a gee-whiz makeover that looks snazzy but provides no useful information about dates.)

At the December joint board meeting, the boards decided not to include in the definition of a lease that the lessee "must have the ability to derive the benefits from directing the use of an identified asset." So the definition remains “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration,” with the requirement that the asset be implicitly or explicitly identified (rather than simply the use of one of an ever-changing pool of assets, which is considered a service contract rather than a lease).

No board deliberations on leases are scheduled for this month.