Lease Accounting blog

EZ13 and Asset Retirement Obligations (ARO)

2012-01-31T12:04:00.001-05:00

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.

LWG favors level expense

2012-01-26T10:33:00.003-05:00

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.

Leases Working Group meeting on expense profile

2012-01-23T17:28:00.002-05:00

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.

December meeting results

2011-12-16T17:45:00.002-05:00

The FASB & IASB met again to discuss leases on Dec. 13 & 14. Significant decisions reached include:

Cancellable leases
If both the lessee and the lessor have the right to cancel the lease (without termination penalties) such that the minimum term, including any non-cancellable period and any notice period, is 12 months or less, it meets the definition of a short-term lease. The key here is that either side can cancel; if one side can require renewal, then normal lease accounting applies.

Investment properties
Rental income from property accounted for (under IFRS 40) as investment property will not be capitalized, as such property is out of scope of the new leasing standard. However, the boards still chose how to recognize rental income: straight line, or another systematic basis if more representative of use of the asset.

Disclosures for these lessor leases are to include:

Maturity analysis of future rents (at least 5 years by year, then the rest combined). This is not to be combined with the maturity analysis for capitalized leases.
Separate entries for minimum contractual rents and variable lease payments
Cost, carrying amount, and accumulated depreciation on leases
Narrative information about lease arrangement

Future meetings
The staff listed the following items to be redeliberated:

the definition of investment property (which is scoped out of this standard)
the "lessee accounting model"--as mentioned in a Wall Street Journal article that I commented on previously, the boards are going to discuss further a way to recognize level expense over the life of a lease, even though they rejected this earlier
additional disclosure items

November meeting results

2011-12-15T18:06:00.000-05:00

Sorry, I'm behind again. This is from a month ago; I'll post the results of December's meeting as quickly as possible. This is from the FASB & IASB joint board meetings of Nov. 15 & 16, 2011:

Leases in business combinations
An acquired lessee lease is set up as if it is a new lease at the acquisition date, except that the asset is to be adjusted for any "off-market" terms in the lease; that is, if the rent due is substantially above or below market rents, the difference between market (present valued) and contract is folded into the asset.

This is a significant change from current accounting, which calls for a fair value calculation for both the asset and the obligation at the date of acquisition, with the result that the two are normally different at the acquisition date. Now the normal case will be equal asset and liability at acquisition, unless the rent is considered off-market.

An acquired lessor lease, using the receivable & residual approach, is set up as if it is a new lease at the acquisition date for purposes of calculating the receivable. The residual is the difference between the receivable and the fair value of the asset.

An acquired lessor lease that is treated as investment property or a short-term lease (originally or according to the remaining life at acquisition) is handled according to current rules under IFRS 3 and FASB Topic 805 for acquired operating leases. (However, I don't actually see anything explicitly talking about operating leases in Topic 805 or its original source, FAS 141, so I'm not sure what that means.)

Transition
If a lessee has a previously recognized intangible asset or liability to reflect (un)favorable terms in an operating lease, that should be folded into the right-to-use asset.

Currently, the sale of operating lease receivables by a lessor cannot be treated as a sale; instead, it is accounted for as a secured borrowing (because the receivable is not recognized on the balance sheet to begin with). The boards discussed whether to permit sale treatment at transition. Requiring it was seen as onerous; permitting it as an option would reduce comparability. The boards decided to permit it on a prospective basis only.

First-time adopters of IFRS generally would apply the same transitional rules as other companies, except that they are to use fair value determinations for a right-to-use asset.

Fighting on the expense profile

2011-11-17T17:17:00.002-05:00

According to a Wall Street Journal article in yesterday's edition (available online only by subscription), most companies are resigned to the new lease accounting standard putting leases on the balance sheet. The primary issue they're pushing back on is the front-loading of expenses (which happens because interest is higher in the early years of a repayment schedule, while the depreciation remains straight-line throughout the lease term). The boards briefly considered, then rejected, a proposal earlier this year to make the expense profile straight-line by making the depreciation expense equal to the obligation repayment in each payment period; they didn't like the way the depreciation would look, and felt it was inconsistent with other aspects of accounting.

However, the topic hasn't died, and the article says that the FASB & IASB staff plan to revisit the issue with the boards, perhaps next month.

The article notes that the front-loaded profile is particularly problematic for retailers, who typically have lower revenues in the first years a store is open. Chains that are rapidly opening up new stores would be especially hard hit. The article indicates that investors also consider the expense front-loading unhelpful.

The article speculates that companies might shorten the life of their leases to reduce the impact of front-loading, but notes that that could cause problems for landlords who depend on long-term leases to guarantee their loans.

In other news, I realized I missed commenting on a November 1 meeting:

The boards worked through lessor disclosures, including:

A table of all lease related income items, listing separately profit at lease commencement, interest income on the receivable, interest income on the residual, variable payments, and short-term lease income.
Information about variable lease terms, renewal options, and purchase options
A reconciliation of the right to receive payments and residual assets (showing beginning balance, additions, payments or residual accretion, terminations, and ending balance)
A maturity analysis of future rent payments, by year for at least five years with the remainder as a lump sum
Information about how the lessor manages risks on the underlying asset

The boards decided that a lessor doesn't need to disclose:

Initial direct costs
The weighted average or range of interest rates on leases
"Fair values" of the receivable or residual (a term of art that requires determining a market price for sale)

Sale/leaseback transition

An existing sale/leaseback transaction that resulted in a capital/finance lease will continue to be accounted for with no adjustments.
A sale/leaseback with an operating lease or with no recognition of sale would be reevaluated based on the criteria for transfer of control of an asset in the proposed revenue standard (which presumably will be finalized no later than the leases standard; its exposure draft was put out Nov. 14). If met, the lease would transition like other operating leases.

Additionally, the FASB clarified that an exception from lease accounting under EITF 01-8, applicable to certain transactions entered into before May 2003, will not be retained, and such transactions will need to be accounted for as leases under the new standard.

This month's boards meeting

2011-10-25T17:23:00.004-04:00

On Oct. 19, the FASB & IASB again met to discuss the new lease accounting standard. In a marathon session (scheduled for 5 hours), they reached a number of decisions in several areas. (Note: in the discussion below, and elsewhere in discussions about this standard, "effective date" is the date companies must start reporting under the new standard, while "date of initial application" is the date, normally two years earlier for U.S. companies, as of which leases must be treated as capital once the new standard takes effect, due to the requirement to restate years shown as comparables in the annual report.)

Lessee transition

All existing capital leases will be carried over with no changes required. Previously, they had planned to require restatement of capital leases with variable payments or renewal options that would be treated differently under the new standard. They decided the benefit wasn't worth the cost, because in most cases the differences would be small (particularly given recent decisions to reduce recognition of variable payments and options).
The incremental borrowing rate to use for operating leases to be capitalized will be a single company-wide rate, not based on the individual characteristics of each transitioning lease.
Operating leases can be recalculated using either a "full" or a "modified" retrospective methodology. The same methodology must be chosen for all leases. Full means going back to lease inception and calculating the lease as capital. Modified is different from what was in the original Exposure Draft; I described it last month. They have clarified that the difference between asset and liability generated by this method is to be booked to retained earnings (no P&L impact).
The simplifications ("reliefs") mentioned last month were all confirmed: leases that terminate before the effective date of the new standard won't have to be restated, even if they start after the date of initial application; initial direct costs are excluded during the same period; and preparers may use hindsight to set up the leases.

Lessor transition

Capital leases other than leveraged leases can be carried over with no adjustments.
Leveraged lease accounting is eliminated. Such leases will have to be restated.
Current operating leases will have a receivable and residual set up using the present value of the rents and expected residual value at date of initial application, the interest rate being the rate charged in the lease as of lease inception; the underlying asset is derecognized. Lessors also have the option of full retrospective application.

Lessor receivables held for sale

A proposal to report receivables held for sale at fair value was rejected. While this would superficially be consistent with IFRS 9 and the FASB's Accounting for Financial Instruments project, it was felt that it added complexity, was inconsistent with the rest of the leasing standard, offered opportunities for structuring, and would add more variability in profit and loss. Instead, any gain or loss would be recognized when a sale of the receivable is completed.

Variable payments for lessors

If the rate a lessor charges a lessee assumes "reasonably assured" variable lease payments will be made, the residual asset (which by default contains the value of those payments, since the value is not in the receivable) will be adjusted by recognizing an adjustment to the residual. The adjustment is the variable lease payment divided by the fair value of the underlying asset, times its carrying amount.

Lessor receivable and residual

Investment property is excluded from the lease standard scope. This keeps those properties under IAS 40 for companies using IFRS. The FASB is working on a project to create the same standard for the U.S. (which presumably will be complete by the time the lease standard takes effect).
Profit on the residual will not be recognized until the asset is sold or re-leased.
The residual is initially booked at the present value of the residual. The value is accreted, with interest income recognized for the accretion, using the same interest rate as for the receivable.

Exposure Draft delayed to 2012

2011-10-21T17:05:00.005-04:00

The FASB & IASB have updated their project schedules to indicate that the revised exposure draft (RED) will be released in Q1 2012. That's another delay of three months from what was expected when they announced in July that a RED would be released. The Equipment Lease and Financing Association is reporting that the comment period will be a full 120 days; there had been speculation that the comment period might be shorter the second time around. That means that the comment period won't end until near the end of Q2. With time for redeliberation, that suggests that the final standard won't be out until late in 2012.

It's yet the latest delay in an oft-delayed project. When originally announced back in 2006, the boards expected to be done in 2009. The latest delay could affect the implementation date; speculation recently has focused on 2015 as the implementation date, but given the planned requirement to restate the prior two years of comparable financials, that means there could be just weeks between the release of the standard and when (1/1/2013) leases will effectively need to be reported under it. During those two years until actual implementation, bookings will be done under current standards, but companies will need to make sure they keep complete information on their leases to enable recreating their accounting under the new methodology. Of course, with the active consideration of full retrospective accounting (though probably not to be required, just optional), it would be good to be keeping information right now on any leases that you expect to remain active into 2015. (It is expected that leases that expire before implementation won't need to be recalculated.)

The boards held a lengthy meeting this week on leases, but I don't have time to review the 5 hours of recordings, and my normal sources haven't yet posted summaries of the events.

Boards get back to work, timeline slips further?

2011-09-26T17:26:00.002-04:00

When the FASB and IASB decided in July to prepare a second Exposure Draft for the proposed new lease accounting standard, they expected to finish all the loose ends in September and release the RED (Revised Exposure Draft) soon after. Oops, here we go again. The whole history of this new standard has been one of delays: when the project was announced in 2006, it was supposed to be completed in 2009.

Even before the meeting, the boards realized they weren't going to be able to do everything this month. (There was no joint meeting in August; it's not clear whether the month off was considered in their July timeline.) But the agenda for this month included the plan to bring "all remaining redeliberation issues to the boards in the October joint board meeting." Now Asset Finance International is reporting that the boards want more time to redeliberate the remaining issues, and that it might take until next February to issue the RED, with a final standard of course being several months after that (to allow time for public comment, then redeliberation). It's not clear what their basis is for this projection; the FASB's Technical Plan still has a Q4 estimated publication date for the RED (with the notation that this was updated 9/23/11), though it doesn't list any date for the final standard. However, some decisions due this month were either completely deferred or have loose ends dangling.

Decisions made at the Sep. 19 and Sep. 21 joint board meetings:

Scope - inventory
Some people had suggested that the right-of-use asset for a lease could in some cases also meet the definition of inventory, and would be subject to potentially conflicting standards. The boards decided that the situation doesn't really seem possible, and therefore there's no need to prepare guidance to distinguish.

Financial asset guidance application to lessor's right to receive payments
A major concern of the boards is keeping accounting consistent between different types of transactions. The lessor's right to receive rent payments could be considered a financial asset. The boards decided that such standards (specifically, IFRS 9, IAS 39, and US GAAP Topic 825) should not apply to regular measurement of the receivable, but would apply to impairment. This also confirms the previous decision that fair value measurement/revision is not permitted for the receivable.

Lessor impairment
For the lessor receivable, the impairment standard for the applicable GAAP environment (Topic 310 for U.S. preparers, IAS 39 for IFRS) applies. For the residual asset, IAS 36 and Topic 360 apply; for US preparers, this indicates impairment is handled in a manner congruent with property, plant, & equipment, rather than intangibles. This is basically the same as lessee treatment.

Lessor balance sheet presentation
Lessors will be required to report all their leased assets, both receivables and residuals, as a "Lease Assets" line in PP&E. Lessors may choose whether to separate the receivables and residuals in the balance sheet, or footnote the detail. Sublease assets should be shown separately.

Subsequent adjustments of variable rents, lessor
The recalculation of variable rent payments due to changes in a rate or index (such as changes in LIBOR or the CPI) can result in a gain or loss. That is to be recognized immediately in profit & loss, rather than being rolled into the asset (as is largely the case for lessees).

Lessor accounting for residual value guarantees
The boards agreed that a residual value guarantee would not be separately recognized (whether provided by the lessee or a third party). It would be taken into account in determining the value of the residual asset, including testing for impairment.

Lessor cash flow statement
Lease payments are classified as operating (not investing) activities. An exception was made, however, for cash flows related to securitized receivables, which would be accounted for under existing guidance.

Transition, lessees
The ED called for lessees to capitalize the remaining rents on all operating leases, with an equal asset and liability set up at the date of initial application. (Note: the effective date is when the standard takes effect; the date of initial application is the date, two years prior for most US companies, as of which leases have to be treated as capital for comparison purposes.) The problem with this for the income statement is that because it treats all (formerly operating) leases as new on the date of initial application, all of those leases will be at the beginning of the interest amortization curve, when the interest recognized is highest. This means that all lessees would face considerably higher expenses than rent payment as of initial application (with expenses dropping over time, as the principal is paid down and interest correspondingly declines).

It was recognized that this results in artificial swings in expenses. For a lessee with a mix of leases starting and ending roughly evenly from year to year, the overall lease expense profile should be relatively flat, even as each individual lease shows more expense in the early years and less in the later years.

In looking for ways to mitigate this, the staffs presented to the boards two alternatives:
1) full retrospective approach
2) modified retrospective approach (distinguished from the ED's "simplified retrospective approach")

Full retrospective is seen as theoretically preferable. However, it is recognized that for some preparers, this may be difficult to execute. One particularly challenging scenario is leases that have been acquired in a business combination, where the original information for the lease may no longer be available. Long-lived leases may have similar issues. Therefore, the staffs proposed a modified methodology, where the liability would be calculated as the ED specified (present value of remaining rents, using the incremental borrowing rate at the date of initial application), and the asset would use the same calculation back to inception, then recognize the fractional amount of the lease term remaining.

Transition example (provided in Agenda Paper 2G/203):
(Please note: I calculate slightly different present values, using an HP12C or Excel, than the agenda paper presents. In the example below, I list first their calculation, then my calculation in parentheses with an asterisk.)
10 year lease, payments of 1000 CU (generic Currency Units) yearly in arrears
interest rate of 5.7%
date of initial application: beginning of 5th year (i.e., 6 years remaining)

present value of rents at inception: 7,472 (*7,466)
present value of rents at application: 4,967 (*4,964)
asset at application: 7,472 * 6 / 10 = 4,483 (*4,479)

The difference between the asset and obligation would be taken as a "cumulative catch-up adjustment." I believe this would be booked directly to retained earnings, not recognized in profit and loss. Because of the way the interest method works, every lease (except possibly a lease that has lower rents at the end of its life) will book a charge to retained earnings to be set up, so the cost of reducing the impact to the income statement is increasing the impact on the balance sheet (debt/equity ratios will balloon even further). Pick your poison.

The boards, however, didn't pick their poison. They deferred the decision to next month, asking to combine the decision with transition rules for lessors and subleases.

The staffs also suggested a few simplifications: 1) leases that terminate between the date of initial application and the effective date would not have to be restated; 2) exclude initial direct costs for leases that start before the effective date; 3) allow use of hindsight in estimating such lease characteristics as variable lease payments, renewals, and impairment. These will be considered as part of the entire transition package.

This kind of continued change is why no software publisher can claim to be compliant with the new lease accounting standard yet. It's a moving target. But we'll update EZ13 once decisions are finalized; in the meantime, EZ13 allows you to treat operating leases as capital, either from inception or as of a specified cutover date as specified in the original ED, to estimate what your exposure is.

Catching up on June results

2011-07-26T20:30:00.001-04:00

June 13 meeting results:

Short-term Lessee Leases

The boards agreed to operating lease accounting for lessee leases with a maximum lease term (including renewal options) of 12 months or less. No asset or liability need be placed on the balance sheet, and rent expense is recognized on a straight-line basis over the lease term. (Lessees may choose to do full finance lease accounting if they wish. How likely is that?) Disclosure of current rent and how representative that's likely to be of the future was discussed.

Subleases

A head lease and sublease are to be accounted for as separate transactions, using normal lessee accounting for the head lease and lessor accounting for the sublease (using the right-of-use asset as the fundamental asset for the transaction, not the original underlying asset).

June 1 meeting results:

Foreign Exchange Differences and Impairment

Both of these are to be recognized in accordance with existing guidance, which is somewhat different between FASB and IASB.

Residual Value Guarantees

The new standard calls for recognizing only the portion of any residual value guarantee that is expected to be payable, rather than the maximum amount. If there is a significant change in the expected RVG payable, an adjustment is required; the portion that applies to current or prior periods is recognized in profit or loss, while the right-of-use asset is adjusted for the portion applying to future periods.

Second Exposure Draft coming

2011-07-26T20:26:00.002-04:00

I need to catch up on the boards' activity over the last two months. I've taken a summer hiatus, but they didn't...

The most important news is that at the July 21 meeting, the boards unanimously decided to release a second Exposure Draft. The changes to the proposed standard from the original Exposure Draft are so significant that they felt it important to get feedback from interested parties. Some decisions remain to be made before the new Draft can be released; they expect to complete those deliberations during Q3, with a new Draft released soon after. The wording seems to suggest that the Draft would come out in early October.

Additional decisions reached this month:

Lessor Accounting

The performance obligation model has been scrapped. All leases (except for short-term leases) will be accounted for using a "receivable and residual" model, which is essentially the same as the "derecognition approach" described in the Exposure Draft. Main points of this model:

* The lessor recognizes a right to receive lease payments (matching the lessee's obligation to make payments) and a residual asset.

* The discount rate to present value the payments is the "rate the lessor charges the lessee" (the internal rate of return, based on the asset's value).

* The residual asset accretes (increases using the interest method, same interest rate) over the lease's life.

* If the asset's carrying amount is lower than the lease's value, a profit (on the portion of the asset represented by the lease receivable) can be recognized at commencement of the lease if reasonably assured.

Short-term leases, defined as those with a maximum term of 12 months or less, will be accounted for as operating leases (no balance sheet effect, just income recognized over the lease term on a systematic basis, usually level). This will protect against needing to do convoluted accounting for things like rental cars and hotel rooms.

Operating lease accounting will also be permitted for leases of investment property measured at fair value. This is currently only available under IFRS (IAS 40). But the FASB is working on a proposed investment property standard which would be similar, with an Exposure Draft scheduled for Q3 2011.

Contingent Rents Dependent on an Index or Rate

While other contingent rents are excluded from the capitalized calculation of leases, those that depend on an index or rate have to be included. An example would be a lease whose rent is based on CPI or LIBOR. Such leases are to be initially measured based on the index/rate at the commencement of the lease, then recalculated at the end of each reporting period using the new index/rate. The change is booked to net income if it applies to the current reporting period, or as an adjustment to the right-to-use asset (for a lessee) for adjustments that relate to future periods. Lessors would recognize an adjustment in the receivable in profit or loss.

This is a potentially significant cause of recalculations on leases; many real estate leases have CPI escalators that adjust every year. The boards decided that the benefit of more accurate presentation of actual rents due outweighs the effort required.

Lessee disclosures

The boards approved a lengthy set of disclosures for lessees:

* Reconciliation of opening & closing balance of right-to-use assets, disaggregated by class of underlying asset
* Reconciliation of opening & closing balance of lease liabilities (no disaggregation required)
* Future rent commitments, similarly to current FAS 13 requirements (by year for five years, then all remaining, then subtracting interest to reconcile to the liability balance). Note that this is different from current IFRS requirements. Preparers would have the option to disclose by year for more than 5 years, if that would provide better information.
* Information about leases signed but not yet started if they create "significant" rights and obligations
* Information about contingent rentals and options
* A table of expenses: amortization, interest, variable payments, and short-term rents, plus a breakdown of principal and interest paid
* Information regarding any expected material changes in short-term rentals

However, they explicitly are not requiring disclosure of discount rates, fair value of liabilities, purchase options, or initial direct costs.

They also explicitly forbid combining interest and amortization expenses and presenting the total as lease or rent expense.

The boards split over whether or not to disclose future commitments for services and other non-lease components; the FASB wants such disclosure (which is already required by the SEC in the unaudited portion of the financial statements), while IASB does not. Presumably this will be reconciled at a later date (perhaps after the Exposure Draft is released and reviewed).

Lessee primary financial statements presentation

Lease right-of-use asssets and liabilities either must be presented separately in the Statement of Financial Position (balance sheet), or shown separately in footnote disclosures. The right-of-use asset is to be presented according to the type of underlying asset (land leases with land owned assets, etc.). They have decided not to define whether the right-of-use asset is tangible or intangible. This is a question that affects some regulated industries for tax and other purposes. The boards have decided to let the relevant regulatory bodies make the determination appropriate to their purposes.

The Statement of Cash Flows would show principal and interest payments in accordance with requirements for other financing. Variable lease payments (not capitalized) and short-term rentals are operating cash flows. New leases (creating a new asset & liability) would be an additional non-cash disclosure.

June meeting results in next post...

The pendulum swings again

2011-05-25T17:32:00.005-04:00

The big news last month was that the FASB & IASB decided to reinstate a close cousin of operating lease accounting for lessees, with a level expense recognition pattern (though the leases would still be reported on the balance sheet). It was a sharply divided vote. Now, a few members of each board have switched sides, and in another divided vote, the boards have decided to ditch the "other-than-finance" lease category and account for all lessee leases the same way, as finance leases. This means a forward-leaning expense profile (depreciation is equal over the life of the lease, but interest is higher at the beginning of the lease, just like with a mortgage), which many respondents to the Exposure Draft vehemently protested. One reason given was that board members didn't like the options for how to account for the level expense recognition.

The boards also informally voted to eliminate the exemption of short-term leases (12 months or less maximum lease term, including renewal options) from the requirements of the standard that was agreed to in March. However, that will be reviewed and finalized at a later meeting.

Options

In another backtrack that most lessees won't like, the boards have increased the likelihood that options will need to be included in the lease term. In deciding whether to include an option, one must decide if there is a "significant economic incentive" to renew. A prior meeting decided that only economic factors should be considered in this determination (including contract-based factors such as below-market rents or penalties for non-renewal, and asset-based factors such as the existence of large leasehold improvements that would normally be amortized over a longer period). The boards have now decided to include "entity-specific factors," such as historical practice of the company or industry and management intention. The boards noted that a single factor does not have to be determinative, but the door is still opened up to an increase in subjectivity and need for ongoing review.

Lessor accounting

The boards haven't decided if lessors will use one or two approaches to accounting for their leases. So they made decisions for either possibility:

One approach

If all leases are treated the same way, the partial derecognition model will be used, with the residual value accreted over the life of the lease. This is, I believe, basically the same as current finance lease accounting (sales type accounting under FAS 13).

Two approaches

If two methods of accounting are used, leases will be distinguished based on whether the lease transfers substantially all of the risks and rewards incidental to ownership of the underlying asset. This is the concept underlying both FAS 13 and IAS 17. The boards clarified that among the indicators would be comparing rent to fair value and the existence of variable rent (the latter would be an indication that risks have been transferred to the lessee). Existence of embedded or integral services would not be considered in the determination.

For leases that transfer substantially all of the risks and rewards of ownership, the entire asset would be derecognized, with the residual initially measured at its present value and accreted over the life of the lease.

For other leases, the boards could not come to an agreement. The IASB preferred derecognition, while the FASB preferred current operating lease accounting. This will be revisited at a future meeting. (Neither board, though, preferred the Performance Obligation (PO) method that was presented in the Exposure Draft. That seems to be dead.)

Lease modifications

The boards decided that a "substantive change" in a lease agreement would result in treating the modified agreement as a new contract. This applies if the new terms would change the determination of whether the contract is or contains a lease, or the determination of whether substantially all the risks & rewards of ownership are transferred to the lessee. A change in circumstances (not of the contract itself) can cause reassessment of whether the contract is or contains a lease, but not whether risks & rewards of ownership are transferred.

Discount rate

The interest rate used to present value the rents and amortize the principal (obligation or receivable, depending on whether it's the lessee or lessor) will not be reassessed if the lease payments don't change. However, if a lease is extended because an option needs to be included (either because an option is exercised, or it is deemed to be includible because of a newly recognized "significant economic incentive"), the discount rate (which is typically the incremental borrowing rate for lessees) is to be reassessed, using the current rate, and the present value of the remaining rents is then recalculated.

Lease accounting standard delayed

2011-04-21T21:27:00.002-04:00

The FASB & IASB have decided that they cannot complete the new lease accounting standard (as well as standards on revenue recognition and financial instruments) by their target of June 30, 2011. Instead, they will continue to work on the standard into the second half of 2011. The FASB Current Technical Plan page suggests a Q3 final standard, but notes that they expect to release a new Exposure Draft, because of the magnitude of changes from the original Exposure Draft released in August 2010. The boards have not officially committed to re-expose, but if they do not, they will do an enhanced public review, making a draft standard available for review, with outreach to interested parties.

Other decisions made this month:

Contingent (variable) payments: The boards stepped back further from their widely criticized ED proposal to capitalize contingent rents. Now the only contingent rents that are to be included are 1) those dependent on an index or rate, and 2) those that are "in-substance fixed lease payments but are structured as variable lease payments in form." This is essentially an anti-abuse provision; it is unlikely that any normal lease would be affected by this. The boards haven't yet decided whether contingent rents based on an index or rate need to be reassessed when the reference number changes; that will be decided at a future meeting. If they decide not to reassess, it would mean a complete reversion to the current standard.

Definition of a lease: There has been substantial discussion over the requirement for a "specified asset." This month's deliberations concluded that a physically distinct portion of a larger asset (like a floor of a building) qualifies, but a capacity portion (like partial usage of a pipeline) does not. The asset can be explicitly or implicitly identifiable.

Other-than-finance leases: Operating leases are back as a category, with the primary difference being that they will now be on the balance sheet. But on a divided vote (with 7 IASB members opposed, plus 1 FASB member), the boards decided to have two accounting approaches for lessees, with the distinction being basically the same as IAS 17 (the IFRS leasing standard, which is similar to FAS 13 but doesn't use the 75% and 90% "bright lines" to differentiate between operating and capital leases). They're using the awkward term "other-than-finance," presumably because they want to differentiate it from current operating lease accounting, which doesn't hit the balance sheet. Maybe somebody will come up with a better name before the standard is released. Such leases will have their expenses recognized as rent expense in the operating section of the income statement, rather than as a financing activity. The liability will still be amortized using the interest method, but the asset will be amortized so as to keep the combined periodic expense level over the life of the lease.

There will similarly be two accounting approaches for lessors, but the boards reached no conclusions on application.

More decisions, summarization so far

2011-03-30T11:31:00.000-04:00

The FASB and IASB met again last week to further deliberate on leases. Among the decisions reached:

Start of accounting: A lease may be signed well in advance of when the lessee takes possession of the property (particularly with property, which may need extensive construction before occupancy). The boards have affirmed that the lease does not hit the books until the "commencement" of the lease, which is normally when possession is granted. Payments made between the "inception" (signing) and "commencement" will be accounted for as prepayments (an asset that is then folded into the ROU asset at commencement). If the lease meets the definition of an "onerous contract," it is to be accounted for during the inception to commencement period according to the Contingencies accounting standards: IAS 37 and FASB Topic 450.

Tenant incentives: Lessees are to subtract these from the right-of-use asset.

Sale & leaseback: Rather than a series of tests in the Exposure Draft to determine whether a transaction qualifies for sale and leaseback accounting, the boards have now decided that as long as the sale part of the transaction meets the existing accounting requirements (under the Revenue Recognition standard) to recognize a sale, it qualifies for SLB treatment. In general, if control of the asset has passed to the buyer/lessor, it qualifies. One change from current SLB accounting is that if the seller/lessee has a gain or loss on sale, that is to be recognized immediately, rather than amortized over the life of the lease.

Leases with service components: When the service component is not clearly identified separately in the agreement, the FASB in the ED called for capitalizing the entire contract as a lease (the IASB favored split recognition). Both boards have now decided that if the purchase price of one component (lease or service) is "observable," you can calculate the split based on that.

Discount rate: FAS 13 calls for the interest rate on lessee capital leases to be based on the lease's implicit interest rate, if known, or the lessee's incremental borrowing rate (IBR). In many cases, the lessee doesn't know the lessor's implicit rate, because the expected value of the asset at lease expiration (the "unguaranteed residual") is not stated, so the IBR tends to be used. (The rate may be higher if the present value of the rents using these rates is more than the fair market value; in that case, a rate is calculated to make the PV of the rents equal to the FMV.)

The ED introduced a new term: "the rate the lessor charges the lessee." This is to be used when available, a decision now confirmed. Finally, though, the boards have defined what they meant; this can be (from the observer summary) "the lessee's incremental borrowing rate, the rate implicit in the lease, or, for property leases, the yield on the property. When more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used." The lessor always by definition knows this rate. If the lessee does not, the IBR is to be used.

Initial direct costs: The boards defined this as "Costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made." The intent is to have a consistent definition for a series of standards (including insurance and revenue recognition, which are at similar stages of development), though there may be slight modifications to meet specific needs of the different standards. Any such differences are intended to be explained by the boards, to maintain the overall consistency.

IDCs are to be capitalized by both lessees and lessors, by adding them to the right-of-use asset and right to receive lease payments, respectively.

Summarization: The IASB staff has prepared a detailed description of the impact on the ED of the new decisions by the boards. This describes both the confirmed decisions and the changes, with links to IASB observer notes for each.

Thanks to the IASB for their podcast and to Asset Finance International for their summary.

Ownership transfer leases, update

2011-03-22T13:21:00.003-04:00

In my March 17 post, I said that it wasn't clear how the scope change affected leases with an ownership transfer. Based on the IASB Update just released regarding last week's meeting, it seems clear that they are also to be considered leases. The boards have decided to simply eliminate the language that took leases with bargain purchase options and ownership transfers out of scope of the leasing standard.

Purchase options and short-term leases

2011-03-17T10:17:00.004-04:00

The FASB & IASB met this week for continuing discussions, on leases as well as other topics. In their meetings on March 14 & 15, they reached the following conclusions for the new lease accounting standard:

The ED had scoped out (excluded) leases with bargain purchase options and ownership transfers (also called "in-substance purchases") from the new lease accounting standard, stating that they should be treated as a sale & purchase and handled according to the revenue recognition standard (which is also at the ED stage). However, this decision was left over from when the boards had briefly planned to treat all lessor leases according to the "performance obligation" model, which would have been inappropriate for these transactions. With a derecognition model for lessors now in place, the need to separate out these types of leases is less evident. The boards agreed that leases with a bargain purchase option should be returned to the scope of the leases standard. It's not yet clear if leases with ownership transfer will be considered leases or sales.
Relatedly, the boards are adjusting the treatment of purchase options. In the ED, these did not need to be accounted for until exercised. Now, they must be accounted for if there is a "significant economic incentive" to exercise them. It remains to be determined how the accounting will work if the conclusion of a significant economic incentive changes in the middle of the life of the lease (in either direction), though the boards concluded that they would not permit a switch between the "finance" and "other than finance" categories they set up last month.
Short-term leases: The boards have decided that leases with a maximum lease term of 12 months or less, including renewal options, can be treated like current operating leases. They will not be shown on the balance sheet for lessees; income and expense will be shown on the income statement as currently (with rent leveling as needed). This will be an option; lessees & lessors can choose to treat short-term leases like other leases. However, the option must be chosen for all leases in an asset class, rather than lease by lease.

Thanks to Deloitte's IAS Plus and Asset Finance International for their reviews of the meetings, which were the basis for this entry.

2015 implementation?

2011-03-17T09:50:00.004-04:00

The new leasing standard is one of several major standard revision projects the FASB & IASB have underway. Others include revenue recognition and insurance contracts, which are considered heavily interrelated with the leases, and other comprehensive income, fair value measurements, financial instruments with characteristics of equity, and financial statement presentation, which are considered more independent of other standards.

The boards put out a separate Exposure Draft asking for comments on implementation dates. While the volume of comments wasn't nearly as high as for the leases ED, the consensus response was that the impending changes are major, and financial statement preparers need substantial time to update their systems. At the boards' combined March 2 meeting, the boards didn't decide whether to implement the three linked standards (leases, revenue recognition, and insurance contracts) at the same time or in staggered order, but stated that they "will provide adequate time for stakeholders to apply the new requirements." Several members of the IASB stated a preference for 1/1/2015 as the implementation date, while most FASB members didn't want to make a commitment to a date at this time, and several expressed a preference for a staggered implementation.

Note that since U.S. companies typically report two years of comparables, and the leases ED says those comparable years will need to be restated on implementation, that means that effectively companies would need to apply the standard effective 1/1/2013, even though they wouldn't be reporting the results accordingly until later. It's not clear yet whether earlier implementation will be encouraged or permitted.

They hear you

2011-02-23T12:31:00.000-05:00

Anyone who had any doubts that the FASB and IASB seriously consider responses received during their "due process" steps need only look to last week's meetings and the decisions reached on lease accounting. In addition to the previously reported complete reversal on the lease term, the boards have made an almost complete reversal on contingent rents, and are planning to substantially alter the standard to respond to the desires of those who want level recognition of expenses over the life of a lease. These three topics were probably the most strenuously argued in comment letters to the Exposure Draft.

The boards aren't backing down on putting lessee leases on the balance sheet. But they're showing that they are willing to work with preparers and accountants to make the standard more workable and less onerous.

Contingent rents

The Exposure Draft called for all contingent rents to be included in the capitalized lease payments using a probability-weighted estimate, based on a "reasonable number" of estimates. Rents based on an index or rate were to use forward rates when "readily available." Estimates would need to be revised as often as once a quarter, with changes in future rents booked as upward or downward adjustments to both the asset and the obligation (changes affecting current or prior periods would be immediately expensed).

Preparers howled. The work involved would be enormous, and would often involve forecasting well beyond normal planning horizons (a 20-year lease with a percent of sales kicker would require forecasting sales out that far, when few companies go past 5 years in their regular forecasting). The requirement for quarterly reassessment, even if softened by stating there needs to be a "significant change," would add measurably to the load of releasing statements. Much of this could not be automated, because contingent rents have immense variability in terms.

The boards have now almost completely reversed themselves. The new plan agreed to last week is that contingent rents need to be included in the capitalized rent stream in just the following cases:

* they are based on an index or rate--and in that case, the current rate is used, with no use of forward rates, though it will need to be updated each reporting period (unlike current GAAP, where the rate at lease inception is used throughout the life of the lease)

* they are "reasonably assured," with the definition to be determined later

* the base rent is below market rates

Other contingent rents will be subject to disclosure, but not capitalization.

Expense recognition pattern & placement

Many respondents to the ED complained about the income statement effect of capitalizing all leases. They didn't like two different aspects of this:

* Amortizing the obligation using the interest method, while amortizing the asset on a straight-line basis, means that expenses are greater in the early months & years of a lease, then decline over time.

* Lease payments and interest expense would classified as financing activities. Both interest and depreciation expense are excluded from EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an important measure of earnings for many companies.

Those who objected felt that level expense recognition was more reflective of economic reality, and that leasing should be considered operational rather than financing activity.

The boards concluded that there are two types of leases. Some leases truly are financing transactions (such as most current capital/finance leases). For those, the boards believe the current plan of interest and depreciation is appropriate. But others, they conclude, do not have a strong financing component, and a level expense pattern would be more appropriate.

Can you say "classification"? One of the big reasons for the new lease accounting standard was supposed to be eliminating classification of leases into two types, because of the concern that similar leases are being accounted for differently (those just on either side of the dividing line). The stories about leases with a present value of 89.9% of the fair value (just below the 90% line that makes a lease capital) have been around for a long time. Just because the bright lines are going away doesn't mean that there won't be structuring.

But the boards seem to be accepting that different reasons for leasing merit different accounting treatment. They may also be swayed by the fact that different ways of recognizing expenses can have collateral impact--companies that depend on expense reimbursement from government medical and other contracts, for instance, noted that rent expense is often reimbursable, while depreciation and interest on debt are not. They may also be concluding that the effect of possible structuring in these cases isn't as egregious as making things disappear entirely from the balance sheet.

Of course, once you say that there are two types of leases, the question becomes, how do you tell which is which? The new standard is supposed to be "principles based" rather than "rule based," so we won't have a 90% or 75% test. Instead, the boards are looking to prepare a list of factors which would be considered. Some of them are (a) residual asset, (b) potential ownership transfer, (c) length of lease term, (d) rent characteristics, (e) underlying asset, (f) embedded or integral services and (g) variable rent (thanks to Deloitte for its notes on the meeting that had this list). The boards will be discussing in the future how these factors interact, as well as proper presentation of leases considered "other than financing."

Lease vs. Service Contract

The boards spent considerable time continuing to try to differentiate between leases and service contracts (when a contract has elements of both). One conclusion they reached is that if an asset is incidental to a service, it doesn't have to be accounted for separately. (So, for instance, when you get a cable TV subscription that includes a cable box, the box doesn't have to be treated as a lease.) They also tentatively decided that the requirement for a specified asset is still met if the lessor has the right to swap out an equivalent item assuming no disruption of service (such as replacing a copier with another of the same model).

Most discussion was focused on lessee accounting. The boards have decided to discuss that primarily at this point, with the intention to get back to lessor accounting to keep things as symmetrical as possible.

A number of the decisions and issues will be reviewed with preparers, users, and accountants, with a report back to the boards at a later date.

"More likely than not" is dead

2011-02-17T09:42:00.004-05:00

At yesterday's meeting (Feb. 16), the IASB and FASB agreed to withdraw the proposal to include lease renewal options in the lease term when judged "more likely than not" to be exercised. This was the proposal in the Exposure Draft, which was almost universally opposed by respondents, particularly preparers of statements. Asset Finance International's summary of the meeting notes in addition to complaints of difficulty of implementation and subjectivity, another persuasive argument for board members was that real estate lease renewals frequently are not actually implemented as stated in the original option, but are subject to negotiation like a new lease, so the stated option doesn't necessarily reflect what the terms will be even if "exercised."

Rather than reinstating current terminology on when to include options (when "reasonably certain" or "reasonably assured" of exercise due to various economic factors), the boards have tentatively chosen the phrase "clear economic incentive." The boards didn't seem to think there was a substantial difference in impact, so it seems to be more a stylistic choice.

Reassessment of lease terms, which previously was required on a quarterly basis, is now to be required only when there is a significant change in circumstances, such as an addition or removal of a "clear economic incentive" on a renewal option.

Contingent rents will be discussed today.

ED response reviews

2011-02-16T15:25:00.003-05:00

Deloitte & Touche has released a "Heads Up" summary of responses to the lease accounting exposure draft.

Asset Finance International (an association of lessors primarily focused on Europe) has its own summary.

Death knell for "more likely than not"?

2011-02-10T17:19:00.004-05:00

The IASB & FASB will be meeting next week. On the agenda on Feb. 16 meeting: the definition of the lease term. The staff briefing paper for the discussion, noting the almost universal rejection of the proposal to include lease options in the lease term if they are judged "more likely than not" to be exercised, recommends that the lease term be defined essentially the same way as it is now under both IAS 17 and FAS 13: the contractual minimum, plus options that are reasonably certain to be exercised. The staff's recommendation is that "reasonably certain" be determined solely on economic factors (such as bargain renewal options, penalties for cancellation, presence of long-lived leasehold improvements, etc.), with no weight given to past practice or management intention, which the majority of the staff considers too subjective. They do list that as an option for the boards, though, along with keeping the "more likely than not" criterion.

Given the vehement rejection of "more likely than not" in the comment letters and other outreach activities, this was, I think, expected by most observers. But assuming it comes through, it'll be a very clear indication of the significance of participating in the boards' due process.

Also on the agenda for the boards' meetings next week is variable (contingent) lease payments.

The majority staff position is that only contingent rents dependent on an index or rate should be included in the lessee's liability to make payments, with the valuation based on the prevailing (spot) rate. A minority would add all payments that are "probable" or "reasonably certain." Additional disclosures would be required, but those won't be discussed at this meeting.

This is again a pretty thorough repudiation of the Exposure Draft, which called for probability-weighted estimates of all contingent rents, including those based on usage and percentage of sales. Combined with the original proposal to include "more likely than not" options, it raised the potential of needing to estimate business and economic conditions for 50 years, an exercise that was unlikely to bear any significant connection to reality.

With these two changes, the complexity in the ED is greatly reduced. There is still the inherent complexity of capitalizing the leases, but that's far less challenging to deal with.

EZ13 data entry tips #2

2011-02-01T16:23:00.003-05:00

See yesterday’s blog entry for information on how to copy a lease, create escalating rents, or create the full series of rents for level principal payments.

Date entry

While you can enter a date by typing it in with slashes, exactly as shown, there are other options.

Click on the down arrow next to a date to display a calendar (on the calendar, click on the month or year to change them, or the left or right arrow to go back or forward a month).
Click on one portion of the date (month, day, year) and press + or – to add or subtract one to that number (note: this cycles without affecting the rest of the date, so if you highlight the day on 1/31/2011 and press +, the date changes to 1/1/2011, not 2/1/2011).
You can enter just the last two digits of the year; EZ13 guesses the century, based on the setting for your computer. By default, the window is 1930-2029. You can change it in the Regional Options of Control Panel. (Control Panel, Regional & Language Options, click on Customize, click on the Date tab, change the end date of the window.)
You can use letters with the same meaning as Quicken/Quickbooks assigns to them:

Y, R - beginning or end of YeaR

M, H - beginning or end of MontH

T - Today

F - Forward one day

B - Back one day

All of these (except T) are cumulative: for instance, if you press Y when at the beginning of a year, the date moves to the beginning of the prior year.

F and B are different from Quicken, which uses + and - for the same purpose.

Help

Context-sensitive help is available throughout EZ13. If the cursor is in a field when you press F1, you get a description of the field and what to enter there. If a different window is displayed, information about that window is provided. Virtually the entire manual is found in the help screens.

EZ13 data entry tips #1

2011-01-31T12:26:00.003-05:00

One of my intentions for this blog has been to provide usage notes for EZ13, FCS's lease accounting software for capital and operating leases, but I’ve ended up generally more focused on what’s happening with the FASB & IASB as they revised the lease accounting standard, because so much has been happening in that regard. Today, though, I’m going to take a moment to offer some tips on using EZ13.

There are a number of features designed to make entry of leases faster and more convenient, but many of them aren’t necessarily obvious. (They're described in the documentation, but I harbor no illusions about how much documentation is read.) I’m going to go through a few of these today:

Copy a lease

You may have several leases that are the same or almost the same (several copiers leased at the same time, for instance). EZ13 allows you to copy all the data entered for a lease to create a new lease record. Use menu item Lease/Copy; all the information from the current lease is copied to the new record, except only for the lease number (since that must be unique).

Rent Escalation clauses

Many real estate leases call for an automatic increase of rent every year or every 5 years. The increase might be a percentage or a dollar amount. (Note that if the increase is based on future events, such as the change in the Consumer Price Index, that’s considered contingent rent, and only the base rent is considered minimum lease payments for FAS 13 reporting purposes; the contingent rent is simply expensed when incurred.) Rather than needing to calculate and enter each rent amount, EZ13 allows you to specify the base rent, the increment (in dollars or percent), and when the change happens. You can separately specify the executory cost, which might remain the same or change with a different increment. Use menu item Lease/Rent Escalation. Note that the rent escalation period does not have to cover the entire life of the lease.

Level Principal Rent

Relatedly, some leases are set up so that the same amount of principal is repaid with each lease payment. Since the interest is constantly decreasing as the principal decreases, this means that each rent payment is different. Entering that for a 36- or 60-month lease can be pretty tedious! EZ13 can set up the full set of payments using menu item Lease/Level Principal Rent, you just enter the initial principal, interest rate, and length of the lease (with an option for additional fixed rent, such as a service charge that's added to each payment, and executory costs).

I’ll describe some additional input convenience features tomorrow.

First redeliberation session

2011-01-28T16:13:00.001-05:00

The IASB & FASB met in joint session last week. On the agenda, as previously noted, was the first round of reconsideration of the new lease accounting standard, reacting to the responses received on the Exposure Draft.

The separation of leases from service contracts is a major issue, including the question of service contracts that include physical assets. One example is a cable TV subscription; if the cable company gives you a cable box, does that make the whole transaction a lease rather than a service? Does the box need to be accounted for separately as a lease? Or should some small amount of physical assets be ignored in this situation? (How small?)

The boards also discussed whether all leases should be considered a form of financing (which merits the accounting proposed with delinked asset and obligation), or if some aren't really financing and should be recognized with a straight-line expense/income pattern.

Lessor accounting was also discussed in detail. Some respondents suggested putting off lessor accounting, but the boards agreed to keep discussing both sides of the transaction, particularly issues that are relevant to both. There is a wide range of views on whether there ought to be one or two kinds of lessor accounting, and if one, which one, though the boards seem to have considerable sympathy for the idea that there are two different business models for leasing that ought to be accommodated.

A number of respondents complained about the lack of symmetry between lessee and lessor accounting (sauce for the goose, sauce for the gander?); the boards directed the staffs to consider two approaches to accounting for both lessors and lessees, one based on the financing concept and the other using straight-line recognition. (One challenge, of course, will be how to differentiate.)

FASB Chairman Leslie Seidman held a webinar on Jan. 25, providing her views on what the board is doing. She noted that the count of comment letters on the lease accounting Exposure Draft is now over 750. She sees general agreement with the concept of placing lease obligations on the lessee balance sheet, but recognizes that many are concerned about the complexity of the current model, especially with regard to options and contingent rents. She also noted that there is "general disagreement" with the front-loaded expense pattern as it affects leases that are currently considered operating, and the classification of the expense in financing rather than operating activities. While she didn't officially back off from a June 30 due date for this and the other current projects, she noted that the boards have been stating that the target dates are subject to the nature and extent of the feedback received. Their goal is standards that are understandable and implementable at a reasonable cost, and "if it takes a little longer to reach that comfort level, we will take that time."

In the webinar's Q&A period, someone asked how the FASB decides when to re-expose a standard if changes are made from the exposure draft. She said their general question is: How significant are the changes from both the original exposure draft and from current accounting? The implication is that if their new plan is significantly different from both an ED and current GAAP, they would re-expose. It is, of course, too soon to tell whether that would happen to the lease accounting standard.

Redeliberations starting, comment letter summary

2011-01-14T12:49:00.004-05:00

The FASB & IASB will have a joint meeting in London on Wednesday, January 19, when they will begin to discuss comments received on the Exposure Draft, and their plan for redeliberations. On Wednesday and Thursday, they will discuss 1) distinguishing leases from services, and 2) lessor accounting. They are not planning to make decisions on those topics.

The IASB meeting page for January has agenda papers for the leases discussions. These include a list of the major issues that the staffs feel should be thoroughly reconsidered, and a secondary list of additional possible issues for reconsideration. Five major issues are noted:

1) Definition of a lease (particularly differentiating from service/executory contracts)
2) Lessor accounting model
3) Lease term (i.e., when to include renewal options)
4) Variable lease payments (i.e., contingent rentals)
5) Profit & loss recognition pattern (whether asset amortization should be adjusted so that overall expense/income for leases is straight-line rather than front-loaded)

A laundry list of other items is listed as potentially needing reconsideration, including scope exclusions, short-term leases, foreign exchange, disclosure, fully retrospective application, lease incentives, and leasehold improvements, among numerous others.

The staffs' comment letter summary notes the "very high" number of responses (760 letters as of Jan. 12), and the fact that the boards have had contacts with several thousand people through various outreach activities. They note that very few financial statement users sent in comment letters, but outreach events included over 500 users.

The summary indicates that almost all comment letter writers disagreed with defining the lease term as the longest possible term more likely than not to occur. Respondents generally suggested either the current standard of including options that are "reasonably assured/reasonably certain" (current US GAAP/IFRS terminology), or "virtually certain" (seen as an even higher threshold), or the Alternative View listed in the IFRS Exposure Draft, to include options only when there are incentives to exercise those options.

The summary indicates likewise almost total disagreement with the contingent rent proposal. Alternative approaches suggested included 1) capitalizing only contingent rents based on an index or rate, 2) including only those that are outside an entity's control, or 3) using a different estimation approach (such as "best estimate" rather than "expected value" with multiple scenarios).

The summary is 70 pages long, so trying to fully recap it here would be tedious. Suffice to say that every question that the boards asked in the ED received lots of comment, with numerous alternatives presented.

Over half of the respondents were preparers of financial statements, with sizable numbers of industry organizations, individuals, and professional organizations. Half came from North America, a bit more than a quarter from Europe. The largest industries represented were financial services (almost 1/4), retail, real estate, and transportation.

Volume of comment letters

2011-01-11T12:44:00.003-05:00

How does the volume of comment letters on the proposed lease accounting standard compare to other recent exposure drafts? The following list may be of interest:

Leases: 746 (and counting)
Fair value measurement: 95
Comprehensive Income: 72
Accounting for Financial Instruments: 2814
Derivative Instruments and Hedging Activities: 127
Amortised Cost and Impairment: 179
Revenue Recognition: 971
Troubled Debt Restructuring: 117

So leases isn't the biggest, but it's up there.

"It's not a done deal."

2011-01-11T11:56:00.004-05:00

That was the statement of Larry Smith, FASB board member, at last Thursday's (Jan. 6) afternoon roundtable discussion on the proposed new lease accounting standard. He was responding to one participant's comment that people in the leasing industry he's talked to thought there was no point in submitting a comment letter or otherwise participating in the boards' outreach activities, because they thought the standard was "a done deal" and the process was just for show. Smith was emphatic in denying that. New FASB Chairman Leslie Seidman concurred, adding, "I've already decided that I will change my position on one or two matters," and suggesting that she may make further changes based on additional review of the comment letters and discussion with interested parties.

The count of comment letters is now up to 746 (including letters received after the deadline, which are still being posted to the FASB website). I can't possibly read them all (I need to do my real job), but members of the FASB and IASB staff are. I spoke to one of the FASB staff who is personally reading every single comment letter on lease accounting, and commented that the letters are substantive (and lengthy); they're impressed by the thoughtful responses presented. I'm sure it'll be a few more weeks before they have compiled a summary for the boards, and the boards can begin redeliberations.

I attended the Thursday afternoon roundtable as an invited participant. Other participants included representatives of KPMG and Ernst & Young, lessors Xerox and International Lease Finance (one of the largest aviation lessors in the world), the CFA Institute (financial analyst, and thus a user of financial statements), Toys R Us, Transocean (the world's largest drilling rig operator, unfortunately now infamous as the driller of the BP well that blew up last year), and consultants to the leasing industry. Also present were all five members of the FASB board, as well as two IASB members and several staff members from both boards.

We had four planned topics of discussion: the definition of a lease, the lessor accounting model, the lease term, and variable lease payments (i.e., contingent rents). Most of the discussion of the definition of a lease centered on the distinction from service contracts. It was noted that the line is sometimes fuzzy even today, but because operating leases and service contracts are accounted for relatively similarly, differentiating them isn't a significant issue. With capitalization of leases, the difference becomes much more significant. Transocean is concerned that they may be seen as lessors, which they haven't been up to now, for contracts which include use of a drilling rig, but provide full crew and other services. Airlines similarly may lease aircraft with crew & maintenance included (a "wet lease") or just the aircraft alone ("dry lease"). Aviation lessees and lessors are concerned that fully capitalizing a wet lease will reduce comparability. No consensus was reached about how or whether to divide services and leases.

We also briefly discussed whether the scope exclusion for "in-substance purchases" should be maintained, with some feeling it was a leftover in the proposal: it was set up when the boards were planning to provide only a performance obligation approach to lessor accounting, and lessors wanted a way to recognize up-front profit if they were effectively selling an asset. With the inclusion of the derecognition model, there seems to be less reason to have a separate methodology for in-substance purchases.

For the lessor accounting model, some prefer performance obligation, some prefer derecognition, and some see a place for both. But a number of participants essentially felt, "If it ain't broke, don't fix it." They don't see significant problems with current lessor accounting, and suggested essentially keeping it in place, with removal of FAS 13's "bright lines" differentiating capital and operating leases (i.e., using IAS 17 terminology of "the lease term is for the major part of the economic life" and "the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset"). The boards seemed to be willing to seriously consider that. Some participants noted that it was important to make this a long-term rather than interim decision (i.e., don't just tweak it until they can revisit it in a few years; if a change is required, do it now).

We spent long enough on these topics that our discussion leader (the FASB staff project manager for leases) decided to combine the issues of the lease term and variable payments, feeling they were in many respects similar. I agreed; in both cases, the boards are calling for capitalization of amounts that don't meet their own definition of a liability. We discussed the operational difficulty of making and updating the estimates for portfolios of thousands of leases. One FASB board member brought up a suggestion, apparently received in another venue, of doing the estimates on a whole portfolio basis rather than lease by lease. Roundtable participants felt that would not be workable, since in many cases there is wide variation in types of leases or characteristics of leases (real estate leases in particular are rarely cookie-cutter). The accountants also felt that such estimates would not be auditable.

The financial analyst expressed interest in an "expected value" approach, but other participants were extremely negative about booking, for instance, fractional lease terms (like a 7.2 year lease for a 5-year lease with several yearly renewal options). I argued that there is a qualitative difference between a 15-year lease and a 1-year lease with 14 yearly renewal options, since the lessee has the flexibility to walk away with no penalty. The current proposal makes those look identical if the renewals are judged "more likely than not," which penalizes the lessee and understates the lessor's risk of nonrenewal (and a nonrenewal would inevitably result in a substantial hit to the lessor's income statement, meaning potential for substantial earnings volatility). Options aren't "structuring;" they provide choices.

For contingent rents, a best estimate was seen as more tolerable than the current "reasonable number of estimates" (what's a reasonable number? does the norm vary from country to country?), though still all the participants in the room other than the analyst were opposed to capitalizing most contingent rents as well as the "more likely than not" threshold for including renewal options in the lease term. People were also opposed to using forward rates to estimate contingent rents that are based on an index or rate, considering it needlessly complex (do you use a different estimated rate for each monthly payment out five years or more?).

The three hours went quickly. Larry Smith of the FASB commented at the end, "We will take time." While the boards' goal has been to complete the project by June 2011, he said that has always been subject to the extent and nature of comment letters and other outreach responses, and they will extend the schedule if needed to properly respond. Their goal is a "comprehensive, converged, improved, and able to be implemented standard."

I definitely felt the board members were listening with open minds. It remains to be seen how they will balance the various perceived needs, and the varying purposes of leasing. One of the fundamental issues they're dealing with is that sometimes leasing is equivalent to purchasing an asset (a computer lease is perhaps the best example, given the short economic life of a computer), while at other times it's closer to provision of a service (a copier lease with low fixed charges and a per-page price). A methodology that provides comparability to one form doesn't work well for the other. But there are so many gradations between that it's hard to define a principle, any more than a bright line, that differentiates them.

Many people are concerned that whatever change the boards make will mess up their current business operations. Yet doing nothing means that true liabilities of a company are largely hidden (as the financial analyst put it, "Disclosure is not enough"). I don't think the boards will back down from requiring lessees to capitalize virtually all leases. But the rest of the standard is certainly in question, and the deliberations this spring are likely to be lengthy and contentious. Stay tuned!

The flood of comment letters

2010-12-30T12:27:00.002-05:00

As of today, 697 comment letters have been posted responding to the exposure draft on Lease Accounting. The IASB has decided that they couldn't host all the comment letters; instead, you need to go to the FASB's web site to view those numbered 248 and higher (letters 1-247 are available on both sites). Some of the letters were received after the deadline, but have still been accepted.

There are far too many comment letters for me to review them all. But I think it's fair to say that the overwhelming majority object to including renewal options in the calculated lease term using the "more likely than not to be renewed" criterion, and to including most contingent rents in the capitalized rent stream. Many respondents are concerned about the cost of initial and ongoing implementation of the new standard (particularly if lease term and contingent rents need to be estimated and capitalized); many also think the new proposed methodology is inconsistent with their business models. Many are also concerned about the impact of reclassifying rent expense into amortization and interest expense, since the new classification moves the cost out of EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an important metric for many companies. Other concerns expressed include the timing of expense recognition (front-loaded under the new model, as opposed to level under current operating lease accounting), potential for violation of debt covenants because companies will be reporting more debt, difficulty of getting expense reimbursements on cost-based contracts, and volatility of earnings (if the lease term & contingent rent proposals are maintained).

The lessor accounting proposal has varied reactions. Some agree with the proposal. Others think derecognition should be used for all lessor leases. One common complaint about the performance obligation approach is that it leads to double-counting (or even triple-counting) of assets: the lessor maintains the original asset on the books, sets up a lease receivable (another asset), and the lessee recognizes an asset for the right-of-use as well. The impact of double-counting for the lessor is mitigated by the proposal to report PO leases net (receivable minus PO), but it still seems conceptually strange to many people. It is also noted that the PO approach does not mirror lessee accounting.

The volume and vehemence of disagreement raises the bar, in my opinion, on review by the boards. We'll see what comes in the next few months.

More comment letters and other discussion

2010-12-14T12:07:00.004-05:00

Comment letters on the proposed new lease accounting standard continue to come in to the boards. Tomorrow (Dec. 15) is the official deadline to submit a comment (though for the preliminary views document, they did continue to accept and post letters received later). Surprisingly, only a handful of letters have been posted since late last week. I have to think that reflects delays, not actual numbers of letters. As I write this, the count of letters posted is 114.

Few if any of the letters agree completely with the boards, and many vehemently oppose some or many of the provisions, on conceptual grounds (such as arguing that unexercised options are not liabilities), on practical grounds (complying will be burdensome for little perceived benefit), and for their implications (loan covenants will be breached, cost recovery contracts that are based on operating leases will be invalidated, etc.). Several are calling for delaying release until the standard can be thoroughly reviewed and reworked, particularly on the lessor side; others are calling for a lengthy implementation period (up to 5 years).

There are so many different objections it'll be a major task for the boards' staff to organize them, not to mention for the boards to consider them. A number of complaints refer to the impact on very specific situations of individual industries ("wet" vs. "dry" leases of planes and ships, for instance, meaning leases that do or don't include personnel to operate the vehicle). Many complain that the proposed standard will harm their business model; numerous letters suggest that the current economic downturn will be further extended because of it.

Asset Finance International reports that at a Nov. 5 meeting in London between lessors and members of the IASB, an IASB member stated that the boards weren't open to reconsidering the capitalization of lessee leases, but that they were willing to reconsider how to measure the asset, including the question of options and contingent rents.

The boards have indicated that they will consider carefully comments and suggestions made at the roundtable discussions scheduled for both in London & Hong Kong later this month and early January in the U.S. I will be participating in the afternoon session on Jan. 6, 2011, in Norwalk, CT (the FASB's headquarters).

Our comment letter posted

2010-11-30T11:42:00.004-05:00

The count of comment letters on the lease accounting standard is now up to 60, with a little more than two weeks to go. Our comment letter is #58.

Comment letters coming in

2010-11-22T12:38:00.004-05:00

The lease accounting exposure draft has already received 45 comment letters, with almost a month to go until the deadline (Dec. 15). By comparison, the March 2009 discussion paper had received just 5 comment letters a month before its deadline. Since the DP got 302 responses, one can fairly expect a considerably larger number of responses to the ED. I don't know an easy way to compare with responses to other EDs, but I think it's fair to guess that this will be one of the more heavily commented on.

All or almost all letters from companies that will need to comply, and many of those from independent accountants, disagree with the proposal to capitalize renewal options and contingent rentals (unless the contingent rentals are disguised minimum lease payments). They make three basic arguments: options that haven't been exercised don't meet the conceptual definition of a liability, the estimates will be highly subjective guesswork, and the burden of complying will be onerous (for questionable benefit).

Some companies argue for keeping operating lease accounting, saying that it better matches expenses to benefits (capitalization results in more expense in the early years of a lease, less at the end, due to the interest method of amortizing the liability).

A number of lessors (and some users of statements) dislike the performance obligation approach, because it is asymmetrical with lessee accounting, it double-counts assets (though the ED calls for the final presentation in the financial statements to be net), and they're concerned that the dividing line between performance obligation and derecognition will be arbitrary. Most would prefer derecognition for all lessor leases, except for short-term leases. I haven't seen any deal with the issue of a re-leased asset that has been fully derecognized.

Will the boards bend to the complaints?

It's not too late for you to add your own voice. Anyone is welcome to submit a letter (see details on how in my earlier post). Current letters include official national bodies, companies from all over the world, individual accountants, accounting students, and a few random people seemingly just speaking for themselves. We'll submit a letter in the next couple of weeks.

Notes from yesterday's FASB webcast

2010-10-29T16:29:00.002-04:00

As previously mentioned, the FASB yesterday offered a one-hour webcast reviewing the proposed new lease accounting standard, for which the Exposure Draft was released in August. The webcast is now available for viewing if you weren't able to view it live (free registration required).

The webcast included both a basic description of the new methodology proposed, and intermittent commentary by Larry Smith, a FASB board member, regarding why particular decisions were made.

On requiring capitalization of options to renew, Mr. Smith said, "The boards wanted to ensure that entities would not structure a one-year lease with additional one-year options to renew with the full intent of a 15-year lease. We wanted to ensure that the lease amounts recorded reflected the true substance of the lease and therefore reflected the likely lease term, which we acknowledge impacts many aspects due to the discounting required. "

Similarly, for contingent rents: "We were concerned with entities in an extreme example having a fixed rent payment of $1, then various contingent and other variable payments which make the monthly expense closer to a million. We wanted to lay out a principle that would capture all expected lease payments to ensure that amounts recorded associated with leases were transparent and inclusive of all lease payments expected."

Obviously the boards are haunted by the structuring that has been common in leasing under FAS 13 (and IAS 17), and are doing everything they can to prevent something like that from happening again. But Mr. Smith says they're open to alternative ways of dealing with the situation; they recognize that they've chosen a method that's complex to implement.

They included preliminary feedback: They feel generally there is agreement with the right-of-use model, but concern about the complexity of contingent rents & determining the lease term, the income statement impact (rather than equal expenses over the life of the lease, depreciation plus interest gives front-end-loaded expenses), differentiating leases from services (and separating service components), applying performance obligation vs. derecognition for lessors, cost/benefit, and doing the transition.

They took questions from viewers of the webcast and answered some. Highlights:

* The boards plan to provide more guidance on distinguishing a service from a lease (and distinct services). They recognize that it will be more significant than it is under FAS 13.
* The FASB plans to consider whether investment property should be accounted for at fair value, as IAS 40 provides (either as an option or mandatory).
* Driving the project is a desire to provide better comparability (eliminating the bright lines between capital and operating leases) and more information to users, who they feel are already attempting to calculate balance sheet impacts on operating leases with limited information.
* While the initial focus was on lessees, they recognized a need to be consistent both between lessees and lessors, and between leasing and the concurrent revenue recognition.
* Mr. Smith: "If we did not provide for including an estimate of contingent rents, leases might be structured very differently to come up with an outcome that would record the minimum asset and liability, and we didn't want to provide those structuring opportunities."
* It is recognized that lessees and lessors will come up with different estimates of lease term, contingent rent, and the like. The lessee most often will probably have better information.

The IASB is also having a webcast, this coming Monday (Nov. 1), at 10 AM and 3 PM GMT. More information is available at the IASB website.

Investors' opportunity to comment

2010-10-19T15:25:00.000-04:00

In September, the FASB & IASB invited lessees and lessors to fill out a survey about their leasing activities and how the proposed new lease standard might affect them. Now users of financial statements (investors, lenders, etc.) are given their own opportunity to comment through a survey. You may respond to the 25 questions any time between now and December 15 (which is also when comment letters on the Exposure Draft are due). No prior knowledge of the ED is assumed; summaries of major points are provided, with users asked whether they favor or oppose the decisions made.

FASB webcast discussion Oct. 28

2010-10-19T14:23:00.003-04:00

The FASB will be holding a webcast to discuss the proposed new lease accounting standard on Thursday, Oct. 28, 11 AM to noon Eastern time. The webcast will both review the Exposure Draft and discuss initial reactions that the boards have gained from outreach activities that they have recently undertaken.

Anyone may register for free either to watch the webcast live, or to view it from archive after the fact.

What happened to executory costs?

2010-10-11T11:44:00.002-04:00

Under FAS 13 accounting, executory costs (expenses such as insurance, taxes, and maintenance) that are billed by the lessor to the lessee are separated out from other rent before a capital lease's rent stream is capitalized. The proposed new standard calls for separating "service components" from the rest of the rent, if they are "distinct" (see exposure draft paragraphs 6 and B5-B8).

It's not clear, though, that "service components" aligns precisely with the old concept of "executory costs." While no doubt maintenance charges would qualify under each term, and probably insurance, what about taxes? Taxes aren't really a service (while one hopes that one gets services for taxes paid, the link is not direct, and failure to receive services is not a justification for not paying). Will this be clarified in the final standard?

Overview of exposure draft

2010-10-11T11:14:00.004-04:00

While I've discussed the individual decisions on the lease accounting exposure draft over the last several months as they've been made, it's appropriate to review the proposal in its entirety. I've posted such a review on the FCS web site. I invite you to look there for a summary of the whole proposal.

Putting your 2 cents in

2010-09-07T13:06:00.003-04:00

The FASB & IASB are inviting all lessees and all lessors to fill out an online survey asking about your leasing activity. The lessee survey is available here; the lessor survey is here. This is not the same thing as submitting a comment letter on the Exposure Draft (for details on submitting that, see my prior blog post). This survey does not require any knowledge of the Exposure Draft, and only limited knowledge of lease accounting in general, for that matter. It's available through the end of September 2010.

I went through the lessee version of the survey. The boards estimate 20 minutes to fill out the survey, but most people can probably fill it out more quickly than that. The survey asks about your volume and type of leasing activity, including what percentage of your leases are operating (within ranges). It asks whether you have leases with options to renew/extend or to purchase, and leases with contingent rents; for each, it asks whether you have few or many such leases, the reason(s) your leases have such features, and whether you currently reassess them after the lease starts.

It asks if you're familiar with the new lease accounting proposals, and you easy you expect it to be to determine contingent rentals, contracts that are leases, expected lease term, incremental borrowing rate, and distinct services, and to provide required disclosures. At the end of the survey, there is space for comments, and an option to make yourself available for a fieldwork project, which entails a “limited conversion of financial information in line with the proposals, and presenting those in workshops with the boards.”

This survey provides a way for the boards to get a large number of lessees and lessors to provide information about their current leasing activity and what the impact of the proposed standard might be. The more people respond, the better the information is for them to work on. So if your company has leases, either as lessee or as lessor (or both), please consider taking a short bit of time to fill out the survey. Presumably the results will be released at a future date, to be part of the boards' deliberations after the Exposure Draft comment period ends on Dec. 15, 2010.

Does the new leasing standard already apply?

2010-09-01T18:36:00.001-04:00

The Exposure Draft of the proposed new lease accounting standard doesn't state the date that financial reporting will need to be prepared in accordance with the new standard. That date remains to be determined, and in the Basis for Conclusions, the boards say that they plan to consider the entire group of new standards for collective application (the FASB reports at least 14 active convergence projects with the IASB). In an online webinar, a staff member said that the boards recognize that a substantial amount of time will be needed for implementation. Discussion I've heard indicates that it wouldn't be before 2013.

The twist, however, is that paragraph 88 of the Exposure Draft states, "the date of initial application is the beginning of the first comparative period presented in the first financial statements in which the entity applies this guidance." All companies as far as I know report at least one prior year for comparison; some report multiple years. So if the standard applies to 2013 annual reports, and you report one prior year for comparison, your date of initial application (i.e., the date as of which you have to capitalize operating leases and renewal options) would be 1/1/2012. If you report three prior years for comparison, you may already be past the date of initial application of the new standard.

It's going to be BIG

2010-08-26T18:02:00.004-04:00

What will the impact be of capitalizing operating leases, with option periods included? For many retail chains, the tally is literally going to be in the billions of dollars. We've done an analysis for one chain whose liability for capitalized leases will be larger than their entire present current and long-term liabilities (and several times their shareholder equity). The effect of putting an equal amount of assets and liabilities of that magnitude on the balance sheet will be a substantial increase in reported leverage and decrease in important financial ratios. This has important implications for loan covenants and other financial requirements.

It should also be noted that previously reported estimates of the impact of the new standard (such as Georgia Tech's study last year) are likely substantially understated, because they were based on the reported future rent commitments of companies. But those reported commitments exclude most renewal options, which now will have to be included in whole or in part. Many retail store leases have an initial term of 20 years, but then renewal options for as many as 40 more years. Under the new "expected payments" requirement, future rents reported may be double or more what is currently reported, with a commensurate increase in assets & liabilities.

Our EZ13 Lease Accounting software permits you to enter your operating leases for current reporting, but capitalize their remaining rents at a cutover date you specify for pro-forma reports in keeping with the exposure draft of the new lease accounting standard.

FASB Chairman Herz resigns

2010-08-25T14:45:00.003-04:00

The chairman of the FASB, Robert Herz, unexpectedly resigned yesterday, effective October 1. There is concern that his departure, and the simultaneous announcement of the Financial Accounting Foundation, the FASB's parent, that the FASB will be increased from 5 to 7 members (undoing a change in 2008), will delay the projects currently underway, including the lease accounting rewrite. The boards have been pushing hard to complete a large number of convergence projects by the end of June 2011, which incidentally is the end of service for the IASB's chairman, Sir David Tweedie. But will FASB want to make all these major decisions with an incomplete board?

Lease Accounting Exposure Draft released

2010-08-17T16:49:00.004-04:00

The FASB and IASB have released the Exposure Draft of the proposed new lease accounting standard (FASB topic 840 in the new Accounting Standards Codification). The FASB has made the ED available here. The IASB has posted the ED, an accompanying Basis for Conclusions (which the FASB has bundled with the ED), a Snapshot Summary, and a Press Release.

The comment deadline is December 15, 2010. The FASB invites people to send comments by email to director@fasb.org, File Reference No. 1850-100. The IASB asks for submissions on their web page. As with the Preliminary Views document last year, the comment letters sent to both boards will be combined for the boards' review (and it is not necessary to send a comment letter both places).

I will post a review of the ED here in coming days, though there shouldn't be any real surprises; this is just a restatement of the decisions made over the last year, which have been reviewed as they happened in earlier posts on this blog. As with the Preliminary Views document, I expect to review the ED section by section.

Exposure Draft imminent; live webcast discussion August 18

2010-08-16T11:02:00.003-04:00

The IASB has scheduled a live webcast on August 18 to present the Exposure Draft of the new lease accounting standard. The webcast will include a Q&A time. They're holding the same event twice, to have it at times that are reasonable in more time zones: 10:30 am & 3:30 pm London time, which is 5:30 am & 10:30 am Eastern Daylight Time in the U.S. You may register for either at the IASB web site. I presume the Exposure Draft itself will be out before the webcast, but I see no sign that it has yet been released.

Final decisions before the Exposure Draft

2010-07-30T16:28:00.001-04:00

At the FASB & IASB meetings July 19, 21, and 22, the boards reached the following decisions for the new lease accounting standard:

Scope & sale/leaseback accounting

Previously, the boards had set several criteria that would indicate a transaction should be considered a sale/purchase rather than a lease. These had the effect of converting many currently capital leases into purchases. The boards have now retreated somewhat from that position, by removing two criteria:

1. The contract covers the whole of the expected useful life of the asset.
2. The contract specifies a fixed return to the transferor.

The boards reaffirmed treatment as a purchase/sale if, at the end of the contract, control of the underlying asset and all but a trivial amount of the risks and benefits associated with that asset are transferred to the recipient. This requirement must be met for sale/leaseback accounting to be permitted.

Lessor accounting: performance obligation vs. derecognition

A lessor that retains exposure to significant risks and benefits associated with the underlying asset should apply the performance obligation approach; if no significant exposure remains, the derecognition approach is to be used. The risks and benefits may be during the expected term, or subsequent to the term (such as the expectation of re-leasing or selling the asset). Counterparty credit risk is not to be considered. The assessment is to be made at the beginning of the lease and not subsequently reassessed.

Risks & benefits during the lease term include: significant contingent rentals based on use or performance of the underlying asset, options to extend or terminate, and material nondistinct services provided. Risks & benefits subsequent to the lease contract include: whether the lease term is short in relation to the useful life of the asset, and whether a significant change in the value of the asset is expected (including the effect of .

In deciding which approach to use, a lessor must include third-party residual guarantees in determining whether the lessor is exposed to significant risks and benefits. (It had been suggested that these should be considered as insurance contracts separate from the lease agreement and not affecting the approach decision; this is now discarded.)

Lessor accounting: leases with service components

The boards disagreed. The majority of the FASB thought that nondistinct services should not be bifurcated from the lease component under derecognition. The majority of the IASB took the opposite view, with the service element to be accounted for in accordance with the new revenue recognition standard. The FASB majority thought that if bifurcation was done, the service element should give rise to a receivable and performance obligation. Presumably both approaches will be presented in the upcoming Exposure Draft.

Exposure draft release

The boards plan to release the Exposure Draft of the proposed new lease accounting standard during the week of August 9. This will restate, in the form of a standard, the various decisions that they've made over the last 9 months. Anyone is invited to submit a comment letter for the boards to review. Some decisions clearly remain to be made, since the boards have disagreed on a few issues, and they're trying to reach a converged standard. And everything so far is couched as "tentatively decided," so in theory everything is subject to alteration. Realistically, though, it is unlikely that the broad outlines of the new standard, particularly placing all leases on the balance sheet, will change.

Leases in business acquisitions

2010-06-25T12:40:00.003-04:00

Under FAS 13, if a business acquires another business that has capital leases, the lease is re-evaluated. The present value of the rents is the new obligation, while the asset is booked at fair value, which may be a different amount.

The FASB has decided, in a June 23 meeting, that this will no longer be the case. Instead, under the new lease accounting standard, an acquirer will account for the lease as if it were a new lease starting on the day of acquisition, and otherwise account for it as any other lease.

A rare win for simplification as part of the lease accounting revision...

Derecognition over performance obligation (sometimes)

2010-06-25T12:39:00.000-04:00

The FASB & IASB, in meetings June 16 & 17, decided to partially pull back from the concept of a performance obligation for lessors in the new lease accounting standard. They have now decided to use that approach (where the original leased assets remains on the lessor's books untouched, and a matching receivable debit and performance obligation credit are set up for the lessor lease, with the receivable amortized using the interest method and the performance obligation amortized straight-line) only for leases "that expose the lessor to significant risks and benefits associated with the underlying asset." In other cases, a derecognition approach is to be used: Once the receivable is calculated for the lessor lease, the owned asset is credited for that amount. The IASB staff commented that this is similar to the current distinction between operating and capital leases (wasn't the goal of the new standard to get away from that?).

The vote was actually split between the boards, with the IASB in favor of this hybrid approach, while a majority of the FASB prefers performance obligations for all leases. However, the FASB Action Alert summary states that "the Boards" decided on the hybrid approach, which suggests that in the interests of convergence, either the IASB has priority or the vote is being tallied in total. I don't know enough about the workings of the convergence project to clarify that.

Other topics covered:

Lessor transition under a derecognition approach

The boards have decided that lessors should recognize a lease receivable at the present value of the remaining lease paymentss, and a residual asset at fair value. The present value is based on the implicit rate at lease inception, but it looks like that includes the residual asset at its current, not original, estimate of future value.

Leases with a service component, lessor derecognition

The boards were unable to come to a conclusion for how to account for leases that include a service component (what is called executory costs under the current leasing standards), when the services and leases are not distinct, for a lessor lease involving derecognition. This will be discussed further in July.

Purchase options

Purchase options are to be accounted for only upon exercise (aside from bargain purchase options, which immediately turn it into an in-substance purchase). This applies to both lessees and lessors.

Retirement of IASB members

Gilbert Gelard, Robert Garnett, and James Leisenring are retiring from the IASB as of June 30. Jim Leisenring has been a particularly forceful voice on the board. He's a former member of the FASB as well, and does not hesitate to make his views known. The impact of the change in personnel remains to be seen.

EZ13 v3.0 released!

2010-06-18T14:45:00.007-04:00

FCS is delighted to announce the release of v3.0 of EZ13, our lease accounting software for lessees and lessors. EZ13 has always provided complete FAS-13-compliant accounting for both operating and capital leases. Some of the significant new features include:

* Notice dates: EZ13 can remind you that rents are changing, leases are expiring, or events that you've entered are coming up. You specify how many days before and after the event you want to be notified. When you've dealt with the matter, you can turn off display of that item without deleting the event.
* Multiple contingent rent types: You can now track up to 7 different types of contingent rent, each with their own account numbers for G/L entry. Two types are user-defined, so you can give them the meaning most relevant to your business.

* Purge leases: You may remove from a database leases that have terminated as of a date you specify. Optionally, these leases can be copied to another database.
* Copy leases to new database: You may copy any number of leases to a new database. This can be useful for testing changes to a lease without affecting your production database.

There are a number of other, less significant features, enhancing flexibility and usability. And of course, bug fixes.

More details about the full range of features EZ13 offers are available at http://www.ez13.com/ez13.htm.

You can download a trial of EZ13 v3.0, either lessee or lessor version, at http://www.ez13.com/download.htm. If you have any questions about how EZ13 can solve your lease accounting needs, please contact me by email or (203) 652-1375.

Performance obligation or derecognition—or both?

2010-05-21T11:05:00.003-04:00

The FASB & IASB, at meetings May 18 & 19, revisited one of the fundamental decisions on lessor accounting made last year. As the staff’s agenda paper put it then, “What is the credit?” Setting up a capital lessor lease means setting up a receivable for the rent income stream. That’s a debit on the balance sheet. How should the balancing credit be characterized?

The boards considered two basic approaches. The first, which is the current methodology under FAS 13 and IAS 17, is derecognition: the owned asset is credited (reduced/eliminated). Under present accounting, the entire asset is derecognized, replaced by the receivable. Things get more complicated in the proposed new system, since many leases will be for only part of the value of the underlying asset. Crediting the asset would leave part of the owned asset on the books. More problematic is that multiple leases of a single asset could result in a sum total of receivables that is greater than the original asset value; how is that to be handled?

The solution the boards came up with was to create the concept of a performance obligation, representing the requirement to make the asset available to the lessee. This is a credit entry that is amortized over the life of the lease, based on passage of time or usage of the asset.

There have been rumblings for several months that several members of the boards are uncomfortable with the performance obligation methodology. Recent notes on lessor accounting have included explicit comment that decisions are “under the performance obligation approach.” At this week’s meetings, there was extensive discussion of going back to a derecognition approach, though this would be a “partial derecognition” approach. Described in detail in the agenda papers for the meetings, this means that the owned asset wouldn’t be completely taken off the books (unless the lease is for the entire useful life of the asset). A portion of the asset would be removed and replaced with the receivable.

The boards made decisions on how to account for various aspects of lessor activity under a partial derecognition approach, without committing to such an approach. You can read the full list of decisions in the FASB Action Alert. I’m not going to repeat all of it because it’s not clear if it will actually take effect, and I’d just be restating what they state there.

One significant implication of a partial derecognition approach is that a lessor could recognize a profit at the beginning of the lease (as is currently done with sales-type capital lessor accounting). The boards' prior decisions on lessor accounting with a performance obligation did not permit an up-front recognition of profit; instead, all income is to be recognized in the form of interest over the life of the lease. This has potentially a major impact on the reported profitability of manufacturers who lease their equipment. One can expect that they will lobby hard for a derecognition approach.

Conceptually, a derecognition approach seems to the staff to be more consistent with the lessee right-of-use approach. However, the unguaranteed residual value becomes much more significant in this approach, which can increase complexity.

The boards haven’t concluded which way to go, and significantly, there’s a difference of opinions between the boards. The FASB prefers to stick with the performance obligation methodology; the IASB prefers a hybrid model, using a performance obligation in some cases and derecognition in others. (The FASB Action Alert summary doesn't list the vote, but based on prior activity, I doubt it was unanimous with either board.) They’ve asked their staff to develop proposals to decide when to apply which model. But won’t that inevitably result in structuring opportunities, and similar transactions being accounted for differently? Eliminating that was supposed to be one of the big improvements of a new lease accounting standard. Will the two boards find a way to resolve the disagreement and keep a converged standard?

Stay tuned for more developments next month.

April meeting results

2010-05-18T17:05:00.002-04:00

The FASB & IASB met again in mid-April for multiple meetings regarding the new lease accounting standard (originally supposed to be a joint meeting in London, the Icelandic volcano forced it to be a videoconference). Lessee topics included sale/leaseback transactions and rent presentation; subleasing was also discussed. Topics for lessors included: performance obligation amortization, impairment, purchase options, and disclosure requirements. Long-term leases of land affect both lessees and lessors.

Sale and leaseback transactions

Under current US GAAP, a sale and leaseback is recognized as such only if it meets criteria specified in FAS 98, which particularly prohibit “continuing involvement” by the seller-lessee in the property other than the leaseback itself. If there is continuing involvement, such as a fixed-price purchase option, nonrecourse financing, or a guaranteed residual, sale/leaseback accounting is prohibited and the transaction must be accounted for as a financing, with the asset remaining on the “seller’s” books.

The boards have decided to tie the definition of a qualifying transaction to their previous decision to account for a lease as a sale of the underlying asset. The relevant definition is “if at the end of the contract control of the underlying asset has been transferred and all but a trivial amount of the risks and benefits associated with the underlying asset have been transferred.” The interesting thing about use of this definition is that in this case, it’s being used to define the sale portion of the transaction, not the lease portion. The impact of the decision should be minimal; that is, generally transactions will get the same treatment (as far as whether they’re treated as sale/leaseback or as financing) under the new standard as the old, but it makes sense to use more consistent definitions within the new standard.

Lessee presentation of total cash rentals paid

Currently, cash rent paid under operating leases is a line item in the income statement; it is not, however, an income statement for capital leases (since the expenses recognized are interest and depreciation). The new standard includes a disclosure with a reconciliation of obligation to pay rentals, along with reporting interest and obligation repayments (separately) in the statement of cash flows; no separate presentation of total rent paid is to be included.

Subleases

As one might expect, a sublease is treated like a lessor lease by the intermediate party. Assets and liabilities for subleases will be reported gross with a net subtotal, separate from the assets and liabilities related to the head lease (the original lease of the asset that is being subleased).

Long-term leases of land

There had been some discussion of possibly treating long-term leases of land as sales (in some countries, land leases of 99 or even 999 years are common due to cultural or legal barriers to actual transfer of land ownership). The boards decided not to go that route; long-term land leases will be treated like any other lease within the new standard.

Lessor performance obligation amortization

Amortization should be in a systematic and rational manner based on the pattern of use of the underlying asset. This could be passage of time, hours of use or items produced for equipment, etc.

The boards have not decided whether or how to permit revenue recognition at the start of a lease (similar to current sales-type lessor lease accounting), and asked the staff to further analyze the issue.

Lessor accounting for purchase options

Purchase options are to be accounted for the same way as renewal and termination options, using the “more likely than not” criterion for exercise.

Lessor accounting for impairment of assets

The receivable is to be reviewed first for impairment, with an adjustment to both the receivable and the performance obligation and any difference being recorded in profit or loss. The underlying asset is also subject to impairment review; the staffs are to further consider how to apply IFRS 36 and ASC Topic 360, each board’s impairment standard.

Lessor disclosures

Descriptive

The nature of the lease arrangement(s), if leasing is a significant part of the lessor’s business activities
Restrictions placed on leased assets by the leases
Existence and terms of any residual value guarantees
Under IFRS: Information on risks surrounding the receivable (cf. IFRS 7)
Under US GAAP: Information on credit quality, the uncertainty of future cash flows, and how the lessor manages those uncertainties
Notation if simplified short-term lease accounting is being used

Quantitative

Maturity analysis, by year for five years and future years as a lump sum, showing the minimum contractual receivables and total estimated receivable
Maturity analysis, by year for three years and future years as a lump sum, of the satisfaction of performance obligations
Reconciliation between opening and closing balances for the receivable and performance obligation, showing the transactions resulting in increases and decreases
If simplified short-term accounting is being used, the gross amount so recognized

The FASB meeting notes indicate that the boards now anticipate a release of the exposure draft in August 2010, rather than the previously planned June. Obviously there’s too much yet to be completed.

This week (May 18 & 19), the boards have scheduled over 7 hours of meeting time to discuss a lessor’s accounting for the performance obligation and the alternative approach of derecognition (i.e., rather than keeping the leased asset on the books and setting up a performance obligation, the lessor would reduce reported owned assets by the amount of the lease receivable).

Revisiting lessor assets; presentation

2010-03-25T17:21:00.003-04:00

A major change in proposed accounting under the new lease accounting standard hits the lessor balance sheet. Under FAS 13 and IAS 17, when a lessor has a capital lease, the underlying asset is removed from the books ("derecognized"), and is replaced with a receivable. For the new standard, the boards agreed (at June, July, and October meetings) to use a "performance obligation" concept; the original asset stays on the books unchanged, a receivable for the rents is set up, and the receivable is balanced by a performance obligation that is amortized over the life of the lease.

While this resolves the problem of a disappearing asset that the lessor still owns, it raises its own complications. One of the most serious is the impact on financial ratios; since a company normally has more assets than liabilities, putting an equal new asset and liability on the balance sheet erodes a company's financial ratio, resulting in the anomaly that a lessor looks like it's in worse financial shape when it successfully leases its assets (which in the real world is a healthy situation).

At the boards' March 23 meeting, they discussed dealing with this through net presentation, showing the performance obligation as a contra asset rather than a liability. However, during the discussion, the strong majority of the IASB expressed a preference to revisit the entire performance obligation concept and possibly jettison it for the old derecognition approach. (The FASB seemed more evenly split, and as this was a physical joint meeting in London, not all the FASB members were present.)

A major concern, however, is the timetable. The boards are trying very hard to keep to releasing an Exposure Draft by June 30, 2010, with a final standard by June 30, 2011. A number of board members felt it would be difficult or impossible to properly flesh out a derecognition model by June 30 to include in the Exposure Draft. One suggestion was to separate lessee and lessor accounting, releasing an Exposure Draft for lessee accounting on time with lessor accounting following a few months later, but before the expiration of the comment period for lessees so that people would have time to review both together and comment accordingly. (Side note: for the first time that I'm aware of, a board member commented on how long it might be until the new standard must be implemented, with a comment of "2, 3, or 4 years later." However, this was an off-the-cuff comment, so I have no idea how much weight to give it.) No decision was reached.

More generally, the March 23 meeting was focused on presentation.

Lessees:

Lease assets and obligations are to be reported separately from other assets and obligations in the statement of financial position (balance sheet).
Lease amortization and interest expense can be separated from other amortization and interest expense either in the primary financials or in a footnote disclosure.
Obligation and interest payments are to be listed separately in the statement of cash flows, in the financing activities section.

Lessors:

The original leased asset, lease receivable, and performance obligation will be reported separately, then combined into a net lease asset or liability.
Lease income and expense will be presented separately from other income and expense items. The FASB wants to combine these into a net lease income or expense; the IASB did not concur, which makes for a rare point of divergence in opinions. (Presumably a converged final standard will be reached after Exposure Draft comments are reviewed, as the boards have made a clear priority of having a converged standard.)

Service components/Executory costs; March 22 meeting

2010-03-23T15:24:00.002-04:00

At the March 22 joint FASB/IASB board meeting (videoconference viewable here; background materials available here), the boards tackled leases that include a service component. This is what FAS 13 calls "executory costs"; the amounts are part of the future minimum rent commitments, but are excluded from capitalization, as they are considered a service contract that is simply expensed without a balance sheet impact. For operating leases, however, they were pretty unimportant to distinguish from other rent.

The boards agreed to keep the concept of separate service (executory) and lease components of the rent, with the service component not counted as part of the obligation/receivable but simply treated as an expense.

Both lessee and lessor need to evaluate whether the payments can be allocated in this way, in keeping with requirements of the Revenue Recognition project simultaneously underway. If the service component is not considered "distinct" from the lease component, they are not to be separated. Services would be considered distinct if, for example, they are available independently of the lessor, or the lessor sells them outside of leasing transactions.

If an entity is unable to determine an allocation between service and lease components, the entire rent is treated as lease. Since treating it as a service will generally be preferable financially, there's an incentive to get the numbers right.

If the total rents later change for a lease that has service and lease components, the entity should try to apportion the changes between the components. If unable to do so, they should divide the change in rents pro rata between the two components.

The new rules will apply immediately with the application of the new standard. For capital leases, it should be a non-issue; operating leases, however, will need to be analyzed to determine what portion should be considered service. (It's not clear whether the terminology is to be changed from "executory costs" to "service component.")

Disclosures and more – March 17 boards meeting

2010-03-23T14:56:00.002-04:00

The FASB and IASB met again on March 17 (videoconference, viewable here; background materials available here) to continue working through issues related to the new lease accounting standard, still aiming to get out an exposure draft by the end of June 2010. Following are highlights of their decisions:

Lessee disclosure requirements

These are items that need to be reported in the footnotes to an entity’s financial statement, not placed in the primary financials. Both narrative and numerical disclosures will be required:

Narrative

A general description of leasing activities, broken up by nature or function.
Statement if simplified short-term lease accounting is being used, with the amounts involved.
Statement if sale & leaseback transactions are entered into, along with material terms & conditions, and associated gains or losses.
Assumptions and estimates for options, contingent rentals, residual value guarantees, discount rate, and amortization method.
“Quantitative and qualitative financial information” to help evaluate uncertain future cash flows, and how the lessee manages those uncertainties.

Numerical

Reconciliation between opening and closing balances for right to use assets and rental obligations (additions, activity, estimate changes, removals, etc.)
Maturity analysis of future rent obligations, breaking out contractual minimums and additional estimated payments by year for five years, with a lump sum for remaining amounts.

The reconciliation is a completely new disclosure. The maturity analysis is an unsurprising extension of the current future minimum rent disclosure.

Lessor transitional provisions

Like lessees, lessors will recognize the present value of the remaining rents at the implementation date on their balance sheet (as a receivable, matching the lessee’s obligation). The performance obligation will be booked for the same amount.
The discount rate for the lease should be the rate the lessor is charging the lessee (which seems to be the same as the implicit interest rate).
Under FAS 13, capital leased assets are derecognized. At transition, those assets will be reinstated at depreciated cost (adjusted for impairment, and for revaluation under IFRS).

Measurement at initial recognition

Assets and liabilities are to be calculated as of the inception of the lease, which can be earlier than the start date of the lease (inception is when the agreement is signed, even if possession is taken and rent starts being paid later).

Residual value guarantees – lessor accounting

The lessor’s receivable should include guaranteed residuals when they can be measured reliably.
Measurement uses an expected outcome technique (i.e., probability-weighted result).
The carrying amount should be reassessed each reporting period if new facts or circumstances indicate a material change.
Changes would be treated as an adjustment to the receivable and performance obligation just like a contingent rent change.

The boards did additional work on the new standard at their March 22 meeting, to be recapped next on this blog.

Booking contingent rent changes and other Feb. 17/18 issues

2010-02-23T17:44:00.002-05:00

In current lease accounting, contingent rent (rent that is uncertain at lease inception, such as that based on percentage of sales, inflation, or usage) is not counted to calculate the asset and obligation, and is simply expensed as incurred. At the extreme, this can mean that a lease has no rent commitment at all (if, for instance, a retail store lease is based solely on a percentage of sales, or a copier lease is priced entirely on copies made).

Under the proposed new lease accounting standard, contingent rents must be estimated (using an "expected outcome" probability-weighted approach) and included in the rent stream that is present valued to determine the asset and obligation. However, since contingent rents are by definition uncertain, there will inevitably be adjustments from the estimate to the actual. The question then arises, how should the adjustments be booked? In the Preliminary Views document, the FASB proposed that changes should be recognized in profit or loss, while the IASB recommended adjusting the right-of-use asset.

At a Feb. 17 & 18 joint meeting of the FASB and IASB, the boards agreed on a compromise position for lessees: changes that apply to rent in current or prior reporting periods should be recognized in profit or loss, while changes that apply to future periods (due to updated estimates) should result in an adjustment to the right-of-use asset. The same principle applies to residual value guarantees (throughout the new lease accounting standard, residual guarantees are treated as simply a variety of contingent rent).

For lessors, the decision is essentially the same, except that the dividing line is based on whether or not the associated performance obligation has been "satisfied." The boards will include guidance with the new standard to clarify how to determine when a performance obligation has been satisfied.

In substance purchases

The boards revisited the issue of "in substance purchases," and decided that a contract which is effectively the sale/purchase of the underlying asset should be treated as a sale & purchase, not as a lease. The following criteria are considered generally to be indications of an in substance purchase:

Contracts in which the title of the underlying asset transfers to the lessee automatically
Contracts that include a bargain purchase option, if it is reasonably certain that the options will be exercised
Contracts in which the return that the lessor receives is fixed
Contracts in which it is reasonably certain that the contract will cover the expected useful life of the asset and any risks or benefits associated with the underlying asset retained by the lessor at the end of the contract are expected to be not more than trivial.

It will be noted that #1 & #2 are FAS 13's 7(a) and 7(b) tests for a capital lease, and #4 is more or less a 100% economic life test (i.e., increasing FAS 13's 7(c) test of the lease term as a percentage of the economic life from 75% to 100%). However, #4 recognizes that sometimes at the end of a lease, the asset, even at the end of its useful life, may have remaining benefits or costs--for instance, an airliner has considerable scrap value, or a building could have either structural value or sizable cleanup costs. In such situations, the contract would still be recognized as a lease.

The boards are aware that sometimes land is leased for extremely long periods (hundreds of years). Since land is considered always to have value, even such long leases would still not be considered sales, though the boards asked the staffs to consider possible alternatives for such leases.

So we're back to classifying, even if everything is now on the balance sheet. A substantial number of current capital leases (particularly computer leases with $1 buyout clauses) will now be treated as purchase/sale transactions, not as leases. They are to be excluded from the scope of this standard. What standard will define how they are booked (how to calculate the asset value, etc.)?

Initial direct costs

Initial direct costs are to be added to the right-of-use asset by lessees and depreciated over the life of the lease; lessors add them to the lease receivable and amortize. At the Feb. 17 meeting, the boards clarified that initial direct costs are to be defined as "incremental costs directly attributable to negotiating and arranging a lease." The operative word is "incremental"--general overhead expenses associated with sales and marketing should not be included. Guidance will be included in the standard to illustrate, with the intention to include items such as commissions, legal fees, and employee total compensation for time spent on negotiating a lease, evaluating the lessee/lessor, preparing documents, and closing the transaction.

Transition

The boards have decided that existing simple capital/finance leases will be left unchanged if they are "simple" leases, i.e., they have no contingent rent, residual value guarantees, or option periods. For such leases, the accounting treatment is virtually unchanged (except for the possibility of a different interest rate), so it is felt that there is no benefit to requiring a recalculation at the standard implementation date. Other capital leases, however, including combined capital building/operating land leases, must be transitioned to the new standard, which means capitalizing the remaining rents at the implementation date.

Where there are large up-front or deferred "balloon" payments, adjustments will be required to avoid understating or overstating the asset. Up-front payments would be discounted and pro-rated over the life of the lease, while the overstatement from balloon payments would be addressed through impairment review.

Implicit interest rate

The new standard will permit lessees to use the implicit interest rate instead of the incremental borrowing rate if it is readily determinable. Also, the lessor is to use this rate for calculating the lease receivable. However, a new definition of implicit rate is necessary because the old definition was based on the underlying asset's fair value and the minimum lease payments; fair value is essentially being jettisoned for the new standard, and the payments used are much more than the minimum payments. The boards decided to accept as the definition: "the rate that the lessor is charging the lessee." That may sound like a tautology, but the boards will include guidance to help users determine the appropriate rate in different circumstances.

Discussions will continue in March. One item deferred to next month is separating service elements (executory costs) from the regular lease payments.

What's a lease?

2010-02-05T10:42:00.002-05:00

The FASB & IASB had a joint meeting on Feb. 2 by videoconference. The topic of discussion was a definition of a lease. They came up with the following definition:

A lease is a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration.

This definition includes contracts which are outside the scope of the new (and current) lease accounting standard. Notably, the definition is not limited to property, plant, and equipment, but the standard is.

There will be further work on the new standard at the upcoming joint videoconference meetings Feb. 16-18.

Not your father's lease accounting

2010-02-01T15:18:00.002-05:00

Enough of the structure of the proposed new lease accounting is set (for presentation in the exposure draft) that it's appropriate to take a step back and look at the larger picture. This rewrite, which brings an end to a 35-year-old lease accounting structure, is not just about putting leases on the balance sheet. More fundamentally, the conceptual basis of reporting has changed radically. There are two conceptual changes, each of which has significant implications.

Under FAS 13, the fundamental concept is that a lease that "transfers substantially all of the benefits and risks of ownership should be accounted for as a" capital lease, representing a sale and purchase transaction, while all other leases are treated as "operating leases, that is, the rental of property." (FASB Current Text section L10 summary) Under the new standard, a right of use is recognized as a lessee asset with a matching rent liability, and a corresponding receivable and performance obligation are recognized as lessor asset and liability; these assets and liabilities are recognized for every lease (subject only to standard materiality limitations, and for lessors, to a scope exclusion for leases of less than 12 months). Off-balance-sheet financing via leasing ceases to exist.

The second conceptual change has not been highlighted as much, but is every bit as significant. FAS 13 is concerned with minimum known lease obligations. A lessee calculates the future rent commitments and the present value of future rents, and from that the asset and obligation on capital leases, based solely on the minimum amount of rent he can be required to pay. Contingent rentals are generally excluded from these numbers (unless based on an index or rate, such as CPI or LIBOR, in which case the future rents are estimated based on the initial rate, and that estimate is never changed), with actual contingent rentals paid simply expensed as incurred. If there are renewal options, they are ignored until exercised unless it is clear at lease inception that the lessee will be economically compelled to exercise them (due to bargain rents, etc.). On the other hand, a guaranteed residual is recognized at the maximum that the lessee can be required to pay, regardless of the likelihood.

The new regime can be described as "the most likely cost of the lease." Contingent rentals of all sorts are to be estimated and included, with the estimate updated each reporting period (i.e., each quarter) if there is a material change. Options are to be included if they are deemed more likely than not to be exercised, based on expectations and past practices as well as economic compulsion. (Once they are actually exercised or not exercised, the lease will of course be updated if the result is different from what was expected.)

What's the result? Many existing capital leases will need to be recalculated under the new regime. Numerous leases will need mid-term adjustments which affect both the balance sheet and the income statement. Some leasing agreements that made a lot of sense under FAS 13 may be inadvisable, and lessees and lessors may face difficult negotiations to revise the agreements to reduce their impact on the parties without disadvantaging either. Prior estimates of the impact of revising FAS 13, based on the minimum lease term and payments, will prove substantially understated for at least some leases (likely to be most affected are real estate leases with multiple lengthy options and percentage of sale contingencies, such as many store leases). As previously noted, some companies face potentially major changes to their income statement and balance sheet due to the new rules. Almost all lessees will face a deterioration of their financial ratios; if an equal amount of asset and liability is added to one's balance sheet, debt and current ratios (for all but the most unhealthy companies) will decline.

What's the benefit? The boards clearly feel that the new methodology more accurately reflects the economic reality of leasing transactions. While they are not deaf to concerns about implementation costs, in most cases they believe those concerns must bow to providing better reporting on the huge volume of leasing (an estimated $1.25 trillion in future lease commitments in the U.S. alone, which doesn't include many of the options that will be included in the new regime). In their view, an airline without airplanes on their balance sheet doesn't reflect economic reality, and neither does a store chain with no stores, that claims all of its lease commitments end in 5 years and shows tiny future rents because percentage sales fees are excluded. In addition, having a common standard for US GAAP and IFRS will be a major step forward for the boards' convergence project to have consistent accounting worldwide.

It goes almost without saying that every company's method of accounting for leases will have to be updated (software, Excel spreadsheets, whatever). Our EZ13 is no exception, and we are currently laying the plans to make the needed changes. While we already permit treating operating leases as capital on a pro-forma basis, that is only a small part of the reporting changes that will be coming. We are committed to releasing an updated version of EZ13 as quickly as possible once the new rules are finalized.

Jan. 20 FASB/IASB meeting

2010-01-23T22:47:00.003-05:00

The FASB and IASB met again on Jan. 20 to continue their review of the new lease accounting standard proposals.

Post-inception measurement of leases with options & contingent rentals
The boards decided that the discount rate for the lease (for both lessees and lessors) should remain the same if the lease term is subsequently changed.
If the contingent rentals change, the discount rate would only change if those rentals are contingent on variable reference interest rates (such as LIBOR).

Short-term leases
The boards decided to provide an optional simplified form of lease accounting for leases with a maximum possible lease term (including all options) of less than 12 months. Discussion noted that this is beyond standard materiality thresholds (such as expensing all purchases or leases below a specific value).
For lessees, the boards decided to permit recognizing the undiscounted remaining rent as the liability and asset. Therefore, no interest would need to be calculated. It will be noted, however, that this will result in a higher liability (and asset) appearing on the balance sheet, so this becomes a potentially costly choice for lessees. However, the interest for a single year would normally be pretty small, so the difference was presumed to be not highly significant.
For lessors, the boards decided to permit treating short-term leases as service contracts, which would not require any recognition of a performance obligation; the receivable would be a simple account receivable.

Investment properties
FAS 13 does not treat properties held for investment differently from other leased assets. IAS 40, however, overrides IAS 17 (the IASB regulation for leases), and permits very different accounting for such leases. The IASB decided to maintain IAS 40 for leased investment properties that are measured at fair value. The FASB asked its staff to prepare an agenda item to consider a similar standard for US GAAP.

Review of additional aspects of lease accounting will continue at a joint February meeting.

A return to classification?

2010-01-18T18:00:00.003-05:00

At the January 5 joint meeting of the FASB and IASB, the boards agreed that leases that represent the purchase (by the lessee) or sale (by the lessor) of the underlying asset should be excluded from the scope of the standard and treated as sales. The key concept to be used is that the lease includes transfer of control of the asset, such as through an ownership transfer or bargain purchase option in the lease. While the intent is to parallel the revenue recognition project in this type of transaction, the boards weren’t happy with using the definition of control the staff provided (which comes from the revenue recognition project), considering it not well suited to the characteristics of leases; they directed the staffs to work on a more appropriate definition.

Some of the FASB/IASB staff suggested that leases whose term (including any bargain renewal options) covers the entire useful life should be treated as sale/purchase transactions. This is in essence putting a 100% level on FAS 13’s 7(c) test. There was substantial discussion about this, with no conclusion reached. Some board members felt this ignored the possibility of major costs or benefits associated with an asset even if it is at the end of its useful life (decommissioning costs or scrap values, for instance). But a number of other board members seemed in favor, depending on how things were defined. This will be revisited at a future meeting.

Dec. 18 meeting recap

2010-01-18T17:54:00.002-05:00

The FASB & IASB held a joint meeting in London on Dec. 18. (I apologize for the delay in posting information; the end of the year is a hectic time at the office with providing year-end reports for clients.) The primary focus for discussion was contingent rentals and residual value guarantees, which were originally to be discussed in November but carried over when they ran out of time.

Contingent rentals

The boards recognized that this topic was one of the most controversial in the preliminary views document. Broadly, the boards reconfirmed their decision to include estimated future contingent rents in the obligation and asset capitalized for leases. To clarify certain aspects of the estimation process:

An expected outcome technique is to be used, but the boards will specify that not every possible scenario must be taken into account in this calculation. (This means that the boards have decided to go with a probability-weighted outcome, rather than the “most likely” approach originally favored by the FASB.)
Contingent rentals based on an index or rate would be measured using readily available forward rates. If none exist, the rates at inception of the lease would be used.
For lessors, a receivable would be recognized for contingent rentals would be recognized only if the receivable could be measured “reliably,” in keeping with other tentative board decisions on revenue recognition (a project that is happening simultaneously).
The obligation/receivable would be reassessed at each reporting date if there is a material change.

The boards could not decide whether the changes in the obligation/receivable should be matched by a change in the right-of-use asset or by a profit/loss entry, and directed the staffs to research the issue further, with plans to revisit the issue at a later date. The staff recommended that the matching entry depend on the type of contingent rent: those that result from the lessee buying more or less of the right of use (such as excess mileage charges on vehicles) would change the asset, while those based on an index or rate, or based on performance (such as percentage of sales) would be recognized in profit/loss.

Residual value guarantees

Guarantees of residual value are to be handled the same way as contingent rentals, as they are simply a specific form of a contingent payment (based on the value received by the lessor for the asset at the end of the lease term). Note that this is a significant difference from current accounting, which requires the entire guarantee to be recognized as a payment to be made; under the new regime, only an estimate of what the lessee is likely to actually pay will be counted.

Scope

The boards have decided to exclude from the scope of this standard leases of intangible assets (including software), leases to explore for or use natural resources, and leases of biological assets. “Non-core” assets will not be excluded.

The boards put the issue of excluding short-term leases back to the staff for further review and later decision.

The boards again ran out of discussion time, and so put off to Jan. 5 a discussion of excluding leases which are in-substance purchases/sales.

Results of joint FASB/IASB meeting, Nov. 18

2009-11-18T15:39:00.004-05:00

The FASB and IASB had a joint meeting via videoconference today. Among several topics of discussion was lease accounting, for both lessees and lessors. The staff’s agenda papers are available at the IASB’s web site (where you can also view an archive of the webcast). Discussion was lengthy enough that the 2-1/2 hours allocated were insufficient, and so discussion of contingent rents was postponed until a December 16-17 joint meeting.

In general, the boards agreed with the staff’s presented recommendations, some of which varied from their preliminary views as presented in the discussion paper (see previous entries in this blog); the changes were prompted by comments on the discussion paper. Some highlights of changes from the preliminary views:

Interest rate for present valuing the rents: The preliminary views called for the lessee always to use their incremental borrowing rate. After lengthy discussion, the boards agreed to permit use of the implicit rate if it is readily determinable.
Initial direct costs associated with a lease will be capitalized by the lessee and amortized over the lease term; a lessor will likewise add initial direct costs to the lease receivable and amortize them (using the interest method). Some members of the boards wanted to clarify that this applies only to incremental costs incurred, not to an allocation of salaries and other expenses that the company would be paying whether or not a lease was signed.
The boards agreed that the incremental borrowing rate should not be changed during the life of the lease (as long as the lease term is not changed). This had been previously a point of disagreement between the boards.
Impairment of leased assets will be determined based on existing impairment standards (which are different for US GAAP and IFRS). Similarly, revaluation will be based on the separate standards (US GAAP does not permit revaluation, while IFRS permits it under limited conditions).
The initial measurement of a lessor’s lease receivable will be based on the present value of the rents, using the lease’s implicit rate (it was noted that this could be different from the explicit rate when promotional rates, like 0% interest, are being offered).
Subsequent measurement of the receivable will be at amortized cost using the effective interest rate (like a current capital lease).
The lessor’s performance obligation (a credit) will be equal to the receivable at lease inception (including any initial direct costs that are added to the receivable as noted above).
The performance obligation would normally be amortized on a straight-line basis unless another method is more representative of usage (there was some discussion of whether the usage pattern would only be time-based as opposed to unit-based; I’m not sure if a conclusion on that was reached).
For recognizing options in the lease term, the boards adopted an altered determination of the term suggested by some discussion paper respondents: rather than the “most likely lease term,” the standard is now “the longest possible lease term that is more likely than not to occur.” Thus, if there were a 40% possibility of the first option being exercised, and a 20% possibility each of exercising through options 2, 3, and 4, options 1 & 2 would be included, because the likelihood that the life will be longer is less than 50%. This applies to both lessees and lessors.
In determining when options are to be included, the discussion paper stated that the review should include contractual, non-contractual, and business factors, but not past practice and lessee intention. That has been changed, and the boards now state that all factors, including past practice and lessee intention, should be considered. The boards are concerned that companies may use “intention” to game the results, but noted that intention will not trump other factors, but will be one of several factors to consider.
Reassessment of whether options should be included, while in theory required each reporting date, need only be undertaken when facts and circumstances have changed, not simply due to the passage of time.

FASB/IASB joint meeting

2009-10-29T14:26:00.003-04:00

Earlier this week, the FASB and IASB held a joint meeting in London. Among the many topics discussed was leases. According to the Summary of Board Decisions, the following important decisions were made:

* The boards reaffirmed the right-of-use approach for lessees. (IOW, the pleas of many discussion paper comments to keep operating lease accounting have been rejected.)
* The boards have decided to accept the idea of "in substance purchases" as being different from leases; they will be excluded from the scope of lease accounting. Criteria will be developed to identify which contracts should be so treated.
* The boards agreed to use a performance obligation approach for lessor accounting--the asset is not removed from the books, but a liability is set up to reflect the obligation to permit use of the asset, balancing the receivable for the rental stream.
* Lessors will no longer be permitted to recognize a profit at the beginning of the lease; everything will be recognized over the lease term.
* A lease will now need to be reflected on the balance sheet (presumably for both lessees and lessors) as soon as the contract is signed, rather than the current practice of waiting until the asset is delivered. However, until delivery it is to be recognized "net" only, which means that in most cases there will be nothing to report (assets and liabilities are equal), except in case of an impairment. Disclosures (in footnotes, not the primary financials) would be required to detail the assets and liabilities, at least when there is a significant gap in time between signing and delivery and/or the amounts are significant.

The boards will discuss further issues in November, including
* initial and subsequent measurement of the asset and obligation
* treatment of leases with options
* contingent rentals and guaranteed residuals

FASB review of comment letters

2009-09-16T10:51:00.000-04:00

This morning, the FASB met to review the comment letters to the Preliminary Views document. No decisions were made at the meeting. The audio is available until the next meeting at http://fasb.trz.cc/archive.php.

A few notable items from the discussion:

There is concern that more attention needs to be given to distinguishing between a service contract and a lease. Up to now, the accounting for operating leases and service contracts hasn't been significantly different, so it hasn't been a big issue. But with leases subject to capitalization, the difference becomes much more substantial, so people are much more concerned. The board plans to discuss this issue in more depth in upcoming months.
As previously noted, many respondents disagree with including options in the capitalized value of a lease. Some members of the FASB are concerned that options are being handled inconsistently in different aspects of accounting (such as financial instruments and revenue recognition)--some are handled through recognition, others through measurement.
There has been a background discussion of "in-substance purchases" throughout the entire lease accounting project. This reappeared, with the mention that the Leases Working Group meeting earlier this month brought up the issue as being very important to lessors, probably more important than to lessees. The definition of "in-substance purchase" seems to be confined to leases with an ownership transfer or bargain purchase option (the first two tests of capitalization under FAS 13, which currently require the leased asset to be depreciated over the economic life rather than the lease term). Lessors particularly want such leases to be treated like purchases, rather than with right-to-use accounting.
Some respondents questioned whether appropriate due process would be followed if lessor accounting didn't go through a preliminary views document. Board members do not think that is a due process requirement; they believe it is sufficient to provide an exposure draft and respond to comments to that. The implication is that they don't want to slow down completion of the leasing project.

The FASB and IASB will have a joint meeting October 26-28. Lessor accounting is part of the agenda for that meeting.

Correction: In my August 27 blog entry, I said that the September 3 meeting of the Leases Working Group was the first in 2-1/2 years. That was incorrect. The Group also met on October 7, 2008, to discuss the proposed Preliminary Views document. A summary of the meeting is available here, but I won't take the time to review it in this blog, since it's pretty old news by now. I have not yet seen any information (or audio) posted about the September 3 meeting.

Comment letters summary

2009-09-11T11:00:00.001-04:00

The FASB and IASB staffs have prepared a summary of 290 comment letters received on Leases: Preliminary Views, the discussion paper released in March, for which the comment period ended in July (though letters were received through mid-August; they cut off review with the letter received on August 10, while 5 more were received in the following week). The summary is available on the IASB web site. The boards plan to discuss the summary next week: The IASB's meeting will be Sep. 15, while the FASB will meet on Sep. 16. Both meetings will be broadcast on the web (IASB includes video, while the FASB is audio only; follow the links to sign up).

Some highlights from the staff's summary (you can see my less systematic review in a prior post):

* Almost half of the respondents were "preparers" (companies and other entities that need to prepare financial statements), with another 51 from industry organizations. The rest were a range of professional associations, accounting firms & standard setters, government agencies, academics, financial statement users, and individuals not claiming other affiliations. Almost half were from Europe, with a third from North America, an eighth from international organizations, and a small number from the rest of the world.

* About half supported the overall concept of a right-of-use asset and corresponding obligation for all leases; a third were opposed, and the rest did not express opinion (in most cases because they were focused on lessor rather than lessee accounting). However, most of those in support also expressed reservations about complexity, especially in dealing with options and contingent rents. Those opposed (virtually all of whom were preparers or industry organizations) largely encouraged keeping the current model with enhanced disclosure.

* "Nearly all of the respondents who commented on the boards' decision to defer consideration of lessor accounting disagree with that decision." People are concerned that the transactions will be unbalanced, and that eventual lessor accounting decisions may require further changes to lessee accounting at considerable extra cost and complexity.

* Most respondents agree with the current scope for lease accounting, though some are concerned that the new rules will lead to pressure to recharacterize leases as service contracts (which are not capitalized). Most who commented favor excluding short-term leases (generally favoring one year as the cut-off) but including "non-core" leases.

* Nearly all respondents agree with valuing the asset and obligation at the present value of the rents, though they were divided on whether lessees should attempt to determine and use the lease's implicit interest rate instead of the incremental borrowing rate.

* Respondents were divided on whether or not options (renewal and purchase), contingent rents, and residual guarantees should be included, with many of those opposed asserting that they do not fit the accounting framework definition of a liability, and also expressing concern about the complexity that would be entailed.

* If contingent rents are included, about half believe the estimates should be updated each reporting date (the boards' tentative view), to provide more accuracy. Others consider this requirement onerous, and would limit it to when a triggering event (to be defined) occurs. If changes in contingent rents happen, most prefer to see it recognized through a change in the carrying amount of the right-to-use asset, not a P&L gain/loss.

* Most who expressed an opinion on lessor accounting wish to see the transaction set up as a derecognition of (a portion of) the existing asset, rather than the performance obligation approach that the boards favored in their July meetings.

* Most who expressed an opinion believe that investment properties should be included in the scope of a lessor accounting standard. However, almost all investment property companies themselves argued against inclusion.

We'll see how significant the comments are in the boards' deliberations next week and over coming months.

Upcoming Leases Working Group meeting

2009-08-27T22:11:00.005-04:00

When the FASB & IASB decided to revise the lease accounting standard back in 2006, they called for members of academia, public accounting, and the world of publicly held companies to volunteer to serve on an advisory panel, called the Leases Working Group. A first meeting was held in January 2007 to discuss the various issues surrounding lease accounting, and get the group's input on possible approaches to deal with the problems.

Then the boards seemed to forget the group existed. It has been over 2-1/2 years since the group met. Finally, on September 3, a second meeting of the Leases Working Group will be held in London. It's planned as an all-day event. Unlike IASB board meetings, this meeting will apparently not be available for live online listening; however, they have promised that audio will be available at a later time. Anyone who wants to attend the meetings live may do so, but needs to register in advance on the IASB website.

Agenda papers for the meeting are also available at the IASB website. They indicate that the issues to be discussed are largely issues that were not covered by the Preliminary Views discussion paper, though there will be a brief review of the 295 comment letters received. Instead, the topics to be discussed are mostly matters that the boards have discussed in their May, June, and July meetings: impairment, revaluation, initial direct costs, sale & leaseback transactions, transition, and lessor accounting, plus in-substance purchases, which some members feel should be accounted for differently than other leases. That has been mentioned at prior meetings, but there has been no in-depth discussion on the topic. Many of the topics for review are ones where the two boards have taken different positions; a number of comment letters urged the boards to come to an agreement on these topics (many respondents felt a unified standard was more important than which position was taken). More detailed information on the topics is available at the IASB's web site, among the agenda papers for prior board meetings (the appropriate papers are noted on p. 3 of the working group's agenda paper #1).

The working group will have to move at a fast pace; less than half an hour per issue has been allotted for the lessee topics, plus 90 minutes for lessor accounting and 45 minutes for in-substance purchases.

The boards plan to discuss the comment letters at meetings in September, and lessor accounting at October meetings. At this point, the schedule for the leases project still indicates an exposure draft in the second half of 2010, and a final standard in the first half of 2011. Whether the boards will stick with that after the September and October meetings, in the face of substantial public pressure for a simultaneous release of new lessee and lessor standards and a large amount of work to do on both sides of the transaction, remains to be seen.

Comment letters update, lessor accounting

2009-07-30T17:31:00.004-04:00

The IASB continues to post comment letters to its web site. As I write this, the count stands at 272, with a notation that "Comment Letters are currently being uploaded to the website." However, fewer than 10 letters have been posted this week. It looks like these are letters received after the deadline, which they are choosing to still include (some of the cover letters have dates after July 17).

At a joint FASB/IASB meeting on July 23, the boards announced that they would review the comment letters at a meeting in September.

At the same meeting, the boards reached the following tentative decisions on lessor accounting (reported in the FASB Action Alert):

1. Initial measurement of the lessor’s right to receive rental payments would follow existing literature for the accounting for financial assets under either IFRSs or U.S. GAAP (IAS 39, Financial Instruments: Recognition and Measurement, for IFRSs and Section 310-10-30 of the FASB Accounting Standards Codification™ for U.S. GAAP).
2. Initial measurement of the lessor’s right to receive rental payments under U.S. GAAP would be discounted using the interest rate implicit in the lease.
3. Initial measurement of the lessor’s performance obligation would equal the customer consideration received (that is, on initial measurement the performance obligation would equal the lessor’s receivable).
4. Subsequent measurement of the lessor’s performance obligation would reflect decreases in the entity’s obligation to permit the lessee to use the leased item over the lease term.

However, they note that all of these decisions presuppose maintaining the overall concept of setting up a performance obligation for lessors (the original asset remains on the books, and a receivable is added to assets with a matching performance obligation as a liability). A number of comment letters have criticized that decision, in part because it seems not to mirror lessee accounting, and the boards have instructed their staffs to do additional analysis of a different model that would derecognize the asset to the extent of the lease. (This was the staff's preference presented to the boards at their May meetings, as previously mentioned on this blog.)

DP comment letters

2009-07-24T18:00:00.001-04:00

The comment period has now closed for the discussion paper, Leases: Preliminary Views, released by the FASB & IASB in March. A flood of comment letters came in close to last Friday's deadline; as of this posting, the comment letters page lists over 200 comment letters received, with a notation that additional letters have yet to be posted.

Letters have been received from almost every conceivable type of party: accounting firms, accounting boards, lessees, lessors, associations of lessees and lessors, accounting academics, and even a few individuals. (FCS's comment letter is available here.) Interestingly, even though a major reason for the proposed revision is to provide better information to users of financial statements (i.e., investors and lenders), I see only a couple of comment letters from such entities, so we have little basis to know whether they feel the changes would help them make better investing decisions. We only have the claims of other interested parties that this or that change would or wouldn't be useful to statement users.

While I haven't had time to read all the comment letters, most of them fall in predictable ways. Accountants generally favor the overall approach, though they may have issues with some of the details. Most lessors and many lessees don't like the elimination of operating leases; many are also concerned about the increased complexity, particularly if reassessment every reporting period is required. (Some comment that lessees made their decisions to lease based on the current rules, and requiring capitalization of existing operating leases messes up their capital structures.) Some lessees are more sanguine about the general approach; JCPenney, for instance, says that it has long been internally managing its capital structure as if real estate operating leases were capitalized, so making that change on the external books is no big deal, and makes a lot of sense to them (though they'd still like to exclude small leases).

Several letters (such as the Office of Advocacy of the U.S. Small Business Administration) express concern about the impact on small businesses leasing items like computers and copiers; the impact on their financial statements, the complexity involved in calculating and amortizing present valued obligations, and the hassles of reconciling differing treatment between book and tax accounting were mentioned as issues. A number of letters suggest that small or short-term leases should be excluded to reduce the reporting burden, considering that the impact would generally be immaterial; other letters (particularly from accounting firms) oppose any exclusions, concerned that it opens the door to evasive manuvers.

Overall, it seems like virtually every question has respondents on both sides of the issue, often with very carefully thought-out reasons. Still, it's not hard to see the "whose ox is being gored" aspect of many of the comments: lessors are concerned that if all leases are capital, many companies will buy instead of lease as the off-balance-sheet benefit disappears (even as they claim that that's rarely why lessees take leases); lessees with lots of operating leases are concerned about the effect on their balance sheet of capitalizing those leases; some academics and accountants seem to be pursuing theoretical accuracy with no concern for the practical costs (while others are very aware of their clients' pain).

There are, however, some areas of general agreement. Virtually no one likes the idea of recalculating the obligation to reflect changes in a lessee's incremental borrowing rate, considering that it adds complexity and doesn't reflect a change in the actual economics of the lease. Very few like the idea of revaluing the obligation at fair value, for similar reasons. Recognizing options and contingent rent based on the most likely amount rather than probability weighting is strongly favored (though many don't want to recognize options until actually exercised or reasonably assured, or contingent rent until incurred, both of which are the current rules). Respondents generally agree with treating residual guarantees similarly to contingent rents.

There is a great deal of concern with complexity and cost, particularly the requirement to reassess at each reporting period (especially with regard to contingent rents). Many respondents suggest that contingent rents should only be capitalized if the regular rents are clearly below-market (otherwise, they would be expensed as incurred, as under current rules). Some accountants, though, believe reassessment is desirable to more accurately portray the current state of the leases. Another area of complexity mentioned by a number of American respondents is book/tax differences which would be generated by treating current operating leases as capital (when they would still be operating or "true leases" for tax purposes).

A large number of letters call for lessor lease accounting to be included in the revision, wanting to make sure that lessee and lessor accounting continue to mirror each other, rather than operate under different standards. Some are concerned, though, that the boards may rush their lessor accounting review to stay on the current lessee schedule.

CFO magazine has an article about the comment letters on their website.

EZ13 v2.3 released

2009-07-23T11:25:00.001-04:00

FCS is delighted to announce the release of version 2.3 of EZ13(TM), the Lease Accounting solution. (The new version was actually released over a month ago, but I forgot to post this announcement.) This latest release includes a wide range of new features:

Contingent rent: EZ13 has a new tab for contingent rent, which is rent paid that is not part of the FAS 13 minimum lease payments. Contingent rent is expensed as incurred. You can enter contingent rent in the screen tab, or upload it using an Excel® spreadsheet (requires Excel installed on your computer). (Not in Mini Edition.)

Rent escalation: EZ13 can automatically create a series of rent steps based on a periodic escalation calculation (increasing by 10% every 5 years, or 5% compounded per year, etc.). This complements the existing automatic calculation of rent for leases with level principal amortization.

Expirations report: Get a list of leases scheduled to expire between two dates.

Transfer additions and terminations: A transfer addition picks up the asset and obligation midstream for the lease; a transfer termination is almost the same as an early termination, but is designed to match a transfer addition. These are useful if a lease is being moved from one department to another, and you want to recognize the expenses up to a certain date as belonging to one account and afterwards to another (using EZ13’s account numbers feature or other distinguishing codes).

Month to month extensions: Sometimes leases are renewed after expiration on a month to month basis. There is no future rent commitment; rent is expensed as incurred (using the contingent rent feature noted above). You can optionally leave the gross asset and accumulated depreciation on the books (assuming the lease is depreciated over the lease term, the gross asset and accumulated depreciation are equal, so the net asset is zero).

Capitalize leases at incremental borrowing rate (not in Lite or Mini Editions): EZ13 has had the capability to treat operating leases as capital, using their incremental borrowing rate as the capital rate. This is intended both for current indenture reporting that some lenders require, and in anticipation of the upcoming rewrite of the lease accounting standard, which plans to capitalize all operating leases at the incremental rate. The current draft of the upcoming standard calls for all leases, including those currently capital, to use the incremental rate; there would be no limitation of the asset value to the fair market value of the underlying asset, which currently causes some capital leases to have higher interest rates. This new option lets you see the effect on your capital leases of the FASB/IASB proposal. (See prior blog entries for more information on the FASB/IASB proposed rewrite of lease accounting standards.)

Some of the feature additions were in response to requests from users of EZ13. We will continue to provide updates (at least one per year) with enhanced features at no additional cost to clients who maintain a support contract. Updated CDs are being sent to all such clients. Any clients who have not maintained their support contract can get the update by reinstating support; contact us for details.

The free demo available for download on our website has been updated to v2.3, so you can try out the new features yourself.

Additional decisions on lessee accounting

2009-07-08T12:45:00.007-04:00

At meetings held June 17 and June 18, the FASB and IASB (respectively) discussed additional lease accounting issues that were not covered in the Preliminary Views discussion paper. The following topics were discussed and conclusions reached:

Sale and leaseback transactions

An asset (most commonly real estate) may be sold and immediately leased back. FAS 98 has an extensive set of tests to determine whether the continuing involvement of both seller/lessee and buyer/lessor are such that the transaction should be recognized as a sale and a lease, or as a financing that doesn’t meaningfully transfer the asset, so that it would remain on the books of the putative seller/lessee. Sale/leasebacks are sometimes done for cash flow purposes; at other times, a major purpose under current accounting may be off-balance sheet financing. With the end of operating lease accounting under the new rules, the latter purpose would disappear.

The boards decided that in a sale/leaseback, the entire asset should be derecognized and replaced with a right-to-use asset (rather than keeping a portion of the original asset on the seller/lessee’s books). The IASB concluded that a gain should be recognized immediately; the FASB’s meeting summary doesn’t indicate their decision. The FASB thinks there may be a need for additional guidance when the sale price or rental payments aren’t at market rates.

Impairments

Existing general accounting standards for impairments should also be used for lease right-to-use assets. This means that US lessees would use FAS 144, while IFRS users would use IAS 36, consistent with their treatment of impairments of other assets.

Revaluation

The FASB holds that revaluation of the right-to-use asset would reflect amortization and impairment. Adjusting based on fair value would generally not be permitted. The IASB refers to revaluation models in IAS 16 for property, plant, & equipment, and IAS 38 for intangible assets, which do permit revaluing based on fair value.

Initial direct costs

Initial direct costs for negotiating and arranging leases are to be expensed as incurred.

Transition

This was a big hole in the preliminary views document. Both boards agreed that leases should be set up using the remaining rents as of the date of application of the new standard, valuing the obligation at the present value of the rents (using the current incremental borrowing rate), and setting the asset to the same value (the IASB notes that there could be an impairment adjustment).

Nothing, however, is said about how to handle the existing deferred liabilities on existing operating leases with scheduled rent increases, or the difference between asset and liability on existing capital leases. Will this be taken directly to retained earnings, or recognized as a gain or loss in the income statement? Most lessees would probably prefer to recognize the change in the income statement, because almost all leases (leveled operating and capital) would show a gain on removal. The argument would be that they have in effect over-expensed these leases, so they should be able to recover that excess expense as part of the changeover.

Next steps

The discussion paper comment period closes a week from Friday, July 17. The boards plan to discuss the comments at meetings in September. In July there will be another meeting to discuss additional matters related to lessor accounting (following up their May meeting); I haven’t seen a specific date yet. The two boards will be holding joint meetings on July 23 & 24, but I don’t see any indication whether they will take that time to discuss leases, or will continue their more typical practice of meeting separately to discuss the issues.

Sources for board information:
IASB meeting summary: http://www.iasb.org/Current+Projects/IASB+Projects/Leases/Meeting+Summaries+and+Observer+Notes/IASB+June+2009.htm
IASB meeting audio: http://www.iasb.org/Current+Projects/IASB+Projects/Leases/Meeting+Audio+Playback/Meeting+Audio+Playback.htm
IASB meeting agenda papers: http://www.iasb.org/Meetings/IASB+Board+Meeting+18+June+2009.htm

FASB meeting summary: http://www.fasb.org/leases.shtml
Meeting handout: http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176156247551

Proposed changes to lessor accounting

2009-06-15T14:45:00.001-04:00

The FASB and IASB met separately on May 18 & May 20 (respectively) to discuss changes to lessor accounting consistent with the move to a right-to-use model for lease accounting. As previously discussed, the boards had decided to delay lessor accounting changes and move ahead with lessee accounting only, because they felt that the need for changes was more urgent for lessee accounting and lessor accounting had complexities that would slow the whole process down.

Now they're getting started with looking at lessor accounting directly, in part perhaps because they realized that sublease accounting is inevitably affected by lessee accounting, and sublease and lessor accounting are inextricably linked.

The boards dealt with a fundamental question in their approach to lessor accounting: Does a lease result in a transfer of a portion of the leased item from lessor to lessee, or does it create a new right and obligation for the lessor? Or as the staff puts it in their discussion paper, "What is the credit?" (Additional examples, with sample journal entries, are in a second discussion paper.) The debit in the transaction is clearly the creation of a receivable representing the discounted flow of rents. Should the credit be recognized as a reduction in the value of the asset on the lessor's books (a derecognition of part of the asset), or should the asset remain untouched and a separate performance obligation created to reflect the requirement to allow the lessee to use the asset?

The FASB staff, which wrote up the discussion paper, favored the first approach (Approach A), derecognizing a portion of the lessor's asset and keeping only the net on the lessor's books. However, the boards decided instead to recognize a performance obligation. The discussion at the IASB (available by webcast until August 19) raised a number of concerns with Approach A, one of the most compelling apparently being that it would result in a steadily diminishing asset on the books which could eventually go negative (if a building that is mostly depreciated, or land recorded at historical cost, is leased based on current market value). A separate but related issue was whether profit should be recognized at the inception of the lease. This is currently permitted for manufacturers and dealers under sales-type leases, but not for direct financing leases. A number of board members did not want to permit recognition of profit at inception, and Approach A was seen as facilitating or even demanding profit recognition. The FASB also preferred Approach B, with members stating their position in favor of no immediate profit recognition and keeping the full asset on the lessor's books as long as the lessor retains title. (A concern raised and not resolved by both boards was whether treatment should be different if the lease transfers ownership at the end of the lease term, so that no interest in the asset remains with the lessor.)

The boards remain concerned about opportunities for structuring transactions to avoid the regulations, and are trying to craft the new regulations to reduce the potential for structuring, ensuring that legal forms don't facilitate treating differently transactions of similar economic substance.

Next steps:

In meetings scheduled for July, the boards will discuss initial and subsequent measurement and presentation of the asset and liability, as well as how to recognize contingent rents and options. (The second discussion paper for the May meetings made assumptions for measurement, but these have not been decided on by the boards.) Additional items for discussion, not necessarily at the July meeting, include how to differentiate a sale of an asset from a lease, and whether the right-to-use model should apply to short-term and immaterial leases. Following that meeting, the boards will decide whether they have made enough progress on lessor accounting to include it in the Exposure Draft scheduled for mid-2010, or if the ED should remain lessee-only.

Types of EZ13 reports

2009-05-05T12:18:00.001-04:00

This is in some ways a continuation of the prior blog entry on how to create spreadsheet output.

EZ13 provides several types of reports. Let's look at what each provides. (I'll describe specifically the spreadsheet output type #1; the text report includes basically the same information, but laid out differently.)

1) Income Statement/Balance Sheet Detail: This is our most comprehensive report of calculated information (all of the accounts involved in lease accounting for a period). We've tried to break out every account so you can see exactly what's happening. Each balance sheet account, for instance, shows five different values: beginning balance, added (for new leases), activity, removed (for terminations), and ending balance. In all, this report shows some 74 columns of calculated data, plus as many as 43 columns of descriptive information (including account numbers if you define them).

And that's just the first tab. On the second tab, we show the future minimum rent information. If you get minimum rents broken out by year for the first 5 years, then all remaining as a lump sum (as FAS 13 requires), the second tab shows 42 columns of calculated data per lease.

2) Income Statement/Balance Sheet Compact: Maybe that's overkill for you. The compact report shows 16 columns of calculated data, giving the essential highlights (just the ending balance for each balance sheet account, for instance).

3) Journal Entries: You may prefer to see each transaction a lease generates in journal entry form (each rent payment is a debit to obligation, a debit to accrued interest, and a credit to cash; etc.). Each line shows the lease number, period start and end date, account name, account number (if defined), debit or credit, and a description of the transaction so you know which lines go together and what they're for.

4) Amortization Schedule - Capital & Operating: You can view the activity for the entire life of a lease, with a separate line entry for each rent payment. Note that this report can get very large if you have many long leases; if you have several hundred leases that run 20 years or more paid monthly, you could exceed the maximum number of rows (65536) in versions of Excel before Office 2007. If that happens, you'll need to select subgroups of leases to report on (or upgrade Excel; the 2007 version permits over 1 million rows).

5) Future Minimum Rents: This report is identical to the second tab of the Income Statement/Balance Sheet Detail report. It's provided in case you only need future rent information.

6) Depreciation Over Economic Life: If you have leases that have an ownership transfer or bargain purchase option, they are depreciated over their economic life, which in most cases is longer than the lease term. Regular EZ13 reports stop reporting on a lease when it expires. This report shows the depreciation after the lease's expiration, until the end of its economic life.

7) Classification Summary: Lists how each lease fits into the four tests for capitalization; if the lease is capital, its capital rate is shown.

8) Listing: As mentioned above, this report is not available in spreadsheet format except as an export of a text report. The reason is that there is really no way to show all the input information for a lease across a single row: There can be an indeterminate number of rent steps, for instance, which can easily overwhelm the maximum number of columns in Excel.

I hope this helps you get the results most useful to you. Most accountants and financial people live in Excel, and it's also a common method of importing and exporting data (such as loading results of EZ13 into a general ledger system). Knowing the best way to get the spreadsheet information you want can make EZ13 much more useful.

EZ13 spreadsheet output

2009-05-04T15:05:00.001-04:00

With the review of the leases discussion paper complete (see previous blog entries for a chapter by chapter review), I thought I'd take some time to review some aspects of EZ13, our lease accounting software that provides complete compliance with FAS 13 for lessee leases (and FAS 13 compliance for most lessor leases as well, in the separate lessor edition).

Based on questions we've gotten from customers, it seems there's some confusion about the ways to get output, particularly spreadsheet output. EZ13 offers two different ways to get spreadsheet output, each having a different purpose.

1) Most people wanting spreadsheet output will want a format where each lease is on a single line, with the accounts and values for that lease each in a separate column. For this type of output, you should choose output to "Spreadsheet" in the report setup page:

As soon as you click on the Spreadsheet button, EZ13 will open a dialog box for the name of the spreadsheet. Most people will create an Excel spreadsheet (.xls format). However, this requires that you have a valid installation of Excel on your computer. If you do not, you can create spreadsheet output in XML format, which can be read by Excel, OpenOffice Calc, and various other spreadsheet applications. To select XML output, go to the File menu, choose System Options, and check the box labeled "XML spreadsheet output." (XML output is also a bit faster to create, and less subject to memory limitations with very large reports.)

Once you click on Generate Report, EZ13 will build the spreadsheet. The output for an Income Statement/Balance Sheet Detail report looks something like this:

Each row shows a different lease. There is a column for the lease number, description, begin date, end date, gross asset beginning value, and so on. The last row is a totals line, which is the summation of all the columns that have value information (as opposed to descriptive information).

2) The other way to get spreadsheet output is using the Export feature of the text output. Text output is designed to be easily readable, putting all the information for a lease together on several lines so that you don't have to constantly scroll back and forth across the line. However, that makes it much less practical to manipulate (sort, select, sum, etc.) in Excel. One advantage of this method of getting spreadsheet output, however, is that the report writer can create an Excel spreadsheet without you having Excel installed on your computer. Also, this is the only way to get a spreadsheet of the listing report, which lists all the input data for a lease.

If you create a text output version of this same report, then export it to Excel, it will look something like this:

This is basically a repeat of what you see on the screen for a text report. Note that sometimes the columns won't line up correctly; the report writer is trying its best to guess what should be aligned, but it doesn't always make the right decisions, and unfortunately there's no way for us to tweak the results. In most cases, an export to PDF, HTML, or a Word .doc document is going to give better looking results. But if you really prefer to get information in Excel format, it's here.

DP Review: Overall comments

2009-04-30T11:59:00.004-04:00

Please look at the last several blog entries for a chapter by chapter summary of the FASB/IASB joint Discussion Paper, Leases: Preliminary Views.

Change is coming. There is no question that both boards are adamant that leases need to be on the balance sheet. Operating leases will cease to exist for lessees once this standard takes effect, with only a possible exception for very short-term leases. The impact of this is expected to be substantial for many industries, particularly retail chains (including restaurants), airlines, property management firms, and others with large amounts of assets held under operating leases. We can also expect a substantial impact on lessors; one reason for leasing is off-balance-sheet financing, and with everything being on the balance sheet, one can expect that some leases will be less financial advantageous to the lessee, and so won’t get done, or at least not with the same terms.

When FAS 13 was first issued in 1976, it was the most complex standard the FASB had released (and probably more complex than standards released by its predecessors as well). The new standard is no doubt intended to be less complex, in keeping with the move to principles-based rather than rules-based accounting. But the wide variety of leasing transactions means some inherent complexity as the boards seek to develop a consistent methodology.

Another big change in the accounting is the requirement for continuous review and adjustment. FAS 13 was basically “set and forget”: the terms in effect at the inception of the lease controlled accounting for the entire lease term, unless there was an actual renegotiation. A renewal or termination option was not recognized until officially exercised. Contingent rents were expensed as incurred, with no implications on future rents (either the minimum rent disclosures or the asset & obligation of a capital lease).

With the new standard, the lessee would review all of these every reporting date (in the U.S., that generally means every quarter). Contingent rent is estimated from the very beginning of the lease, and as it changes, the rent obligation would be recalculated (though the boards can’t agree whether the balancing entry would be to asset or profit). Options to renew will be included based on factors outside the lease such as the loss of valuable leasehold improvements, relocation costs, and industry practice, not just the existence of a penalty or other factors in the lease itself, and this inclusion decision would again be reviewed quarterly, not just when the option exercise date arrives. (For U.S. lessees, the SEC Chief Accountant’s letter of Feb. 7, 2005, made leasehold improvements a reason to include renewal options, but this proposal’s wording is broader.)

This means that the calculations for capital leases are going to become more complex, particularly in handling midcourse adjustments, which are likely to become much more numerous. (Any retail store lease with a percentage of sales kicker will probably need to be adjusted every quarter to reflect actual sales; leases with CPI clauses will need adjustments at least once a year, and perhaps quarterly.) Since some changes in rents can result in a change to both the obligation and the asset, there is no certainty that the periodic depreciation charge will remain the same throughout the lease (since the asset being depreciated may change). Depending on how the boards resolve their disagreements, it’s possible that gains and losses will be recognized in the middle of the life of a lease when certain changes are recognized, rather than just at termination.

For all the work done, there is much left to accomplish. And one topic hasn’t even been discussed: transition to the new standard. How are existing leases to be recognized? Restate from inception? Grandfather? Set up as if a new lease on a specific day, or the first day of the fiscal year in which the standard takes effect? For capital leases which change, does the change hit profit or retained earnings, or is it part of the new lease’s carrying amount?

The boards welcome public input; that’s the purpose of a discussion paper. If you want to make a response, you are invited to contact either board (but not both; all comments will be shared between the two boards), by July 17, 2009.

FASB email: Send to director@fasb.org, File Reference #1680-100.
IASB online: Use their web form for comments.

Note that all comments will become part of the public record, available on the boards’ web sites.

FCS is committed to updating EZ13 to meet the new lease accounting standard once it is released. The current Standard Edition of EZ13 includes the ability to treat operating leases as capital at their incremental borrowing rate; we are adding the ability to use the incremental borrowing rate on capital leases in v2.3, which we expect to release next month.

DP Chapter 10: Lessor accounting

2009-04-29T12:58:00.003-04:00

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 10.

Summary:

The boards list some of the issues that need to be resolved to set up lessor accounting in a right-to-use model, as well as to properly handle subleases. Subleases must be addressed with the lessee standard, but the boards have yet to discuss the alternatives available, such as using existing sublease rules with the new lessee standard, keeping leases with subleases under the existing standards, or defining a new right-to-use methodology for subleases before doing so for lessor leases.

Detailed review:

Lessor leases

In July 2008, the boards decided that rewriting lessor accounting would slow their project too much, and that the more crucial need was for a revised lessee standard. Therefore, they decided to postpone making any changes to lessor accounting, so as not to delay further the lessee standard (which has already been delayed two years from the original schedule).

This chapter describes in general how a right-to-use model might apply to lessors. The first option would convert the original asset into two assets: a receivable (a financial asset) for the rents due, plus a residual value (non-financial) asset for the remainder of the asset’s value after the end of the lease. (Alternatively, the lessor might derecognize only the portion of the original asset that matches the receivable, leaving the remaining asset portion on the books.) No obligation would be recognized.

The second possible approach to lessor accounting would create a liability to recognize the lease (the performance obligation to provide the asset to the lessee), while leaving the original asset on the lessor’s books and creating a new asset for the receivable (equal to the obligation).

The boards would need to decide when, if ever, profit (or loss) could be recognized on the lease, particularly keeping in mind that many manufacturers lease equipment as a method of sales. For such transactions, recognizing profit on the “sale” would seem more appropriate, more consistent with similar transactions, than recognizing just interest income. (This is currently done with sales-type lessor leases under FAS 13.) On the other hand, if a bank is providing the financing on the lease, one would normally expect all the income to come through interest.

Subleases

After the decision to defer lessor accounting, the boards were reminded that subleases raise many of the same issues as lessor leases. Leaving sublease accounting alone while changing lessee accounting raises issues, because current sublease accounting uses a different methodology that results in different measurements and inconsistencies in treatment. At the least, the boards would probably offer additional guidance on how to apply the current standards to subleases in the new regime. They suggest that they could also require additional disclosures.

Alternatively, the boards could exclude a head lease from the scope of the new standard, so that a lease with a sublease would continue to be accounted for as under the current standard (FAS 13/IAS 17). However, this reduces comparability because leases with subleases would be accounted for differently than other leases. It leaves those leases out of the head lessee’s balance sheet, understating its assets and obligations. And no one knows what to do if a sublease is entered into after the start of the head lease.

A third option is to develop a lessor right-to-use model for subleases only. This would be more consistent through the whole series of transactions. But it would be inconsistent with the current lessor accounting model, which means that a lessor that buys some of its assets to lease out and leases others (resulting in some lessor leases and some subleases) would account for the transactions differently, some under FAS 13/IAS 17 and others under the new standard. And the boards would have to work through many of the issues of lessor accounting, even though they wanted to defer that.

The boards note the following additional issues which need to be dealt with for lessor accounting:

(a) investment property
(b) initial and subsequent measurement
(c) leases with options
(d) contingent rentals and residual value guarantees
(e) leveraged leases (for US GAAP)
(f) presentation
(g) disclosure

Investment property is the only issue discussed in detail; the others are simply named. Investment property is treated different by US GAAP (FASB standards) and IFRSs (IASB standards); international standards exclude investment property from IAS 17 lease accounting, instead using IAS 40, Investment Property, which among other things includes an option for carrying the property at fair value rather than cost. It remains to be decided whether investment property would continue to be excluded from lease accounting, or otherwise treated differently from other lessor leases. (US GAAP does not differentiate investment property and accounts for it under FAS 13 as any other lease.)

DP Chapter 9: Other lessee issues

2009-04-28T09:18:00.003-04:00

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 9.

Summary:

The boards have not yet discussed, but plan to make decisions on, the following topics:

• Timing of initial recognition
• Sale and leaseback transactions
• Initial direct costs
• Leases that include service arrangements
• Disclosure

Detailed review:

This is only one of a large number of accounting standards projects that are taking place simultaneously (the FASB project web page lists at least 37 different projects currently underway), and so even though the boards started this project in July 2006, they have not had enough time to discuss everything that will need to be resolved to produce a new standard. The following are issues that they recognize they need to work on:

Timing of initial recognition

There is often a gap of time between when a lease is signed and when it starts (the lessee takes possession of the asset and starts paying rent). Currently, a capital lease doesn’t hit the balance sheet until the lease starts. However, it could be argued that signing a lease results in rights and obligations that meet the standard definition of assets and liabilities. In rebuttal, some argue that before delivery, the lease agreement is an executory contract, which is not normally recognized on the balance sheet.

Therefore, the boards much decide if the assets and liabilities should be recognized at signing. If recognition is required, an appropriate measurement of value is needed, as it may not be the same as the asset/liability at the start of the lease. In addition, if construction is required during the period between signing and occupancy, there may be additional measurement issues, as rent may be subject to adjustment for construction costs, and so the exact amount is not known at signing.

Sale and leaseback transactions

A popular recent method of financing has been a sale/leaseback transaction, wherein an owner of an asset (most often real estate) sells the asset and leases it back. In some cases, FAS 98 prohibits the transaction from being recognized as a sale and a lease; instead, it must be treated as a deposit or financing, with the asset remaining on the books of the original owner and no lease shown. The continuing involvement can result in valuations that aren’t consistent with market values (there might be a below-market sales price in exchange for a below-market rent, for instance).

The boards will consider several options for sale/leaseback transactions:

Treating all sale/leasebacks as financings—the sale and lease would be ignored, and sales proceeds would be treated as a liability, repaid by the “lease” payments like any other loan. If this option is chosen, the boards need to decide if there are circumstances under which a gain or loss could result from the sale.
Treating all sale/leasebacks as sales—the asset would be sold and taken off the balance sheet, and a regular lease recognized with asset and obligation. If this option is chosen, the boards need to decide in what, if any, situations a gain on the sale would be deferred.
A hybrid approach, treating some transactions as financings and others as sales, depending on whether the transaction meets certain criteria (perhaps using those in current standards). This, of course, raises the potential for structuring.

Initial direct costs

IAS 17 currently calls for costs incurred in negotiating & arranging a lease (such as commissions, legal fees, and internal costs) to be added to the asset value of a capital lease and amortized over its life. FAS 13 has no such requirement; such costs are immediately expensed. IAS 17 is consistent with the treatment of costs associated with purchasing assets; FAS 13 is consistent with the treatment of costs in business combinations and for the acquisition of some financial instruments. The boards must decide which direction to take.

Leases that include service arrangements

Currently, costs for services associated with leases are considered executory costs, which are excluded from capitalization. Some leases clearly define the costs that are for services vs. the rent for the asset. Others, however, do not; with all leases capitalized, it becomes more important to properly separate service costs from asset costs. The boards will consider providing additional guidance.

Disclosure

The boards have not discussed disclosures; the primary current disclosure is the footnote report of future minimum lease payments. The boards will consider whether disclosures should provide additional information regarding the presence of options and contingencies.

DP Chapter 8: Presentation

2009-04-27T10:20:00.006-04:00

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 8.

Summary:

Lease obligations should be reported as a financial liability; the boards disagree on whether they should be reported separately from other financial liabilities.
Lease assets should be reported according to the nature of the underlying asset (leases on vehicles with owned vehicles, etc.).
Leases of property, plant, and equipment generate “depreciation” while those of intangible assets generate “amortization.”
Interest expense would be separated from other interest if obligations are separated.
For cash flows presentation, the lessee must classify the lease asset as operating or investing; the obligation and interest could be classified operating, investing, or financing.

Detailed review:

Once again, the boards have gone in slightly different directions. While they agree that the obligation and asset for a lease should be reported on the lessee’s balance sheet, they differ on how for the obligation. The IASB sees no need to separate lease obligations from other obligations; the FASB does, in part because they consider the uncertain nature of obligations related to options to change the quality of the value. For the assets, the boards agree that they should be reported according to the nature of the underlying asset, rather than grouped together as leases, though they do want to see leased assets separated from owned assets of the same type as a subledger entry.

The boards rejected options to present some or all leased assets as an intangible asset. Some FASB members want to do that for leases that are not “in substance purchases” (a concept first raised in chapter 5, but one that has not been defined by those members or the board; at the least, it would seem to include leases with an ownership transfer or bargain purchase option, but whether it covers other leases is unclear).

On the income statement, leases for property, plant, and equipment should show depreciation, while the term used for intangible assets is amortization. Interest expense would be shown separately from other interest if (as the FASB prefers) lease obligations are separated from other obligations.

The cash flows presentation is tied to the boards’ separate discussion paper, Preliminary Views on Financial Statement Presentation; the boards have not discussed it specifically as part of the lease accounting review. According to those preliminary views (which will presumably be finalized prior to finalization of the lease accounting standard), a leased asset is considered a business asset, and the lessee must decide whether to classify it as an operating or an investing asset based on the nature of the asset and its use. The obligation and interest could be classified by the lessee as an operating, investing, or financing liability.

Again, the boards will need to come to a common agreement where they differ. How they decide will depend in part on the responses they receive from the public to this discussion paper.

DP Chapter 7: Contingent rentals and residual value guarantees

2009-04-24T11:09:00.002-04:00

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 7.

Summary:

Contingent rentals and residual guarantees would be treated the same: The expected cost is estimated and included in the asset and obligation. Estimates are reassessed each reporting period, with the change applied to the obligation. The boards disagree on how to calculate the reassessment, and whether the asset should be changed or the change should be booked immediately to profit/loss.

Detailed review:

Contingent rentals

Once again, we have a significant departure from the existing standards for capital leases. In FAS 13 and IAS 17, contingent rentals (rent that changes due to factors occurring after the inception of the lease, such as percentage rents, rebilled costs for taxes and maintenance, inflation adjustments, etc.) have no effect on the minimum lease payments or the asset and obligation. They are simply expensed as incurred. (See my March 19 blog entry for more information on the current rules on contingent rentals.)

In the new standard, the boards have concluded that contingent rentals should be included in the calculation of the asset and obligation. However, the boards differ in their approach.

The IASB prefers a probability-weighted calculation: The lessee determines the likelihood of a number of possible outcomes, the rents due under each outcome, and then the probability-weighted total. The example given is of a store with a 1% of sales kicker. The lessee considers a 10% probability of 10,000 in sales; 60% probability of 20,000 in sales; 30% probability of 35,000 in sales. The probability-weighted calculation of contingent rentals is 10% * 100 + 60% * 200 + 30% * 350 = 235.

The FASB prefers a most-likely-rental approach. With the same example, 20,000 is most likely, so the expected contingent rentals are 200.

Each approach has advantages and disadvantages:

Probability weighting, when combined with reassessment, provides a more current view of the lessee’s obligations. It provides a reflection of various possibilities that may be realistic even if not the most likely. And it is consistent with measurement of some other uncertain liabilities, such as in IAS 37. But it is more complex, and could therefore be more costly to determine. It may be difficult to accurately determine probabilities. And it could result in a value that cannot actually happen (there might be two discrete possible outcomes, and probability weighting would give a result in the middle).
Most likely rental is simpler, and will never provide an impossible value. But it doesn’t reflect the uncertainty of possible outcomes, so there is no difference shown between a fixed and contingent rent of the same amount.

The FASB also believes that if contingent rents are based on an index or rate, the initial estimate for the life of the lease should be based on the index or rate in effect at inception, with changes due to subsequent changes in the index recognized in profit or loss.

The boards agreed that contingent rents, like other aspects of the lease, should be remeasured at each reporting date.

However, they again disagreed on how changes due to remeasurement should be reported. Both agree that the change in rents should be reflected in the obligation. However, The IASB wants to treat changes in contingent rentals the same as changes in other rents, with a change to the carrying amount of the asset. The FASB wants to recognize the change in obligation as a profit or loss.

Residual guarantees

Here’s a rare instance where the accounting under the new standard would be less rigorous than under the existing standard. Currently, when a residual value guarantee exists on a lease (a requirement that if the value of the asset at the end of the lease, such as when sold at auction by the lessor, is less than a stipulated amount, the lessee must make up the difference), the entire amount of the guarantee must be included in the minimum lease payments, even if there is virtually no possibility that the entire amount would be paid.

Under the new standard, a residual guarantee would be treated exactly the same as contingent rentals. That means, though, that there is disagreement about how to treat it: IASB wants a probability-weighted calculation, while FASB wants the most likely outcome. Similarly, a reassessment after the start of the lease which causes the obligation to change would, according to the IASB’s preference, result in a change to the asset carrying amount, while the FASB would see it reflected in profit or loss.

DP Chapter 6: Leases With Options

2009-04-23T10:18:00.003-04:00

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 6.

Summary:

The lease term should be the “most likely” term, including options to renew, cancel, or purchase.
Likelihood should be judged including contractual, non-contractual, and business factors, but not lessee-specific factors like intention and past practice.
Lease term is reassessed at each reporting date, with any change recognized as an adjustment to the carrying amount of the asset and obligation.

Detailed review:

We’re now moving into areas where even existing capital leases are going to be face alterations in the new standard. Under FAS 13 (with IAS 17 being similar), an option to renew is recognized as part of the lease term in most cases only if there is a financial incentive or penalty that causes renewal to be “reasonably assured.” If the renewal was more or less at market rate, in general it was never included in the original lease term, even if the lessee was virtually certain to renew, until actual contractual notice of renewal had been served.

Not under the new standard. While some board members favor keeping this methodology, theirs is a minority view. The majority of both boards has determined that the lessee is to determine the probability of renewal; each possible term would be considered, and the one that management concludes has the greatest probability (even if under 50%) is the term to use.

The boards rejected three other approaches:

Probability-weighted life: In this approach, if a lessee has a 10-year lease with a 5-year option to renew, and considers that there is an 80% chance of renewal, the lease would be set up with a life of 14 years. This, of course, results in a pro-forma term that can never actually happen.
Probability threshold: Each option would be considered based on a threshold (virtually certain, reasonably certain, probable, or more likely than not—one of these would have to be chosen). However, the boards feared that this would result in a bright-line, arbitrary rule, when the goal is to switch to principle-based rather than rule-based standards.
Qualitative assessment: No guidance would be provided; preparers would use their judgment on the basis of “reasonable and supportable” assumptions. But the boards feared that this could be too wide-open, and that constituents would almost inevitably ask for guidance anyway.

It was noted that the most likely lease term doesn’t distinguish between leases with and without options in the middle of the calculated term. This, however, is addressed by requiring reassessment of the lease term at each reporting date on the basis of any new facts or circumstances. If the term changes based on this reassessment, the change in rents due is recognized by adjusting the remaining asset and obligation by the present value of the rents involved. This is another change from the current standard, which alters the lease term only when a contractual exercise of an option is completed.

The boards discussed what could be appropriate factors to consider in determining which options (to extend or terminate) are likely to be exercised. They grouped the factors into four categories:

Contractual factors (explicit terms of the lease): bargain rents, residual guarantees, penalties, costs for returning the leased asset
Non-contractual financial factors: existence of valuable leasehold improvements, relocation costs, lost production costs, tax consequences, replacement costs
Business factors: nature of the asset (core/non-core, specialized, potential competitor’s use), location, industry practice
Lessee specific factors: lessee intentions, past practice

The boards considered not providing any guidance on these considerations, but concluded they should, and decided the first three categories of factors are appropriate to consider, while lessee specific factors should not be part of the determination of the lease term.

Purchase options are to be considered using the same methodology: most likely outcome, reassessed at each reporting date, any change reflected in the carrying amount of the asset and obligation (including the exercise price of the option in the rent stream if the option is going to be exercised). If the purchase option is included in the lease term, the right to use asset is amortized over the useful life of the underlying asset.

DP Review: Subsequent measurement

2009-04-22T15:32:00.002-04:00

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today's installment covers chapter 5.

Summary:

Assets and obligations are to be measured during the life of the lease using an amortized-cost approach.
Assets and obligations are measured separately, so that during the life of the lease, the net asset typically will not equal the remaining obligation (just as is the case with current capital leases).
If the cash flows change, the present value of the additional rent is added to the remaining asset and obligation.
Board disagreement: The FASB wants to keep the interest rate as the initial incremental borrowing rate during the entire life of the lease. The IASB wants to update the rate to the current market rate during the lease’s life.

Detailed review:

The boards first dispense with one possible approach, a “linked” approach that causes the asset and obligation to be reduced by the same amount each period. Using this method, the depreciation expense would be equal to the obligation reduction; since the interest is equal to rent minus obligation, the result is that the expense recognized each period is identical to the rent paid.

The problems, in the boards’ view, are that

This approach is being promoted in conjunction with the idea of maintaining a distinction between leases that are currently classified as “capital” and “operating.” The proponents would apply this method only to currently operating leases. Current capital leases would be treated as purchases, with depreciation and interest calculated the way they are now. This means that similar leases (those just above and just below the threshold dividing capital and operating leases, whatever that threshold may be) would be accounted for quite differently, which is one of the problems this revision is intended to resolve.
This approach results in different accounting than that used for other financial liabilities, which again reduces comparability.
The asset and liability for a lease during its term are not always linked, since impairment and other changes in the asset value are independent of the rental obligation.

Because of these problems, the boards rejected this approach, choosing instead a “non-linked” approach to measuring assets and obligations (i.e., they are calculated independently of each other).

Obligation measurement

The boards also rejected using a fair value method of measuring the ongoing obligation to pay rentals, considering it inconsistent with other financial liabilities, inconsistent with the initial measurement of the lease based on cost, and burdensome in cost and complexity to comply with.

Instead, the obligation to pay rentals is to be valued based on the discounted present value of the rents. However, the interest rate to use is a point of disagreement between the boards. The FASB wants to use the incremental borrowing rate from the inception of the lease. The IASB, however, believes the rate should be the current incremental borrowing rate. The FASB rejected that for essentially the same reasons as they rejected fair value measurement, while the IASB believes that using market rates is consistent with IAS 37 and provides more relevant information to users of financial statements. However, the IASB did not decide whether remeasurement should happen at each reporting date or only when there is a change future cash flows (i.e., a change in rent due).

If the future rents change (such as due to the exercise of a renewal), the boards discussed how the change should be recognized. Rather than keeping the remaining or initial obligation amount the same and calculating a new interest rate needed to make the present value of the rents match that (which could result in very high interest rates), they concluded that the additional rent should be added to the obligation by present valuing it using the incremental borrowing rate (the FASB recommending the original incremental rate, with the IASB recommending the current rate).

Asset measurement

As with obligations, the boards rejected a fair value approach to valuing the asset, for basically the same reasons. Therefore, they decided that assets should be amortized over the shorter of the lease term or the economic life; if title to the asset is expected to transfer at the end of the lease, then the economic life should be the amortization term. This is basically the same as the current standard for capital leases.

Some FASB members want to call the reduction in asset value “rent expense” rather than “depreciation” or “amortization,” at least for some leases, but this option is not fully worked out, and clearly reflects a minority opinion (which apparently none of the IASB is interested in).

The asset should also be reviewed for impairment, but the boards haven’t yet considered how that will be done.

There is no reference here to how (or if) the asset should be changed if the future rents change. In the next chapter, they state that the asset should be adjusted the same way the obligation is.

Initial measurement of leases

2009-04-16T12:40:00.006-04:00

Continuing with the review of the boards' Discussion Paper on lease accounting. Today's installment covers chapter 4.

Summary:

A lease is to be valued at the present value of the rents due, using the lessee's incremental borrowing rate as the interest rate. The asset and obligation start with the same value. There is no limitation to the asset's fair market value (unlike the current standards).

Detailed review:

Conceptually, the boards wish to determine the initial asset and obligation of the lease by determining its fair value. The boards decided that the fair value of the obligation to pay rentals is not always obvious, and therefore decided to use a discounted cash flow methodology for measurement. This is the same type of methodology used currently for capital leases, and similar to some other financial instruments.

Calculating a discounted cash flow requires deciding on an interest rate to use. The boards considered two possible rates to use:

The interest rate implicit in the lease (the discount rate needed to make the present value of the rents plus the unguaranteed residual equal to the fair value of the leased asset plus the lessor’s initial direct costs)
The lessee’s incremental borrowing rate (the interest rate the lessee would pay on a similar lease or to borrow a similar amount of money over a similar term to purchase the asset)

For both rates, the definition used is that of IAS 17, not FAS 13, which is slightly different (most notably, FAS 13 doesn’t refer to the lessor’s initial direct costs for the implicit rate).

The boards rejected the implicit rate because it is often difficult for lessees to determine (they may not know the residual value or the initial direct costs); it was particularly noted that for many leases currently considered operating, the unguaranteed residual can be a large percentage of the total value, and thus mistakes in valuation could significantly affect the calculation.

The boards decided to use the present value of the rents, at the incremental borrowing rate, as the value of both the asset and the obligation at the inception of the lease. They rejected a separate calculation of the fair value of the right-to-use asset, considering “measurement at cost” for the asset to be consistent with the initial measurement of other non-financial assets and less costly to determine than a fair value measurement.

This means that the current capital lease requirement of limiting the gross asset value to not more than the fair market value of the asset will be eliminated.

Those who disagree with the boards’ conclusions are asked to offer their recommended alternative and reason for the switch.

EZ13 has an option to report operating leases capitalized using their incremental borrowing rate, as contemplated by the discussion paper, so you can see today how this change would affect your reporting.

Lease Accounting: The New Approach

2009-04-06T15:47:00.002-04:00

Continuing with the review of the boards' Discussion Paper on lease accounting:

The basic reason for the revision of lease accounting is that the boards have concluded that current accounting “fails to represent faithfully the economics of many lease contracts,” which they believe entail rights (to use property) and obligations (to pay rent) that are not recognized on the balance sheet with a current operating lease.

The boards started their analysis with a simple 5 year lease, non-cancellable, no renewal options, no purchase option, and no residual value guarantees. Based on both boards’ conceptual understanding of assets and liabilities, they conclude that the right to use the machine qualifies as an asset, and that the obligation to pay rentals is a liability. The obligation to return the property, they conclude, should not be treated as a liability (while the lessee has possession of the property, it has no right to the property once the lease term is up, and is then essentially a custodian until the property is returned).

Therefore, the boards conclude that leases should be recognized as a right-to-use asset with a matching liability for rents. This new approach, they conclude, will meet many of the criticisms of the current standard, by putting all leases on the balance sheet, improving comparability between companies and transactions, reducing the opportunities to structure transactions as “unrecognised financing,” and being more consistent with the boards’ conceptual frameworks and recent standards in other areas.

Many leases are more complex, and the boards considered options to renew, to terminate early, to purchase the asset, to pay variable or contingent rentals, and to make residual value guarantees. They considered recognizing these components separately, but decided that the problems outweighed any possible benefits, and that a single asset and obligation, encompassing all rights and obligations, should be recognized.

The boards rejected three other approaches:

“Whole asset:” The premise is that during the lease term the entire asset is under the control of the lessee, who should thus recognize the full economic value of the asset on the balance sheet, for both the term of the lease and the remaining value at lease’s end. However, the boards consider that the economic position of a lessee is quite different from a purchaser; it overstates assets and liabilities, because it considers as an asset or liability the value of the property after the end of the lease, which is not available to the lessee; and it raises definitional issues, since very short-term leases would seem inappropriate to treat this way, and defining what should and shouldn’t be included returns to the discredited capital/operating distinction.

“Executory contract:” This method would treat all leases more or less like current operating leases. The boards rejected this because they are convinced that leases do give rise to assets and obligations.

“Existing standard:” The boards consider the current approach unsuitable because 1) operating leases, which in their view do actually give rise to assets and obligations, currently are accounted for without balance sheet effect; 2) similar transactions (those just above and just below the line separating capital and operating leases) are accounted for very differently, reducing comparability and increasing structuring opportunities; and 3) They find it difficult to define a good dividing line between capital and operating leases.

Respondents are asked whether they agree with the boards’ conclusions, and if not, what analysis of leases and components they would prefer and why.

Scope of new standard

2009-04-01T11:54:00.002-04:00

This is the first in a series of blog postings I’ll make regarding the lease accounting revision discussion paper released by the FASB and IASB on March 19. I’ll go basically chapter by chapter through the DP reviewing the issues. (FWIW, I'm looking at the FASB's edition of the DP.)

The first question that needs to be asked in the new lease accounting standard is: What transactions does it cover? There is a difference in scope between FAS 13 and IAS 17, the current standards of the FASB and IASB, respectively. FAS 13 applies to arrangements that convey a right to use property, plant, and equipment, while IAS 17 more expansively applies to rights to use an asset, including intangible assets.

Some people have suggested rebuilding the definition of a lease from the ground up. The boards have tentatively decided not to, and to base the scope on the existing standards’ scope.

The DP notes that some people would like the standard to exclude “non-core assets” and “short-term leases.” However, each of these suggestions raises serious problems. The first is again, how to define each term. What one company thinks of as non-core, another similar company may consider core, thus reducing comparability (which is one of the key reasons for the new standard). And “non-core assets” may still amount to significant assets and liabilities, which are relevant for review of financial statements no matter what their use. “Short-term leases” are typically defined as those of less than a year in length, but the boards are concerned that large numbers of short-term leases could still total up to material amounts. And the experience of the past 30 years suggests that a short-term safe harbor would result in lease structuring to evade reporting under the new regime. Both issues are still undecided, however, with not even a preliminary decision reached.

The DP notes that as with all standards, immaterial items can be excluded.

Respondents to the DP are asked whether they agree with the proposed scope. If they think non-core assets or short-term leases should be excluded, how should those be defined?

International Lease Finance in trouble

2009-03-26T15:21:00.005-04:00

The Wall Street Journal reports that the world's biggest lessor of airplanes, International Lease Finance Corp., says in a recent filing that its financing needs could threaten its survival. ILFC is a (profitable) part of AIG, and AIG's woes have been impairing its ability to borrow money to finance its purchases of planes, which it leases to many of the world's airlines. ILFC owns 955 planes worth $50 billion. It had been using commerical paper for a lot of its financing, but with the cut in credit ratings it has suffered as part of AIG, that market is now closed.

The article speculates that ILFC is too big to fail, as it's the largest customer for both Boeing and Airbus (not to mention the prime supplier of airplanes to numerous airlines). AIG is trying to sell ILFC to raise money to repay their borrowings from the feds.

Discussion paper released

2009-03-21T22:00:00.001-04:00

The same day (March 19) as my previous post, wondering when the discussion paper on the proposed new lease accounting standard would be released, it was actually released. It's available now from the FASB or IASB (the copies vary because of the differences between American English and British English, a reminder of George Bernard Shaw's witticism that we're two countries separated by a common language). Anyone is welcome to comment to the boards (they request that you pick one board or the other, not both, to comment to) by July 17, 2009. The FASB permits sending comments to director@fasb.org, File Reference No. 1680-100. The IASB has a web form for comments. All comments become part of the public record, available for viewing on the web. The boards also plan to have a live web presentation on the DP in May, with details to come.

The DP is over 100 pages; while the information is generally a restatement of the boards' decisions, it'll take me a day or two to look through the full text and post comments (not least because some big projects are on my plate right now). The FASB has also posted a press release about the DP. Predictably, not everyone is happy: the Equipment Leasing and Finance Association, the main US trade association for equipment lessors, issued a press release expressing concern about the complexity of the proposal and its potential to increase the cost of capital. In other words, they're afraid fewer people will lease equipment if they can't keep the transaction off the balance sheet. No doubt that's true, though I don't know how anyone can realistically estimate the magnitude of the effect.

WebCPA has an article on the DP.

Discussion Paper, when?

2009-03-19T15:31:00.003-04:00

The FASB has released the agenda for its joint meeting with the IASB next week. The agenda does not have an item for leases, so apparently the discussion paper won't be part of the meeting. Whether it will be released without further board involvement, or has been delayed, is unclear at this time. The FASB leases project page still says the DP will be released in Q1 2009, but the page hasn't been updated since the end of January.

Contingent rent, now and future

2009-03-19T14:46:00.005-04:00

One of the more confusing aspects of lease accounting is dealing with contingent rents. The FASB defines these as "The increases or decreases in lease payments that result from changes occurring subsequent to the inception of the lease in the factors (other than the passage of time) on which lease payments are based..." [FAS 29, para. 11] Typical causes for contingent rents are inflation adjustments, percentage of sales, a rental amount based on a floating interest rate (like LIBOR), property taxes, and maintenance fees.

Under FAS 13, contingent rents are handled in one of two ways. Both are based on the overall concept of making a one-time estimate at the beginning of the lease, and expensing the difference between the estimate and the actual payment when the payment is made.

1) If the amount to be paid is based on usage, such as a percentage of sales or machine hours of use, the up-front estimate is zero. All payments based on usage are considered contingent rent, and fall outside of the "minimum lease payments" for the lease (since if you end up not using the asset, your minimum charge is 0); they are expensed as incurred.

2) If the amount to be paid is based on a rate or index, such as LIBOR or the consumer price index, the minimum lease payments are calculated as if the rate or index will be the same over the entire life of the lease. This calculation is not changed over the entire life of the lease (unless the agreement is renegotiated). The difference between the estimate and the actual payment is expensed as incurred; note that this difference could be positive or negative.

One question that often comes up is whether to treat the CPI as a rate or as an index. Officially, CPI is an index, showing the value of a basket of goods and services. The overall value was normed to 100 in 1967; the percentage increase that is broadcast on the news is the change in that index. While some companies take the position that they should assume the current rate of increase in calculating their minimum lease payments, a strict reading of FAS 13 seems to indicate that instead one should assume that the index will not change, i.e., there will be no inflation (or deflation), and future inflation adjustments will be treated entirely as contingent rent.

Of course, if the increases in rent are specified in advance, they must be considered part of the minimum lease payments, even if they're supposedly intended to cover inflation. The key is whether the rent amount is known at inception, or dependent on future events.

The current version of EZ13, v2.2, does not track contingent rents at all, because they're not part of the minimum lease payments. However, we are currently working on a new release which will include the ability to record and report contingent rents; that will be released later this year.

The FASB/IASB revision plans to change this. According to the boards' current thinking, lessees will need to estimate their rents for all types of contingent rent. Unfortunately, the two boards have differing opinions on how to estimate: The FASB wants to use a "best estimate" approach, while the IASB wants a probability-weighted expected outcome approach. Both want lessees to remeasure their leases at each reporting date (normally every fiscal quarter), with the obligation changed by the change in present value of the remaining rents. They disagree about how to balance the change transaction: for changes caused by contingent rents, the FASB wants an immediate recognition of profit or loss, with no change to the carrying value of the asset, while the IASB wants to add or subtract the change to both the obligation and the asset. The depreciation on the asset would then be altered to depreciate the remaining asset over the remaining life.

Since the boards intend to release a united standard, some negotiation between the boards will be necessary to resolve this. Further, it remains to be seen how companies and users of financial statements will respond to this idea; clearly this is a potentially large increase in the complexity of accounting for leases, with the possibility that valuations would change every quarter with corresponding changes in interest and depreciation, along with the change in the actual rent.

What's the impact?

2009-03-13T17:40:00.006-04:00

The chairman of the IASB, Sir David Tweedie, has said as a half-joking example of the need for lease accounting reform that it's his life's ambition to fly on an airplane that's shown on the books of the airline flying him. This slightly overstates the situation (for instance, United Airlines' annual report shows capital as well as operating leases, as well as some owned aircraft), but it is true that corporations have made huge commitments through operating leases that currently have no impact on the balance sheet (aside from the possible impact of leveling scheduled rent increases) and are only reported as a footnote to the financial statements. (United's operating lease commitments are nearly 3 times its capital leases, and include the majority of its aircraft.) The SEC recently estimated that the total value of future rent commitments in the U.S. is $1.25 trillion (yes, that's with a T).

In mid-2007, the Georgia Tech College of Management's Financial Analysis Lab did a study looking at the impact of forcing operating leases to be capitalized on a number of presumably representative retail store chains. Chain stores are one of the industry groups likely to be most affected by forcing all leases to be capitalized, as the FASB & IASB intend. While the Lab didn't have complete information available to calculate precise results, their estimates were stunning: while the impact would be modest for many stores, they estimated that BJ's Wholesale could face an 80% drop in reported earnings per share. (The median impact was a much more modest 5.3% drop, still significant, and likely to be larger in the current difficult retail environment.) The effect on stores' leverage was even more significant: the median increase in the liabilities to equity ratio was 26%, and several companies would see that ratio more than double.

What would be the impact on loan covenants? We don't know. It might be minimal, as some banks already require their borrowers to treat operating leases as capital for covenant calculations. Yet there are probably other lenders who haven't taken that careful a view of operating leases; if a borrower suddenly doubles its reported debt load, they could easily find themselves either in default or facing penalty interest rate hikes.

The FASB/IASB haven't said how they plan to transition to the new regime of capitalizing leases that are currently operating. The most likely scenario would seem to be booking the remaining rent commitments at the effective date of the new regulation, rather than restating from inception. Some people are holding out hope that existing leases would be grandfathered, but that doesn't seem to mesh with the boards' stated intention of recognizing the "economic reality" that leases convey a benefit and obligation.

FCS has been providing indenture reporting capabilities for our clients for years, calculating operating leases as capital at either a single rate or a series of rates based on our customer's cost of debt at different terms. EZ13 allows users to use either the incremental borrowing rate or a fixed interest rate to capitalize operating leases, without changing the lease record (so that regular and indenture reports can be run without changes).

Discussion Paper coming

2009-03-13T17:10:00.005-04:00

The FASB and IASB have been discussing the revision of the lease accounting regulations for over 2-1/2 years (first announced in July 2006). Finally, they have reached the point of releasing a Discussion Paper, which details the decisions they have made to this point and asks for public comment. The boards have a joint meeting scheduled for March 23 & 24 in London; we expect that the DP will be approved at that meeting. The FASB project page indicates that the deadline for public comments will be some time during Q2 2009.

Getting started

2009-03-13T16:24:00.006-04:00

Welcome to the lease accounting blog! This is offered by Financial Computer Systems, Inc., which for over 30 years has specialized in providing lease accounting software to corporations throughout the United States and Canada.

Lease accounting is in the midst of a major overhaul, as the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) agreed jointly in 2006 to begin a comprehensive review of the regulations for lease accounting (FAS 13 and IAS 17, respectively), with the goal of developing a joint revised standard. Rising unhappiness with the level of off-balance-sheet financing through leasing has been the major driver of this decision, and the boards have agreed to essentially eliminate what are currently known as operating leases, which have no impact on the balance sheet.

Later this month, a discussion paper presenting the boards' intentions will be released for public comment. I'm going to take time both now and in coming days to look at what has been decided so far, what is still undecided, and what the implications are for lessees (and to a certain extent for lessors, including sublessors).

Financial Computer Systems markets both software and services to provide complete lessee accounting for both capital and operating leases. We have been specialists in FAS-13 compliance ever since FAS-13 was issued in 1976 (we actually developed our first version of software in 1975 to meet the predecessor regulation, ASR-147). We'll talk more about how our EZ13 software can help with lease accounting on this blog as well.