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.
Showing posts with label Contingent rent. Show all posts
Showing posts with label Contingent rent. Show all posts
Thursday, April 21, 2011
Wednesday, February 23, 2011
They hear you
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.
Tuesday, February 23, 2010
Booking contingent rent changes and other Feb. 17/18 issues
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:
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.
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.
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.
Monday, February 1, 2010
Not your father's lease accounting
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.
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.
Saturday, January 23, 2010
Jan. 20 FASB/IASB meeting
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.
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.
Monday, January 18, 2010
Dec. 18 meeting recap
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.
Friday, April 24, 2009
DP Chapter 7: Contingent rentals and residual value guarantees
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:
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.
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 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.
Thursday, March 19, 2009
Contingent rent, now and future
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.
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.
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