LWG favors level expense

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

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.

FASB review of comment letters

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.

Upcoming Leases Working Group meeting

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.