This month's boards meeting

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.
  

Boards get back to work, timeline slips further?

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.

Disclosures and more – March 17 boards meeting

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

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:

1. Contracts in which the title of the underlying asset transfers to the lessee automatically
2. Contracts that include a bargain purchase option, if it is reasonably certain that the options will be exercised
3. Contracts in which the return that the lessor receives is fixed
4. 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.

Additional decisions on lessee accounting

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