DP Chapter 8: Presentation

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

Summary:

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

Detailed review:

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

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

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

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

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

DP Chapter 7: Contingent rentals and residual value guarantees

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

Summary:

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

Detailed review:

Contingent rentals

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

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

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

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

Each approach has advantages and disadvantages:

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

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

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

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

Residual guarantees

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

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

DP Chapter 6: Leases With Options

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

Summary:

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

Detailed review:

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

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

The boards rejected three other approaches:

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

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

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

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

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

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

DP Review: Subsequent measurement

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

Summary:

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

Detailed review:

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

The problems, in the boards’ view, are that

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

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

Obligation measurement

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

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

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

Asset measurement

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

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

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

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

Initial measurement of leases

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

Summary:

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

Detailed review:

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

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

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

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

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

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

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

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

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

Lease Accounting: The New Approach

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

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

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

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

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

The boards rejected three other approaches:

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

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

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

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

Scope of new standard

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

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

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

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

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

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