What's a lease?

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

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

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

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

Not your father's lease accounting

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

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

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

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

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

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

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

Jan. 20 FASB/IASB meeting

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

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

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

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

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

A return to classification?

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

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

Dec. 18 meeting recap

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

Contingent rentals

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

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

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

Residual value guarantees

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

Scope

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

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

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

Results of joint FASB/IASB meeting, Nov. 18

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

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

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

FASB/IASB joint meeting

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

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

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