The FASB & IASB met again in mid-April for multiple meetings regarding the new lease accounting standard (originally supposed to be a joint meeting in London, the Icelandic volcano forced it to be a videoconference). Lessee topics included sale/leaseback transactions and rent presentation; subleasing was also discussed. Topics for lessors included: performance obligation amortization, impairment, purchase options, and disclosure requirements. Long-term leases of land affect both lessees and lessors.
Sale and leaseback transactions
Under current US GAAP, a sale and leaseback is recognized as such only if it meets criteria specified in FAS 98, which particularly prohibit “continuing involvement” by the seller-lessee in the property other than the leaseback itself. If there is continuing involvement, such as a fixed-price purchase option, nonrecourse financing, or a guaranteed residual, sale/leaseback accounting is prohibited and the transaction must be accounted for as a financing, with the asset remaining on the “seller’s” books.
The boards have decided to tie the definition of a qualifying transaction to their previous decision to account for a lease as a sale of the underlying asset. The relevant definition is “if at the end of the contract control of the underlying asset has been transferred and all but a trivial amount of the risks and benefits associated with the underlying asset have been transferred.” The interesting thing about use of this definition is that in this case, it’s being used to define the sale portion of the transaction, not the lease portion. The impact of the decision should be minimal; that is, generally transactions will get the same treatment (as far as whether they’re treated as sale/leaseback or as financing) under the new standard as the old, but it makes sense to use more consistent definitions within the new standard.
Lessee presentation of total cash rentals paid
Currently, cash rent paid under operating leases is a line item in the income statement; it is not, however, an income statement for capital leases (since the expenses recognized are interest and depreciation). The new standard includes a disclosure with a reconciliation of obligation to pay rentals, along with reporting interest and obligation repayments (separately) in the statement of cash flows; no separate presentation of total rent paid is to be included.
Subleases
As one might expect, a sublease is treated like a lessor lease by the intermediate party. Assets and liabilities for subleases will be reported gross with a net subtotal, separate from the assets and liabilities related to the head lease (the original lease of the asset that is being subleased).
Long-term leases of land
There had been some discussion of possibly treating long-term leases of land as sales (in some countries, land leases of 99 or even 999 years are common due to cultural or legal barriers to actual transfer of land ownership). The boards decided not to go that route; long-term land leases will be treated like any other lease within the new standard.
Lessor performance obligation amortization
Amortization should be in a systematic and rational manner based on the pattern of use of the underlying asset. This could be passage of time, hours of use or items produced for equipment, etc.
The boards have not decided whether or how to permit revenue recognition at the start of a lease (similar to current sales-type lessor lease accounting), and asked the staff to further analyze the issue.
Lessor accounting for purchase options
Purchase options are to be accounted for the same way as renewal and termination options, using the “more likely than not” criterion for exercise.
Lessor accounting for impairment of assets
The receivable is to be reviewed first for impairment, with an adjustment to both the receivable and the performance obligation and any difference being recorded in profit or loss. The underlying asset is also subject to impairment review; the staffs are to further consider how to apply IFRS 36 and ASC Topic 360, each board’s impairment standard.
Lessor disclosures
Descriptive
The nature of the lease arrangement(s), if leasing is a significant part of the lessor’s business activities
Restrictions placed on leased assets by the leases
Existence and terms of any residual value guarantees
Under IFRS: Information on risks surrounding the receivable (cf. IFRS 7)
Under US GAAP: Information on credit quality, the uncertainty of future cash flows, and how the lessor manages those uncertainties
Notation if simplified short-term lease accounting is being used
Quantitative
Maturity analysis, by year for five years and future years as a lump sum, showing the minimum contractual receivables and total estimated receivable
Maturity analysis, by year for three years and future years as a lump sum, of the satisfaction of performance obligations
Reconciliation between opening and closing balances for the receivable and performance obligation, showing the transactions resulting in increases and decreases
If simplified short-term accounting is being used, the gross amount so recognized
The FASB meeting notes indicate that the boards now anticipate a release of the exposure draft in August 2010, rather than the previously planned June. Obviously there’s too much yet to be completed.
This week (May 18 & 19), the boards have scheduled over 7 hours of meeting time to discuss a lessor’s accounting for the performance obligation and the alternative approach of derecognition (i.e., rather than keeping the leased asset on the books and setting up a performance obligation, the lessor would reduce reported owned assets by the amount of the lease receivable).
Tuesday, May 18, 2010
Thursday, March 25, 2010
Revisiting lessor assets; presentation
A major change in proposed accounting under the new lease accounting standard hits the lessor balance sheet. Under FAS 13 and IAS 17, when a lessor has a capital lease, the underlying asset is removed from the books ("derecognized"), and is replaced with a receivable. For the new standard, the boards agreed (at June, July, and October meetings) to use a "performance obligation" concept; the original asset stays on the books unchanged, a receivable for the rents is set up, and the receivable is balanced by a performance obligation that is amortized over the life of the lease.
While this resolves the problem of a disappearing asset that the lessor still owns, it raises its own complications. One of the most serious is the impact on financial ratios; since a company normally has more assets than liabilities, putting an equal new asset and liability on the balance sheet erodes a company's financial ratio, resulting in the anomaly that a lessor looks like it's in worse financial shape when it successfully leases its assets (which in the real world is a healthy situation).
At the boards' March 23 meeting, they discussed dealing with this through net presentation, showing the performance obligation as a contra asset rather than a liability. However, during the discussion, the strong majority of the IASB expressed a preference to revisit the entire performance obligation concept and possibly jettison it for the old derecognition approach. (The FASB seemed more evenly split, and as this was a physical joint meeting in London, not all the FASB members were present.)
A major concern, however, is the timetable. The boards are trying very hard to keep to releasing an Exposure Draft by June 30, 2010, with a final standard by June 30, 2011. A number of board members felt it would be difficult or impossible to properly flesh out a derecognition model by June 30 to include in the Exposure Draft. One suggestion was to separate lessee and lessor accounting, releasing an Exposure Draft for lessee accounting on time with lessor accounting following a few months later, but before the expiration of the comment period for lessees so that people would have time to review both together and comment accordingly. (Side note: for the first time that I'm aware of, a board member commented on how long it might be until the new standard must be implemented, with a comment of "2, 3, or 4 years later." However, this was an off-the-cuff comment, so I have no idea how much weight to give it.) No decision was reached.
More generally, the March 23 meeting was focused on presentation.
Lessees:
While this resolves the problem of a disappearing asset that the lessor still owns, it raises its own complications. One of the most serious is the impact on financial ratios; since a company normally has more assets than liabilities, putting an equal new asset and liability on the balance sheet erodes a company's financial ratio, resulting in the anomaly that a lessor looks like it's in worse financial shape when it successfully leases its assets (which in the real world is a healthy situation).
At the boards' March 23 meeting, they discussed dealing with this through net presentation, showing the performance obligation as a contra asset rather than a liability. However, during the discussion, the strong majority of the IASB expressed a preference to revisit the entire performance obligation concept and possibly jettison it for the old derecognition approach. (The FASB seemed more evenly split, and as this was a physical joint meeting in London, not all the FASB members were present.)
A major concern, however, is the timetable. The boards are trying very hard to keep to releasing an Exposure Draft by June 30, 2010, with a final standard by June 30, 2011. A number of board members felt it would be difficult or impossible to properly flesh out a derecognition model by June 30 to include in the Exposure Draft. One suggestion was to separate lessee and lessor accounting, releasing an Exposure Draft for lessee accounting on time with lessor accounting following a few months later, but before the expiration of the comment period for lessees so that people would have time to review both together and comment accordingly. (Side note: for the first time that I'm aware of, a board member commented on how long it might be until the new standard must be implemented, with a comment of "2, 3, or 4 years later." However, this was an off-the-cuff comment, so I have no idea how much weight to give it.) No decision was reached.
More generally, the March 23 meeting was focused on presentation.
Lessees:
- Lease assets and obligations are to be reported separately from other assets and obligations in the statement of financial position (balance sheet).
- Lease amortization and interest expense can be separated from other amortization and interest expense either in the primary financials or in a footnote disclosure.
- Obligation and interest payments are to be listed separately in the statement of cash flows, in the financing activities section.
- The original leased asset, lease receivable, and performance obligation will be reported separately, then combined into a net lease asset or liability.
- Lease income and expense will be presented separately from other income and expense items. The FASB wants to combine these into a net lease income or expense; the IASB did not concur, which makes for a rare point of divergence in opinions. (Presumably a converged final standard will be reached after Exposure Draft comments are reviewed, as the boards have made a clear priority of having a converged standard.)
Tuesday, March 23, 2010
Service components/Executory costs; March 22 meeting
At the March 22 joint FASB/IASB board meeting (videoconference viewable here; background materials available here), the boards tackled leases that include a service component. This is what FAS 13 calls "executory costs"; the amounts are part of the future minimum rent commitments, but are excluded from capitalization, as they are considered a service contract that is simply expensed without a balance sheet impact. For operating leases, however, they were pretty unimportant to distinguish from other rent.
The boards agreed to keep the concept of separate service (executory) and lease components of the rent, with the service component not counted as part of the obligation/receivable but simply treated as an expense.
Both lessee and lessor need to evaluate whether the payments can be allocated in this way, in keeping with requirements of the Revenue Recognition project simultaneously underway. If the service component is not considered "distinct" from the lease component, they are not to be separated. Services would be considered distinct if, for example, they are available independently of the lessor, or the lessor sells them outside of leasing transactions.
If an entity is unable to determine an allocation between service and lease components, the entire rent is treated as lease. Since treating it as a service will generally be preferable financially, there's an incentive to get the numbers right.
If the total rents later change for a lease that has service and lease components, the entity should try to apportion the changes between the components. If unable to do so, they should divide the change in rents pro rata between the two components.
The new rules will apply immediately with the application of the new standard. For capital leases, it should be a non-issue; operating leases, however, will need to be analyzed to determine what portion should be considered service. (It's not clear whether the terminology is to be changed from "executory costs" to "service component.")
The boards agreed to keep the concept of separate service (executory) and lease components of the rent, with the service component not counted as part of the obligation/receivable but simply treated as an expense.
Both lessee and lessor need to evaluate whether the payments can be allocated in this way, in keeping with requirements of the Revenue Recognition project simultaneously underway. If the service component is not considered "distinct" from the lease component, they are not to be separated. Services would be considered distinct if, for example, they are available independently of the lessor, or the lessor sells them outside of leasing transactions.
If an entity is unable to determine an allocation between service and lease components, the entire rent is treated as lease. Since treating it as a service will generally be preferable financially, there's an incentive to get the numbers right.
If the total rents later change for a lease that has service and lease components, the entity should try to apportion the changes between the components. If unable to do so, they should divide the change in rents pro rata between the two components.
The new rules will apply immediately with the application of the new standard. For capital leases, it should be a non-issue; operating leases, however, will need to be analyzed to determine what portion should be considered service. (It's not clear whether the terminology is to be changed from "executory costs" to "service component.")
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.
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.
Friday, February 5, 2010
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.
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.
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.
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