Derecognition over performance obligation (sometimes)

The FASB & IASB, in meetings June 16 & 17, decided to partially pull back from the concept of a performance obligation for lessors in the new lease accounting standard. They have now decided to use that approach (where the original leased assets remains on the lessor's books untouched, and a matching receivable debit and performance obligation credit are set up for the lessor lease, with the receivable amortized using the interest method and the performance obligation amortized straight-line) only for leases "that expose the lessor to significant risks and benefits associated with the underlying asset." In other cases, a derecognition approach is to be used: Once the receivable is calculated for the lessor lease, the owned asset is credited for that amount. The IASB staff commented that this is similar to the current distinction between operating and capital leases (wasn't the goal of the new standard to get away from that?).

The vote was actually split between the boards, with the IASB in favor of this hybrid approach, while a majority of the FASB prefers performance obligations for all leases. However, the FASB Action Alert summary states that "the Boards" decided on the hybrid approach, which suggests that in the interests of convergence, either the IASB has priority or the vote is being tallied in total. I don't know enough about the workings of the convergence project to clarify that.

Other topics covered:

Lessor transition under a derecognition approach

The boards have decided that lessors should recognize a lease receivable at the present value of the remaining lease paymentss, and a residual asset at fair value. The present value is based on the implicit rate at lease inception, but it looks like that includes the residual asset at its current, not original, estimate of future value.

Leases with a service component, lessor derecognition

The boards were unable to come to a conclusion for how to account for leases that include a service component (what is called executory costs under the current leasing standards), when the services and leases are not distinct, for a lessor lease involving derecognition. This will be discussed further in July.

Purchase options

Purchase options are to be accounted for only upon exercise (aside from bargain purchase options, which immediately turn it into an in-substance purchase). This applies to both lessees and lessors.

Retirement of IASB members

Gilbert Gelard, Robert Garnett, and James Leisenring are retiring from the IASB as of June 30. Jim Leisenring has been a particularly forceful voice on the board. He's a former member of the FASB as well, and does not hesitate to make his views known. The impact of the change in personnel remains to be seen.

EZ13 v3.0 released!

FCS is delighted to announce the release of v3.0 of EZ13, our lease accounting software for lessees and lessors. EZ13 has always provided complete FAS-13-compliant accounting for both operating and capital leases. Some of the significant new features include:

* Notice dates: EZ13 can remind you that rents are changing, leases are expiring, or events that you've entered are coming up. You specify how many days before and after the event you want to be notified. When you've dealt with the matter, you can turn off display of that item without deleting the event.
* Multiple contingent rent types: You can now track up to 7 different types of contingent rent, each with their own account numbers for G/L entry. Two types are user-defined, so you can give them the meaning most relevant to your business.

* Purge leases: You may remove from a database leases that have terminated as of a date you specify. Optionally, these leases can be copied to another database.
* Copy leases to new database: You may copy any number of leases to a new database. This can be useful for testing changes to a lease without affecting your production database.

There are a number of other, less significant features, enhancing flexibility and usability. And of course, bug fixes.

More details about the full range of features EZ13 offers are available at http://www.ez13.com/ez13.htm.

You can download a trial of EZ13 v3.0, either lessee or lessor version, at http://www.ez13.com/download.htm. If you have any questions about how EZ13 can solve your lease accounting needs, please contact me by email or (203) 652-1375.

Performance obligation or derecognition—or both?

The FASB & IASB, at meetings May 18 & 19, revisited one of the fundamental decisions on lessor accounting made last year. As the staff’s agenda paper put it then, “What is the credit?” Setting up a capital lessor lease means setting up a receivable for the rent income stream. That’s a debit on the balance sheet. How should the balancing credit be characterized?

The boards considered two basic approaches. The first, which is the current methodology under FAS 13 and IAS 17, is derecognition: the owned asset is credited (reduced/eliminated). Under present accounting, the entire asset is derecognized, replaced by the receivable. Things get more complicated in the proposed new system, since many leases will be for only part of the value of the underlying asset. Crediting the asset would leave part of the owned asset on the books. More problematic is that multiple leases of a single asset could result in a sum total of receivables that is greater than the original asset value; how is that to be handled?

The solution the boards came up with was to create the concept of a performance obligation, representing the requirement to make the asset available to the lessee. This is a credit entry that is amortized over the life of the lease, based on passage of time or usage of the asset.

There have been rumblings for several months that several members of the boards are uncomfortable with the performance obligation methodology. Recent notes on lessor accounting have included explicit comment that decisions are “under the performance obligation approach.” At this week’s meetings, there was extensive discussion of going back to a derecognition approach, though this would be a “partial derecognition” approach. Described in detail in the agenda papers for the meetings, this means that the owned asset wouldn’t be completely taken off the books (unless the lease is for the entire useful life of the asset). A portion of the asset would be removed and replaced with the receivable.

The boards made decisions on how to account for various aspects of lessor activity under a partial derecognition approach, without committing to such an approach. You can read the full list of decisions in the FASB Action Alert. I’m not going to repeat all of it because it’s not clear if it will actually take effect, and I’d just be restating what they state there.

One significant implication of a partial derecognition approach is that a lessor could recognize a profit at the beginning of the lease (as is currently done with sales-type capital lessor accounting). The boards' prior decisions on lessor accounting with a performance obligation did not permit an up-front recognition of profit; instead, all income is to be recognized in the form of interest over the life of the lease. This has potentially a major impact on the reported profitability of manufacturers who lease their equipment. One can expect that they will lobby hard for a derecognition approach.

Conceptually, a derecognition approach seems to the staff to be more consistent with the lessee right-of-use approach. However, the unguaranteed residual value becomes much more significant in this approach, which can increase complexity.

The boards haven’t concluded which way to go, and significantly, there’s a difference of opinions between the boards. The FASB prefers to stick with the performance obligation methodology; the IASB prefers a hybrid model, using a performance obligation in some cases and derecognition in others. (The FASB Action Alert summary doesn't list the vote, but based on prior activity, I doubt it was unanimous with either board.) They’ve asked their staff to develop proposals to decide when to apply which model. But won’t that inevitably result in structuring opportunities, and similar transactions being accounted for differently? Eliminating that was supposed to be one of the big improvements of a new lease accounting standard. Will the two boards find a way to resolve the disagreement and keep a converged standard?

Stay tuned for more developments next month.

April meeting results

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).

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:

• 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.

Lessors:

• 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.)

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.")

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.