Revised Exposure Draft released

At long last, the Revised Exposure Draft (RED) for the proposed new lease accounting standard has been released by the IASB and FASB. A press release is available here; the actual RED is available from either the IASB or FASB.

The public comment period lasts until Sep. 13, 2013. Comments may be submitted here or by email to director@fasb.org; email submissions should include File Reference No. 2013-270. (You can also submit comments via the IASB web site if you're a registered user; it all goes into a single compilation.) There are 12 specific questions that the boards are asking for responses to. The FASB online response form is structured with boxes to respond to each question (plus a box for any other issues that someone may want to comment on).

The boards will have public webcasts to discuss the RED on May 20. The IASB will hold one at 8:30 BST (British Summer Time, GMT +1); registration is available here. A joint FASB/IASB webcast will be held at a more reasonable hour for Americans, 10:30 AM EDT; registration is available here.

One interesting thing that jumps out is that FASB has assigned a new topic number in the Accounting Standards Classification. Leases currently is Topic 840. The new proposed standard is Topic 842. The use of a new number may reflect the fact that the two of them will be active simultaneously. There's no indication from the IASB whether they will keep IAS 17 as the standard number for Leases.While the boards say that the texts are almost identical, with the differences "primarily related to existing differences between U.S. GAAP and IFRS and decisions the FASB made related to nonpublic entities" (quoting from the press release), they're formatted quite differently, as the FASB has structured the RED to fit the format of the ASC, with four multidigit numbers separated by dashes defining the hierarchical structure (it starts at 842-10-05-1), and various changes to related current standards are shown with strikeouts of existing text and underlined new text. Frankly, the IASB version is far easier to read; I haven't liked the ASC ever since it came out, because the structure makes everything so choppy (especially if you don't have a paid subscription to the online ASC).

Another item that immediately jumps out is that the boards haven't been able to come up with a good name for the different types of leases: A "Type A" lease uses the current capital/finance lease accounting methodology, while a "Type B" lease uses the straight-line expense methodology. Couldn't they use slightly more descriptive titles? I suppose over time we'll get accustomed to them, but do we really need more monikers that have no inherent meaning? Some people have been referring to the two types as I&A (interest and amortization) and SLE (single lease expense), which focuses on the most noticeable difference between the two types; I think something like that would be far less confusing.

While the pieces of the proposal have been discussed here in numerous prior posts, we'll take some time in coming weeks to look at the RED systematically.

Let the comments begin!

Revised exposure draft coming in May

On April 10, the FASB met for a final go/no-go decision on the revised exposure draft (RED) for the new lease accounting standard. The board members were asked, as part of the FASB's standard due process, whether they have concerns about financial reporting complexity in the draft. Three members consider the draft to have too much complexity, and favor various alternatives; four, however, favor going forward with the draft as it stands. Even some of the supporters mentioned reservations (Chair Leslie Seidman, for instance, would like a different point for drawing the dividing line between rental and financing lease types), so there is definitely potential for further changes to the standard based on the responses received during the upcoming exposure draft's 120-day comment period.

The RED will include the alternative views, inviting respondents to comment both on the main proposal and on the alternatives (and, of course, anyone is free to offer their own suggestions as well). The staff announced that they expect the RED to be released in May, with the comment period then extending to September. We could then expect the boards to start discussing the comments possibly in October, but more likely in November (assuming the RED gets a similar number of comments to the original ED, and that most come in very close to the deadline, it'll take a few weeks for the comments to be reviewed and summarized).

Indications are that members of the IASB are not as reluctant to support the RED. Both boards have been making compromises for the sake of convergence (i.e., a common standard promulgated by both boards), but it remains to be seen how the dynamics of convergence, complexity, constituent pressure, consistency with the overall accounting framework and other standards, and the other matters that come into a vote will shape the final outcome.

A fundamental issue is that leasing serves different purposes for different companies (both lessees and lessors). On one extreme, a 4- or 5-year computer lease is clearly a purchase executed over time. On the other, a 12-month real estate lease uses only a negligible portion of the value of the underlying asset. To treat those as the same type of transaction seems inappropriate. But there are leases that fall at every point of the spectrum in between, and any dividing line will inevitably be either arbitrary or inconsistent. Individual reporting entities, as well as users of financial statements, are going to advocate for what works best for them, but the boards have to make a decision that works reasonably for all and that limits the potential for problems, particularly in the off-balance-sheet burying of material financial information which was the primary original impetus for the rewrite in the first place.

The timeline for implementation seems to be slipping again. Even if the boards don't make any significant changes between the RED and the final standard (which seems increasingly unlikely), it's doubtful they could finish before the end of this year. Given the complexity of the changes (the boards have been clear that they're going to allow plenty of time for implementation), and the need for a 2-year lookback for U.S. companies, it seems that 2016 is becoming infeasible as an implementation date, and 2017 is more likely. It's astonishing when you remember that the project was announced in July 2006. For one thing, it will mean that not a single FASB member who voted to start the project will be in office when it actually takes effect (since members serve a maximum of 10 years). In fact, I'm not sure that any of the board members at the announcement date will even vote on the final standard; Thomas Linsmeier joined the board right about that time, but he's the only one (other than Leslie Seidman, whose second term expires this summer) going that far back.

More decisions, more delays

The slow march to a new lease accounting standard has been drawn out yet again. On January 29 & 30, the FASB and IASB met to discuss issues that had arisen during the drafting process for the Revised Exposure Draft (RED). Details of those issues are below, but the most important news out of the meeting is that the staff announced that the exposure draft is "planned for publication in the second quarter of 2013." Up to now, the (most recent) plan had been to release it during Q1. I'm not aware of reasons for the further delay.

At this point, it seems unlikely that a new standard will be released before the end of the year, given the time required for the next steps of the process (4 months for comment period, a month to compile the comments, time for the boards to review the comments and decide to make any changes, then time to draft the final standard and release it). And that's even if they don't make major changes; with several influential bodies expressing reservations about aspects of the RED, that's by no means assured.

Decisions at the Jan. 29-30, 2013 meeting

A lease sometimes includes multiple types of assets. Building leases, for instance, inherently include land (perhaps just the land the building is on, but often a larger area, some of which might be used as a parking lot). A factory might be leased with associated equipment (beyond just the equipment inherent in a building, like HVAC, elevators, etc.). Since the RED proposes to classify leases with a substantial part of the determination based on the type of underlying asset, how should the type of asset be determined in these cases? When should the lease be broken up into multiple pieces, accounted for separately?

The boards agreed with the staff proposal to use the same methodology as is in the draft Revenue Recognition standard (currently also working through the deliberative process), that components would be separated if they can be used independently (either as is or using other resources that are readily available). For instance, a building with land for a parking lot would be a single lease, while a lease that includes a second plot of land that could be developed separately would be separated into two components. Another example the staff presented is a manufacturing plant with two large pieces of manufacturing equipment installed, equipment that is available separately (perhaps from other suppliers), which would be considered three lease components, each to be accounted for separately.

If a lease contains both property and non-property elements, the decision of whether to treat the lease as property or not for purposes of applying the classification tests should be based on the "primary asset." An example given is an oil storage tank, which is considered equipment. The lease includes the land the tank is on, but the tank is the purpose of the lease, and the land is simply necessary to hold the tank. The lease would be classified according to non-property rules.

Current accounting separates buildings and land when the building is capital; the land is always operating (unless the lease contains an ownership transfer or bargain purchase option). The boards decided that there is no need to separate them in the new standard.

The staff introduced a new set of terms for the different types of leases. "Type 1" leases are those to be handled like current capital (finance) leases, with a front-loaded expense profile (interest expense is higher in the early months of the lease, while depreciation is recognized straight-line). "Type 2" leases are those that will use the single lease expense methodology (primarily those that are operating leases under the current standards). It's not clear whether this terminology will become official, or is simply a temporary placeholder.

Pushback, and pushed back

Opposition to the Revised Exposure Draft (RED) of the lease accounting standard is starting to build. Asset Finance International is reporting that the FASB's Investors Technical Advisory Committee (ITAC), at a meeting on July 24, unanimously disagreed with the boards' new approach to lease accounting, though the committee split three ways on their preferred methodology (capitalize all leases using the current methodology, use the new SLE (straight line expense) methodology for all leases, or keep current accounting but with more disclosure). "At the meeting FASB chairman Leslie Seidman acknowledged: 'I can hear that none of you think that we got it right.' "

Bill Bosco, a well-known leasing consultant and member of the boards' Leases Working Group advisory group, sent the boards a letter disagreeing with the proposals as well, though for different reasons. He is particularly concerned with the disparate treatment of equipment and real estate leases.

ELFA, the primary trade organization for equipment lessors in the U.S., has also weighed in with an unsolicited comment letter to the boards. They had been broadly in favor of the idea of revising the lease accounting standard, particularly to put leases on the lessee's balance sheet, but now are considering withdrawing support of the proposed standard, primarily because of the standard's presumption that virtually all equipment leases are essentially purchases (and thus merit finance lease accounting).

The boards are meeting this week to discuss sale/leaseback details (in particular, how to coordinate lease accounting with revenue recognition accounting to make them as consistent as possible), as well as handling impairment of SLE leases, whether to allow another systematic basis other than straight line, whether finance vs. SLE classification is subject to revision after commencement, and how to handle classification of a sublease.

The documents posted for this week's meeting indicate that the delivery date for the RED has been pushed back to first quarter 2013. It was previously expected in November.

It's a wrap, finally

On July 17, the IASB & FASB met to make their last decisions before releasing a revised exposure draft (RED) for the new lease accounting standard. The following decisions were reached (according to meeting notes posted at IASPlus):

Lessee accounting

Statement of financial position (balance sheet)

Assets and liabilities for the two types of leases (finance, also called "interest and amortization" or I&A, and straight line expense (SLE)) will be reported separately, either on the SFP itself or in disclosure notes. Assets are to be presented based on the type of underlying asset.

Statement of cash flows

Cash paid for SLE leases will be reported as an operating activity. It was previously decided that cash paid for I&A leases will be reported as a financing activity for the principal portion, and in accordance with applicable IFRS or US GAAP standards for interest (IFRS permits it as either operating or financing, while US GAAP puts it in financing).

Several board members expressed interest in additional disclosure of cash paid for leases that would distinguish I&A, SLE, short-term leases, and variable lease payments. The staffs will review this and potentially provide a future staff paper for board action.

Disclosure

The maturity analysis (future rent commitments by year for at least 5 years, then combined to expiration) will not be separated between I&A and SLE leases. This was justified by the fact that the liability is calculated the same way for both types of leases. The FASB had previously decided that commitments for services and other non-lease components need to be disclosed; the FASB decided that this disclosure will also be a single report for all leases, not separated between I&A and SLE.

Reconciliation of the opening & closing balances on liabilities will be separated between I&A and SLE leases, because the liabilities themselves are being reported separately.

On the asset side, the boards disagreed. The FASB chose not to require a reconciliation at all. The IASB chose to require separate reconciliations for I&A and SLE leases.

The staff recommended a disclosure table for lease expenses, including amortization and interest for I&A leases, variable lease payments, short-term lease payments, SLE, principal & interest on I&A leases, and SLE cash paid. The boards thought this was overload, and decided only to require disclosure of variable lease payments.

Transition: SLE lease asset

The boards previously changed their approach for transitioning existing operating leases to the new regime: in the original exposure draft, they planned to make the asset and liability equal at the date of initial application, but because that would have front-loaded expenses for all leases, they decided to switch to a "modified retrospective" approach which results in an asset value largely similar to what one would have restating from inception (see my discussion of the details here). With SLE leases, however, front-loading isn't an issue, so the boards approved using the original methodology with the asset and liability equal at the date of initial application (though with an option for a fully retrospective application, which is also permitted for I&A leases). If there's a deferred rent liability/asset due to unequal lease payments, that is applied to the asset.

Lessor accounting

The boards decided that when a lease is terminated early and the lessor takes back the asset, the remaining receivable and the residual should be combined and set up as a re-recognized asset. No gain or loss would be reported on the transaction (though impairment might separately be recognized, if the remaining receivable that's being reclassified is less than the fair value of the leased portion of the asset plus any penalty payments made).

Interim disclosure

For both lessees and lessors, the boards decided that generally interim disclosures (that is, disclosures required during interim reporting periods, such as quarterly reports for US companies) should be handled consistently with existing standards (IAS 34, US GAAP Topic 270, and SEC Regulation S-X, Rule 10-01). However, an additional disclosure for lessors to detail components of lease income was approved. The FASB approved the proposal as presented by the staffs; the IASB preferred to permit a single lease income number in some cases. This leaves a rare non-convergent situation to be dealt with in the post-RED redeliberations.

Next steps

This isn't quite the end of the decision-making process. The FASB will be meeting next week to discuss a few FASB-only issues.

With these decisions complete, the staffs will now assemble all the "tentative" decisions into the form of an exposure draft. The draft will then be circulated to the boards to make sure it accurately reflects the decisions reached, then released to the public. The expectation is that it will be released during Q4, probably in November. There will be a 120-day comment period, which thus would be expected to end in March 2013 (though that might get tweaked because it falls in the middle of annual reporting for companies on a calendar year basis). Once that's complete, figure a month or so for the staffs to compile the results of the comments, so probably in May the boards will start their review and redeliberations. One can expect that there is still going to be some controversy over the decisions, so redeliberations will probably take a few months. At the meeting, two members of each board indicated an intention to dissent from the exposure draft, with an additional member of each board considering dissent; concerns included complexity and cost/benefit, exclusion of variable lease payments, insufficient disclosure, maintaining two types of leases when unified accounting was a key objective originally, and inconsistency between lessor accounting and the concurrent revenue recognition project.

If there are no significant changes, it may be possible to get the final standard approved in 2013, but it would seem to me it's not likely to be out until late in 2013. Given that, it seems almost certain that implementation would be required for 2016 (with restatement of prior years going back two years for most U.S. firms). That makes a total of just under 10 years from the time the project was announced in July 2006 to final implementation; the original plan was to have the final standard released in 2009, with implementation in 2011.... In a webinar today (July 19), the staff indicated that they expect that earlier implementation will be permitted, while non-public entities may get additional time for implementation.

Two expense profiles

At the joint meeting of the IASB & FASB yesterday (June 13), the boards came to an agreement on the expense recognition patterns for lessee leases to be presented in the Revised Exposure Draft (RED). (My thanks to Asset Finance International for their summary of the board meeting.) If you're looking at the meeting papers prepared by the staff (available here), the choice made was for Approach 3, meaning that some leases will be accounted for using current finance/capital lease accounting (recognizing interest and depreciation expense, with the effect that expenses are higher at the beginning of the lease), while others will be accounted for with a single lease expense item which is recognized straight line over the life of the lease. If the rent payments are equal over the life of the lease, the asset and liability balances will be equal at any date. If they are unequal, the adjustment required to balance cash rent vs. accrual expense (what is shown under current operating lease accounting as a deferred rent liability) will be taken to the asset. The asset will also be adjusted for any initial direct costs or impairments, both of which are to be recognized over the life of the lease (or remaining life, for an impairment).

The second decision was where to draw the line between the two types of expense recognition. The boards opted for Option 3 (as described in agenda paper 3D/237):

(a) Leases of property (defined as land or a building – or part of a building – or both) should be accounted for using a straight-line presentation in the income statement ... unless:
(i) The lease term is for the major part of the economic life of the underlying asset; or
(ii) The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

(b) Leases of assets other than property should be accounted for under Approach 1 [finance accounting] ... unless:
(i) The lease term is an insignificant portion of the economic life of the underlying asset;
(ii) The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

The boards' push for convergence was in evidence in the voting. A solid majority of the IASB preferred a single methodology for all leases, using finance lease accounting. However, members of the FASB very strongly felt that straight line expensing was a necessary part of the standard, and the IASB agreed in the interest of having a common standard.

The implications are that virtually all equipment (except leases of 12 months or less, which have previously been excluded from the standard and will be treated like current operating leases) will use finance accounting, while the vast majority of property leases will use straight line accounting. Only when a property lease is for nearly all of an asset's useful life (or there is an ownership transfer or bargain purchase option) will finance accounting be used. We'll have to see how this sorts out in practice, but this probably means that a lease of a building for less than 30 or 40 years will use straight line unless there are very special circumstances.

Lessor accounting

Having made that decision, the boards discussed the implications for lessors. Since they previously decided that lessors of "investment property" could use operating lease accounting, and this would cover virtually all property lessors, the focus was on equipment lessors. The boards decided that they would use accounting more or less symmetrical with lessee accounting, so the "receivable and residual" model will apply to equipment leases unless the lease has an "insignificant" term or receivable. This is similar to current capital lessor accounting, but with the benefit to lessors that they are permitted to recognize a portion of profit at inception (proportional to the value of the receivable compared to the residual), whereas currently profit is recognized over the life of the lease.

Next steps

There will be some wrap-up decisions to make at the July joint boards meeting, related to the RED comment period, transition, and disclosure adjustments. After that, the staff will prepare the RED, with the expectation that it will be released in Q4 2012. (If no further hitches come up, early in the quarter would seem likely.) With an expected 4-month comment period, then time to redeliberate based on comments received, a mid-year 2013 release date of the new standard seems possible, unless there's strong pushback. However, the boards seem to have met the biggest objections, so I think any changes this time around are likely to be modest (tweaks of wording, adjustments of disclosures, etc.), not the wholesale rewrite that we got between the original ED and the RED.

At this point, I wouldn't expect an effective date before 2016, to allow companies time to update their systems and gather any needed information. However, the requirement to restate prior years remains, so U.S. companies will generally need to recalculate 2014 & 2015 when they first apply the standard in 2016. If early implementation is permitted, the recalculation period would move forward commensurately. In other words, 2016 isn't that far away.

EZ13

Here at Financial Computer Systems, we're finishing up the latest update of EZ13, which will be released this summer. We won't have the new level expense capital methodology in that version, but will be working on it later this year. We'll have it in place, including transitions from current accounting, long before implementation is required. We do right now provide for pro forma capitalizing operating leases according to current capitalization rules, so you can see what your balance sheet exposure is under the RED.

"We need to be ready to make a decision"

The FASB & IASB had separate "education sessions" on June 6, to review the materials the staffs have prepared for next week's joint meeting regarding the new lease accounting standard (and other projects). The FASB session is available here; the discussion on leases starts at about 1 hour, 30 minutes in from the beginning. You can view the IASB session by clicking on the "Register" link on this page. The discussion won't make a lot of sense without having the agenda papers available to look at; those are available here (right-click to download the zip file).

The staffs have, as directed by the boards last month, prepared three possible approaches for expense recognition:

1. The current plan: All leases are treated using current finance lease accounting.
2. What was called "Approach D" last month: level expense recognition, with the asset and liability linked throughout the life of the lease (if rent payments are equal throughout the lease life, asset and liability will be equal at all times).
3. A combination of the two approaches, with the necessity to decide which leases need which treatment.

More information was provided about Approach D, now Approach 2. It hadn't been clear last month how to account for leases where the rents change over the life. I speculated that there might be a deferred rent liability, as with current operating lease accounting. Now the staff has clarified that such adjustment should be recognized in the asset, rather than in a separate account. Other adjustments to the asset could also result in assets and liabilities being unequal, such as initial direct costs (added) or impairments (subtracted).

If Approach 3 is desired, then the boards need to decide where to "draw the line" to determine which leases get which treatment. Four options were presented:

1. Finance lease accounting when the lease transfers substantially all the risks and rewards of ownership (the language used currently in IAS 17, which is also the concept behind FAS 13; the determination, however, would be made using IAS 17 principles, rather than FAS 13's "bright lines" of 75% and 90%).
2. Finance lease accounting when the ROU asset represents the acquisition of a more than insignificant portion of the underlying asset.
3. Determination based on the nature of the underlying asset:
   
   • Property leases would use Approach 2 (straight line) unless the lease term is for the major part of the economic life of the underlying asset or the present value of the rent accounts for substantially all of the asset's fair value;
   • Equipment leases would use Approach 1 (financing) unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the rents is insignificant relative to the asset's fair value. 
4. Determination based on the lessee’s business purpose for entering into the lease arrangement.

Most of the FASB board members (at least 5 of the 7) felt that it was appropriate to draw a line, considering that there are different purposes and intentions for different types of leasing transactions, and that it is appropriate to recognize those. Outreach indicated that virtually all property lessees see their transactions as generally not having a financing component; they see it as simply gaining use of an asset for a period of time. Equipment lessees are more split; some deny a financing component, but major aircraft lessees admit that that's part of the transaction.

Option 4 seemed to have the least support; while it seemed superficially to allow preparers to account for their actual intentions, there was substantial concern of gaming the system and a lack of comparability between different companies. Options 2 & 3 were seen as effectively the same, simply stated differently; Option 2 might be seen as more principles-based, while Option 3 is perhaps easier to put into practice. Some thought that Option 1 would be the simplest to apply, since everyone is familiar with the concept already; however, that would result in most aircraft leases getting straight-line rather than finance accounting, which was troubling. (Aircraft operating lease accounting is a poster child for the need for a new lease accounting standard.)

One board member indicated that he thought in-substance purchases were scoped out of the new lease standard. That's news to me; it had been discussed at one point, but I thought that was long since discarded. I don't see any support for that in the FASB's summary of tentative decisions to date.

During the outreach, most users of financial statements (i.e., financial analysts and investors) expressed a preference for a single approach to lessee accounting, but generally the more important issue to them was getting everything on the balance sheet. It was felt that proper disclosure could enable users who prefer to see leases a different way to make the adjustments they need.

There was some discussion regarding the implications for lessor accounting. Some board members consider symmetry important. Others consider the different business models and purposes on the two sides of the transactions sufficient that symmetry doesn't matter; at least one suggested that no change at all to lessor accounting from current practice is necessary.

The boards are concerned that their decision not seem arbitrary, recognizing that some people will be unhappy with whatever decision they make. They want to be able to defend it on a theoretical, not just practical, basis.

At the end of the session, a FASB board member asked the staff for what preferences had been expressed at the IASB education session held earlier in the day. It was reported that a majority of the IASB seems to have a first preference for Approach 1, but also that the strength of preference for that over Approach 3 would depend on where a line was to be drawn. So we have a difference of opinion between the boards; we know that they want very strongly to release a unified standard, so we'll have to see how that gets resolved.

To wrap up, though, the comment was, "We need to be ready to make a decision." The staff said a similar sentiment was expressed by the IASB. They've scheduled 5-1/2 hours of discussion for Wednesday & Thursday, June 13 & 14.

The staff expects this meeting to include the last substantive decisions on the new standard to be presented in the revised exposure draft (RED). They plan to follow up in July with wrap-up decisions, such as the comment period for the RED and interim disclosures, plus any decisions that may need to follow on from June decisions (such as adjusting disclosures if the approach to lessee accounting changes). After that, they would be ready to draft the RED and release it later in the year. The FASB Current Technical Plan is now reporting that the RED is expected to be released in Q4 2012 (that's a recent development; just a few weeks ago, it was simply "second half of 2012").