Jan. 20 FASB/IASB meeting

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

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

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

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

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

A return to classification?

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

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

Dec. 18 meeting recap

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

Contingent rentals

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

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

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

Residual value guarantees

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

Scope

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

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

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

Results of joint FASB/IASB meeting, Nov. 18

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

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

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

FASB/IASB joint meeting

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

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

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

FASB review of comment letters

This morning, the FASB met to review the comment letters to the Preliminary Views document. No decisions were made at the meeting. The audio is available until the next meeting at http://fasb.trz.cc/archive.php.

A few notable items from the discussion:

• There is concern that more attention needs to be given to distinguishing between a service contract and a lease. Up to now, the accounting for operating leases and service contracts hasn't been significantly different, so it hasn't been a big issue. But with leases subject to capitalization, the difference becomes much more substantial, so people are much more concerned. The board plans to discuss this issue in more depth in upcoming months.
• As previously noted, many respondents disagree with including options in the capitalized value of a lease. Some members of the FASB are concerned that options are being handled inconsistently in different aspects of accounting (such as financial instruments and revenue recognition)--some are handled through recognition, others through measurement.
• There has been a background discussion of "in-substance purchases" throughout the entire lease accounting project. This reappeared, with the mention that the Leases Working Group meeting earlier this month brought up the issue as being very important to lessors, probably more important than to lessees. The definition of "in-substance purchase" seems to be confined to leases with an ownership transfer or bargain purchase option (the first two tests of capitalization under FAS 13, which currently require the leased asset to be depreciated over the economic life rather than the lease term). Lessors particularly want such leases to be treated like purchases, rather than with right-to-use accounting.
• Some respondents questioned whether appropriate due process would be followed if lessor accounting didn't go through a preliminary views document. Board members do not think that is a due process requirement; they believe it is sufficient to provide an exposure draft and respond to comments to that. The implication is that they don't want to slow down completion of the leasing project.

The FASB and IASB will have a joint meeting October 26-28. Lessor accounting is part of the agenda for that meeting.

Correction: In my August 27 blog entry, I said that the September 3 meeting of the Leases Working Group was the first in 2-1/2 years. That was incorrect. The Group also met on October 7, 2008, to discuss the proposed Preliminary Views document. A summary of the meeting is available here, but I won't take the time to review it in this blog, since it's pretty old news by now. I have not yet seen any information (or audio) posted about the September 3 meeting.

Comment letters summary

The FASB and IASB staffs have prepared a summary of 290 comment letters received on Leases: Preliminary Views, the discussion paper released in March, for which the comment period ended in July (though letters were received through mid-August; they cut off review with the letter received on August 10, while 5 more were received in the following week). The summary is available on the IASB web site. The boards plan to discuss the summary next week: The IASB's meeting will be Sep. 15, while the FASB will meet on Sep. 16. Both meetings will be broadcast on the web (IASB includes video, while the FASB is audio only; follow the links to sign up).

Some highlights from the staff's summary (you can see my less systematic review in a prior post):

* Almost half of the respondents were "preparers" (companies and other entities that need to prepare financial statements), with another 51 from industry organizations. The rest were a range of professional associations, accounting firms & standard setters, government agencies, academics, financial statement users, and individuals not claiming other affiliations. Almost half were from Europe, with a third from North America, an eighth from international organizations, and a small number from the rest of the world.

* About half supported the overall concept of a right-of-use asset and corresponding obligation for all leases; a third were opposed, and the rest did not express opinion (in most cases because they were focused on lessor rather than lessee accounting). However, most of those in support also expressed reservations about complexity, especially in dealing with options and contingent rents. Those opposed (virtually all of whom were preparers or industry organizations) largely encouraged keeping the current model with enhanced disclosure.

* "Nearly all of the respondents who commented on the boards' decision to defer consideration of lessor accounting disagree with that decision." People are concerned that the transactions will be unbalanced, and that eventual lessor accounting decisions may require further changes to lessee accounting at considerable extra cost and complexity.

* Most respondents agree with the current scope for lease accounting, though some are concerned that the new rules will lead to pressure to recharacterize leases as service contracts (which are not capitalized). Most who commented favor excluding short-term leases (generally favoring one year as the cut-off) but including "non-core" leases.

* Nearly all respondents agree with valuing the asset and obligation at the present value of the rents, though they were divided on whether lessees should attempt to determine and use the lease's implicit interest rate instead of the incremental borrowing rate.

* Respondents were divided on whether or not options (renewal and purchase), contingent rents, and residual guarantees should be included, with many of those opposed asserting that they do not fit the accounting framework definition of a liability, and also expressing concern about the complexity that would be entailed.

* If contingent rents are included, about half believe the estimates should be updated each reporting date (the boards' tentative view), to provide more accuracy. Others consider this requirement onerous, and would limit it to when a triggering event (to be defined) occurs. If changes in contingent rents happen, most prefer to see it recognized through a change in the carrying amount of the right-to-use asset, not a P&L gain/loss.

* Most who expressed an opinion on lessor accounting wish to see the transaction set up as a derecognition of (a portion of) the existing asset, rather than the performance obligation approach that the boards favored in their July meetings.

* Most who expressed an opinion believe that investment properties should be included in the scope of a lessor accounting standard. However, almost all investment property companies themselves argued against inclusion.

We'll see how significant the comments are in the boards' deliberations next week and over coming months.