They hear you

Anyone who had any doubts that the FASB and IASB seriously consider responses received during their "due process" steps need only look to last week's meetings and the decisions reached on lease accounting. In addition to the previously reported complete reversal on the lease term, the boards have made an almost complete reversal on contingent rents, and are planning to substantially alter the standard to respond to the desires of those who want level recognition of expenses over the life of a lease. These three topics were probably the most strenuously argued in comment letters to the Exposure Draft.

The boards aren't backing down on putting lessee leases on the balance sheet. But they're showing that they are willing to work with preparers and accountants to make the standard more workable and less onerous.

Contingent rents

The Exposure Draft called for all contingent rents to be included in the capitalized lease payments using a probability-weighted estimate, based on a "reasonable number" of estimates. Rents based on an index or rate were to use forward rates when "readily available." Estimates would need to be revised as often as once a quarter, with changes in future rents booked as upward or downward adjustments to both the asset and the obligation (changes affecting current or prior periods would be immediately expensed).

Preparers howled. The work involved would be enormous, and would often involve forecasting well beyond normal planning horizons (a 20-year lease with a percent of sales kicker would require forecasting sales out that far, when few companies go past 5 years in their regular forecasting). The requirement for quarterly reassessment, even if softened by stating there needs to be a "significant change," would add measurably to the load of releasing statements. Much of this could not be automated, because contingent rents have immense variability in terms.

The boards have now almost completely reversed themselves. The new plan agreed to last week is that contingent rents need to be included in the capitalized rent stream in just the following cases:

* they are based on an index or rate--and in that case, the current rate is used, with no use of forward rates, though it will need to be updated each reporting period (unlike current GAAP, where the rate at lease inception is used throughout the life of the lease)

* they are "reasonably assured," with the definition to be determined later

* the base rent is below market rates

Other contingent rents will be subject to disclosure, but not capitalization.

Expense recognition pattern & placement

Many respondents to the ED complained about the income statement effect of capitalizing all leases. They didn't like two different aspects of this:

* Amortizing the obligation using the interest method, while amortizing the asset on a straight-line basis, means that expenses are greater in the early months & years of a lease, then decline over time.

* Lease payments and interest expense would classified as financing activities. Both interest and depreciation expense are excluded from EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an important measure of earnings for many companies.

Those who objected felt that level expense recognition was more reflective of economic reality, and that leasing should be considered operational rather than financing activity.

The boards concluded that there are two types of leases. Some leases truly are financing transactions (such as most current capital/finance leases). For those, the boards believe the current plan of interest and depreciation is appropriate. But others, they conclude, do not have a strong financing component, and a level expense pattern would be more appropriate.

Can you say "classification"? One of the big reasons for the new lease accounting standard was supposed to be eliminating classification of leases into two types, because of the concern that similar leases are being accounted for differently (those just on either side of the dividing line). The stories about leases with a present value of 89.9% of the fair value (just below the 90% line that makes a lease capital) have been around for a long time. Just because the bright lines are going away doesn't mean that there won't be structuring.

But the boards seem to be accepting that different reasons for leasing merit different accounting treatment. They may also be swayed by the fact that different ways of recognizing expenses can have collateral impact--companies that depend on expense reimbursement from government medical and other contracts, for instance, noted that rent expense is often reimbursable, while depreciation and interest on debt are not. They may also be concluding that the effect of possible structuring in these cases isn't as egregious as making things disappear entirely from the balance sheet.

Of course, once you say that there are two types of leases, the question becomes, how do you tell which is which? The new standard is supposed to be "principles based" rather than "rule based," so we won't have a 90% or 75% test. Instead, the boards are looking to prepare a list of factors which would be considered. Some of them are (a) residual asset, (b) potential ownership transfer, (c) length of lease term, (d) rent characteristics, (e) underlying asset, (f) embedded or integral services and (g) variable rent (thanks to Deloitte for its notes on the meeting that had this list). The boards will be discussing in the future how these factors interact, as well as proper presentation of leases considered "other than financing."

Lease vs. Service Contract

The boards spent considerable time continuing to try to differentiate between leases and service contracts (when a contract has elements of both). One conclusion they reached is that if an asset is incidental to a service, it doesn't have to be accounted for separately. (So, for instance, when you get a cable TV subscription that includes a cable box, the box doesn't have to be treated as a lease.) They also tentatively decided that the requirement for a specified asset is still met if the lessor has the right to swap out an equivalent item assuming no disruption of service (such as replacing a copier with another of the same model).

Most discussion was focused on lessee accounting. The boards have decided to discuss that primarily at this point, with the intention to get back to lessor accounting to keep things as symmetrical as possible.

A number of the decisions and issues will be reviewed with preparers, users, and accountants, with a report back to the boards at a later date.

"More likely than not" is dead

At yesterday's meeting (Feb. 16), the IASB and FASB agreed to withdraw the proposal to include lease renewal options in the lease term when judged "more likely than not" to be exercised. This was the proposal in the Exposure Draft, which was almost universally opposed by respondents, particularly preparers of statements. Asset Finance International's summary of the meeting notes in addition to complaints of difficulty of implementation and subjectivity, another persuasive argument for board members was that real estate lease renewals frequently are not actually implemented as stated in the original option, but are subject to negotiation like a new lease, so the stated option doesn't necessarily reflect what the terms will be even if "exercised."

Rather than reinstating current terminology on when to include options (when "reasonably certain" or "reasonably assured" of exercise due to various economic factors), the boards have tentatively chosen the phrase "clear economic incentive." The boards didn't seem to think there was a substantial difference in impact, so it seems to be more a stylistic choice.

Reassessment of lease terms, which previously was required on a quarterly basis, is now to be required only when there is a significant change in circumstances, such as an addition or removal of a "clear economic incentive" on a renewal option.

Contingent rents will be discussed today.

ED response reviews

Deloitte & Touche has released a "Heads Up" summary of responses to the lease accounting exposure draft.

Asset Finance International (an association of lessors primarily focused on Europe) has its own summary.

Death knell for "more likely than not"?

The IASB & FASB will be meeting next week. On the agenda on Feb. 16 meeting: the definition of the lease term. The staff briefing paper for the discussion, noting the almost universal rejection of the proposal to include lease options in the lease term if they are judged "more likely than not" to be exercised, recommends that the lease term be defined essentially the same way as it is now under both IAS 17 and FAS 13: the contractual minimum, plus options that are reasonably certain to be exercised. The staff's recommendation is that "reasonably certain" be determined solely on economic factors (such as bargain renewal options, penalties for cancellation, presence of long-lived leasehold improvements, etc.), with no weight given to past practice or management intention, which the majority of the staff considers too subjective. They do list that as an option for the boards, though, along with keeping the "more likely than not" criterion.

Given the vehement rejection of "more likely than not" in the comment letters and other outreach activities, this was, I think, expected by most observers. But assuming it comes through, it'll be a very clear indication of the significance of participating in the boards' due process.

Also on the agenda for the boards' meetings next week is variable (contingent) lease payments.

The majority staff position is that only contingent rents dependent on an index or rate should be included in the lessee's liability to make payments, with the valuation based on the prevailing (spot) rate. A minority would add all payments that are "probable" or "reasonably certain." Additional disclosures would be required, but those won't be discussed at this meeting.

This is again a pretty thorough repudiation of the Exposure Draft, which called for probability-weighted estimates of all contingent rents, including those based on usage and percentage of sales. Combined with the original proposal to include "more likely than not" options, it raised the potential of needing to estimate business and economic conditions for 50 years, an exercise that was unlikely to bear any significant connection to reality.

With these two changes, the complexity in the ED is greatly reduced. There is still the inherent complexity of capitalizing the leases, but that's far less challenging to deal with.

EZ13 data entry tips #2

See yesterday’s blog entry for information on how to copy a lease, create escalating rents, or create the full series of rents for level principal payments.

Date entry

While you can enter a date by typing it in with slashes, exactly as shown, there are other options.

• Click on the down arrow next to a date to display a calendar (on the calendar, click on the month or year to change them, or the left or right arrow to go back or forward a month).
• Click on one portion of the date (month, day, year) and press + or – to add or subtract one to that number (note: this cycles without affecting the rest of the date, so if you highlight the day on 1/31/2011 and press +, the date changes to 1/1/2011, not 2/1/2011).
• You can enter just the last two digits of the year; EZ13 guesses the century, based on the setting for your computer. By default, the window is 1930-2029. You can change it in the Regional Options of Control Panel. (Control Panel, Regional & Language Options, click on Customize, click on the Date tab, change the end date of the window.)
• You can use letters with the same meaning as Quicken/Quickbooks assigns to them:

Y, R - beginning or end of YeaR

M, H - beginning or end of MontH

T - Today

F - Forward one day

B - Back one day

All of these (except T) are cumulative: for instance, if you press Y when at the beginning of a year, the date moves to the beginning of the prior year.

F and B are different from Quicken, which uses + and - for the same purpose.

Help

Context-sensitive help is available throughout EZ13. If the cursor is in a field when you press F1, you get a description of the field and what to enter there. If a different window is displayed, information about that window is provided. Virtually the entire manual is found in the help screens.

EZ13 data entry tips #1

One of my intentions for this blog has been to provide usage notes for EZ13, FCS's lease accounting software for capital and operating leases, but I’ve ended up generally more focused on what’s happening with the FASB & IASB as they revised the lease accounting standard, because so much has been happening in that regard. Today, though, I’m going to take a moment to offer some tips on using EZ13.

There are a number of features designed to make entry of leases faster and more convenient, but many of them aren’t necessarily obvious. (They're described in the documentation, but I harbor no illusions about how much documentation is read.) I’m going to go through a few of these today:

Copy a lease

You may have several leases that are the same or almost the same (several copiers leased at the same time, for instance). EZ13 allows you to copy all the data entered for a lease to create a new lease record. Use menu item Lease/Copy; all the information from the current lease is copied to the new record, except only for the lease number (since that must be unique).

Rent Escalation clauses

Many real estate leases call for an automatic increase of rent every year or every 5 years. The increase might be a percentage or a dollar amount. (Note that if the increase is based on future events, such as the change in the Consumer Price Index, that’s considered contingent rent, and only the base rent is considered minimum lease payments for FAS 13 reporting purposes; the contingent rent is simply expensed when incurred.) Rather than needing to calculate and enter each rent amount, EZ13 allows you to specify the base rent, the increment (in dollars or percent), and when the change happens. You can separately specify the executory cost, which might remain the same or change with a different increment. Use menu item Lease/Rent Escalation. Note that the rent escalation period does not have to cover the entire life of the lease.

Level Principal Rent

Relatedly, some leases are set up so that the same amount of principal is repaid with each lease payment. Since the interest is constantly decreasing as the principal decreases, this means that each rent payment is different. Entering that for a 36- or 60-month lease can be pretty tedious! EZ13 can set up the full set of payments using menu item Lease/Level Principal Rent, you just enter the initial principal, interest rate, and length of the lease (with an option for additional fixed rent, such as a service charge that's added to each payment, and executory costs).

I’ll describe some additional input convenience features tomorrow.

First redeliberation session

The IASB & FASB met in joint session last week. On the agenda, as previously noted, was the first round of reconsideration of the new lease accounting standard, reacting to the responses received on the Exposure Draft.

The separation of leases from service contracts is a major issue, including the question of service contracts that include physical assets. One example is a cable TV subscription; if the cable company gives you a cable box, does that make the whole transaction a lease rather than a service? Does the box need to be accounted for separately as a lease? Or should some small amount of physical assets be ignored in this situation? (How small?)

The boards also discussed whether all leases should be considered a form of financing (which merits the accounting proposed with delinked asset and obligation), or if some aren't really financing and should be recognized with a straight-line expense/income pattern.

Lessor accounting was also discussed in detail. Some respondents suggested putting off lessor accounting, but the boards agreed to keep discussing both sides of the transaction, particularly issues that are relevant to both. There is a wide range of views on whether there ought to be one or two kinds of lessor accounting, and if one, which one, though the boards seem to have considerable sympathy for the idea that there are two different business models for leasing that ought to be accommodated.

A number of respondents complained about the lack of symmetry between lessee and lessor accounting (sauce for the goose, sauce for the gander?); the boards directed the staffs to consider two approaches to accounting for both lessors and lessees, one based on the financing concept and the other using straight-line recognition. (One challenge, of course, will be how to differentiate.)

FASB Chairman Leslie Seidman held a webinar on Jan. 25, providing her views on what the board is doing. She noted that the count of comment letters on the lease accounting Exposure Draft is now over 750. She sees general agreement with the concept of placing lease obligations on the lessee balance sheet, but recognizes that many are concerned about the complexity of the current model, especially with regard to options and contingent rents. She also noted that there is "general disagreement" with the front-loaded expense pattern as it affects leases that are currently considered operating, and the classification of the expense in financing rather than operating activities. While she didn't officially back off from a June 30 due date for this and the other current projects, she noted that the boards have been stating that the target dates are subject to the nature and extent of the feedback received. Their goal is standards that are understandable and implementable at a reasonable cost, and "if it takes a little longer to reach that comfort level, we will take that time."

In the webinar's Q&A period, someone asked how the FASB decides when to re-expose a standard if changes are made from the exposure draft. She said their general question is: How significant are the changes from both the original exposure draft and from current accounting? The implication is that if their new plan is significantly different from both an ED and current GAAP, they would re-expose. It is, of course, too soon to tell whether that would happen to the lease accounting standard.