The pendulum swings again

The big news last month was that the FASB & IASB decided to reinstate a close cousin of operating lease accounting for lessees, with a level expense recognition pattern (though the leases would still be reported on the balance sheet). It was a sharply divided vote. Now, a few members of each board have switched sides, and in another divided vote, the boards have decided to ditch the "other-than-finance" lease category and account for all lessee leases the same way, as finance leases. This means a forward-leaning expense profile (depreciation is equal over the life of the lease, but interest is higher at the beginning of the lease, just like with a mortgage), which many respondents to the Exposure Draft vehemently protested. One reason given was that board members didn't like the options for how to account for the level expense recognition.

The boards also informally voted to eliminate the exemption of short-term leases (12 months or less maximum lease term, including renewal options) from the requirements of the standard that was agreed to in March. However, that will be reviewed and finalized at a later meeting.


Options

In another backtrack that most lessees won't like, the boards have increased the likelihood that options will need to be included in the lease term. In deciding whether to include an option, one must decide if there is a "significant economic incentive" to renew. A prior meeting decided that only economic factors should be considered in this determination (including contract-based factors such as below-market rents or penalties for non-renewal, and asset-based factors such as the existence of large leasehold improvements that would normally be amortized over a longer period). The boards have now decided to include "entity-specific factors," such as historical practice of the company or industry and management intention. The boards noted that a single factor does not have to be determinative, but the door is still opened up to an increase in subjectivity and need for ongoing review.

Lessor accounting

The boards haven't decided if lessors will use one or two approaches to accounting for their leases. So they made decisions for either possibility:

One approach

If all leases are treated the same way, the partial derecognition model will be used, with the residual value accreted over the life of the lease. This is, I believe, basically the same as current finance lease accounting (sales type accounting under FAS 13).

Two approaches

If two methods of accounting are used, leases will be distinguished based on whether the lease transfers substantially all of the risks and rewards incidental to ownership of the underlying asset. This is the concept underlying both FAS 13 and IAS 17. The boards clarified that among the indicators would be comparing rent to fair value and the existence of variable rent (the latter would be an indication that risks have been transferred to the lessee). Existence of embedded or integral services would not be considered in the determination.

For leases that transfer substantially all of the risks and rewards of ownership, the entire asset would be derecognized, with the residual initially measured at its present value and accreted over the life of the lease.

For other leases, the boards could not come to an agreement. The IASB preferred derecognition, while the FASB preferred current operating lease accounting. This will be revisited at a future meeting. (Neither board, though, preferred the Performance Obligation (PO) method that was presented in the Exposure Draft. That seems to be dead.)

Lease modifications

The boards decided that a "substantive change" in a lease agreement would result in treating the modified agreement as a new contract. This applies if the new terms would change the determination of whether the contract is or contains a lease, or the determination of whether substantially all the risks & rewards of ownership are transferred to the lessee. A change in circumstances (not of the contract itself) can cause reassessment of whether the contract is or contains a lease, but not whether risks & rewards of ownership are transferred.

Discount rate

The interest rate used to present value the rents and amortize the principal (obligation or receivable, depending on whether it's the lessee or lessor) will not be reassessed if the lease payments don't change. However, if a lease is extended because an option needs to be included (either because an option is exercised, or it is deemed to be includible because of a newly recognized "significant economic incentive"), the discount rate (which is typically the incremental borrowing rate for lessees) is to be reassessed, using the current rate, and the present value of the remaining rents is then recalculated.

Lease accounting standard delayed

The FASB & IASB have decided that they cannot complete the new lease accounting standard (as well as standards on revenue recognition and financial instruments) by their target of June 30, 2011. Instead, they will continue to work on the standard into the second half of 2011. The FASB Current Technical Plan page suggests a Q3 final standard, but notes that they expect to release a new Exposure Draft, because of the magnitude of changes from the original Exposure Draft released in August 2010. The boards have not officially committed to re-expose, but if they do not, they will do an enhanced public review, making a draft standard available for review, with outreach to interested parties.

Other decisions made this month:

Contingent (variable) payments: The boards stepped back further from their widely criticized ED proposal to capitalize contingent rents. Now the only contingent rents that are to be included are 1) those dependent on an index or rate, and 2) those that are "in-substance fixed lease payments but are structured as variable lease payments in form." This is essentially an anti-abuse provision; it is unlikely that any normal lease would be affected by this. The boards haven't yet decided whether contingent rents based on an index or rate need to be reassessed when the reference number changes; that will be decided at a future meeting. If they decide not to reassess, it would mean a complete reversion to the current standard.

Definition of a lease: There has been substantial discussion over the requirement for a "specified asset." This month's deliberations concluded that a physically distinct portion of a larger asset (like a floor of a building) qualifies, but a capacity portion (like partial usage of a pipeline) does not. The asset can be explicitly or implicitly identifiable.

Other-than-finance leases: Operating leases are back as a category, with the primary difference being that they will now be on the balance sheet. But on a divided vote (with 7 IASB members opposed, plus 1 FASB member), the boards decided to have two accounting approaches for lessees, with the distinction being basically the same as IAS 17 (the IFRS leasing standard, which is similar to FAS 13 but doesn't use the 75% and 90% "bright lines" to differentiate between operating and capital leases). They're using the awkward term "other-than-finance," presumably because they want to differentiate it from current operating lease accounting, which doesn't hit the balance sheet. Maybe somebody will come up with a better name before the standard is released. Such leases will have their expenses recognized as rent expense in the operating section of the income statement, rather than as a financing activity. The liability will still be amortized using the interest method, but the asset will be amortized so as to keep the combined periodic expense level over the life of the lease.

There will similarly be two accounting approaches for lessors, but the boards reached no conclusions on application.

More decisions, summarization so far

The FASB and IASB met again last week to further deliberate on leases. Among the decisions reached:

Start of accounting: A lease may be signed well in advance of when the lessee takes possession of the property (particularly with property, which may need extensive construction before occupancy). The boards have affirmed that the lease does not hit the books until the "commencement" of the lease, which is normally when possession is granted. Payments made between the "inception" (signing) and "commencement" will be accounted for as prepayments (an asset that is then folded into the ROU asset at commencement). If the lease meets the definition of an "onerous contract," it is to be accounted for during the inception to commencement period according to the Contingencies accounting standards: IAS 37 and FASB Topic 450.

Tenant incentives: Lessees are to subtract these from the right-of-use asset.

Sale & leaseback: Rather than a series of tests in the Exposure Draft to determine whether a transaction qualifies for sale and leaseback accounting, the boards have now decided that as long as the sale part of the transaction meets the existing accounting requirements (under the Revenue Recognition standard) to recognize a sale, it qualifies for SLB treatment. In general, if control of the asset has passed to the buyer/lessor, it qualifies. One change from current SLB accounting is that if the seller/lessee has a gain or loss on sale, that is to be recognized immediately, rather than amortized over the life of the lease.

Leases with service components: When the service component is not clearly identified separately in the agreement, the FASB in the ED called for capitalizing the entire contract as a lease (the IASB favored split recognition). Both boards have now decided that if the purchase price of one component (lease or service) is "observable," you can calculate the split based on that.

Discount rate: FAS 13 calls for the interest rate on lessee capital leases to be based on the lease's implicit interest rate, if known, or the lessee's incremental borrowing rate (IBR). In many cases, the lessee doesn't know the lessor's implicit rate, because the expected value of the asset at lease expiration (the "unguaranteed residual") is not stated, so the IBR tends to be used. (The rate may be higher if the present value of the rents using these rates is more than the fair market value; in that case, a rate is calculated to make the PV of the rents equal to the FMV.)

The ED introduced a new term: "the rate the lessor charges the lessee." This is to be used when available, a decision now confirmed. Finally, though, the boards have defined what they meant; this can be (from the observer summary) "the lessee's incremental borrowing rate, the rate implicit in the lease, or, for property leases, the yield on the property. When more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used." The lessor always by definition knows this rate. If the lessee does not, the IBR is to be used.

Initial direct costs: The boards defined this as "Costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made." The intent is to have a consistent definition for a series of standards (including insurance and revenue recognition, which are at similar stages of development), though there may be slight modifications to meet specific needs of the different standards. Any such differences are intended to be explained by the boards, to maintain the overall consistency.

IDCs are to be capitalized by both lessees and lessors, by adding them to the right-of-use asset and right to receive lease payments, respectively.

Summarization: The IASB staff has prepared a detailed description of the impact on the ED of the new decisions by the boards. This describes both the confirmed decisions and the changes, with links to IASB observer notes for each.

Thanks to the IASB for their podcast and to Asset Finance International for their summary.

Ownership transfer leases, update

In my March 17 post, I said that it wasn't clear how the scope change affected leases with an ownership transfer. Based on the IASB Update just released regarding last week's meeting, it seems clear that they are also to be considered leases. The boards have decided to simply eliminate the language that took leases with bargain purchase options and ownership transfers out of scope of the leasing standard.

Purchase options and short-term leases

The FASB & IASB met this week for continuing discussions, on leases as well as other topics. In their meetings on March 14 & 15, they reached the following conclusions for the new lease accounting standard:

• The ED had scoped out (excluded) leases with bargain purchase options and ownership transfers (also called "in-substance purchases") from the new lease accounting standard, stating that they should be treated as a sale & purchase and handled according to the revenue recognition standard (which is also at the ED stage). However, this decision was left over from when the boards had briefly planned to treat all lessor leases according to the "performance obligation" model, which would have been inappropriate for these transactions. With a derecognition model for lessors now in place, the need to separate out these types of leases is less evident. The boards agreed that leases with a bargain purchase option should be returned to the scope of the leases standard. It's not yet clear if leases with ownership transfer will be considered leases or sales.
• Relatedly, the boards are adjusting the treatment of purchase options. In the ED, these did not need to be accounted for until exercised. Now, they must be accounted for if there is a "significant economic incentive" to exercise them. It remains to be determined how the accounting will work if the conclusion of a significant economic incentive changes in the middle of the life of the lease (in either direction), though the boards concluded that they would not permit a switch between the "finance" and "other than finance" categories they set up last month.
• Short-term leases: The boards have decided that leases with a maximum lease term of 12 months or less, including renewal options, can be treated like current operating leases. They will not be shown on the balance sheet for lessees; income and expense will be shown on the income statement as currently (with rent leveling as needed). This will be an option; lessees & lessors can choose to treat short-term leases like other leases. However, the option must be chosen for all leases in an asset class, rather than lease by lease.

Thanks to Deloitte's IAS Plus and Asset Finance International for their reviews of the meetings, which were the basis for this entry.

2015 implementation?

The new leasing standard is one of several major standard revision projects the FASB & IASB have underway. Others include revenue recognition and insurance contracts, which are considered heavily interrelated with the leases, and other comprehensive income, fair value measurements, financial instruments with characteristics of equity, and financial statement presentation, which are considered more independent of other standards.

The boards put out a separate Exposure Draft asking for comments on implementation dates. While the volume of comments wasn't nearly as high as for the leases ED, the consensus response was that the impending changes are major, and financial statement preparers need substantial time to update their systems. At the boards' combined March 2 meeting, the boards didn't decide whether to implement the three linked standards (leases, revenue recognition, and insurance contracts) at the same time or in staggered order, but stated that they "will provide adequate time for stakeholders to apply the new requirements." Several members of the IASB stated a preference for 1/1/2015 as the implementation date, while most FASB members didn't want to make a commitment to a date at this time, and several expressed a preference for a staggered implementation.

Note that since U.S. companies typically report two years of comparables, and the leases ED says those comparable years will need to be restated on implementation, that means that effectively companies would need to apply the standard effective 1/1/2013, even though they wouldn't be reporting the results accordingly until later. It's not clear yet whether earlier implementation will be encouraged or permitted.

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.