December meeting results

The FASB & IASB met again to discuss leases on Dec. 13 & 14. Significant decisions reached include:

Cancellable leases
If both the lessee and the lessor have the right to cancel the lease (without termination penalties) such that the minimum term, including any non-cancellable period and any notice period, is 12 months or less, it meets the definition of a short-term lease. The key here is that either side can cancel; if one side can require renewal, then normal lease accounting applies.

Investment properties
Rental income from property accounted for (under IFRS 40) as investment property will not be capitalized, as such property is out of scope of the new leasing standard. However, the boards still chose how to recognize rental income: straight line, or another systematic basis if more representative of use of the asset.

Disclosures for these lessor leases are to include:

• Maturity analysis of future rents (at least 5 years by year, then the rest combined). This is not to be combined with the maturity analysis for capitalized leases.
• Separate entries for minimum contractual rents and variable lease payments
• Cost, carrying amount, and accumulated depreciation on leases
• Narrative information about lease arrangement

Future meetings
The staff listed the following items to be redeliberated:

• the definition of investment property (which is scoped out of this standard)
• the "lessee accounting model"--as mentioned in a Wall Street Journal article that I commented on previously, the boards are going to discuss further a way to recognize level expense over the life of a lease, even though they rejected this earlier
• additional disclosure items
  

November meeting results

Sorry, I'm behind again. This is from a month ago; I'll post the results of December's meeting as quickly as possible. This is from the FASB & IASB joint board meetings of Nov. 15 & 16, 2011:

Leases in business combinations
An acquired lessee lease is set up as if it is a new lease at the acquisition date, except that the asset is to be adjusted for any "off-market" terms in the lease; that is, if the rent due is substantially above or below market rents, the difference between market (present valued) and contract is folded into the asset.

This is a significant change from current accounting, which calls for a fair value calculation for both the asset and the obligation at the date of acquisition, with the result that the two are normally different at the acquisition date. Now the normal case will be equal asset and liability at acquisition, unless the rent is considered off-market.

An acquired lessor lease, using the receivable & residual approach, is set up as if it is a new lease at the acquisition date for purposes of calculating the receivable. The residual is the difference between the receivable and the fair value of the asset.

An acquired lessor lease that is treated as investment property or a short-term lease (originally or according to the remaining life at acquisition) is handled according to current rules under IFRS 3 and FASB Topic 805 for acquired operating leases. (However, I don't actually see anything explicitly talking about operating leases in Topic 805 or its original source, FAS 141, so I'm not sure what that means.)

Transition
If a lessee has a previously recognized intangible asset or liability to reflect (un)favorable terms in an operating lease, that should be folded into the right-to-use asset.

Currently, the sale of operating lease receivables by a lessor cannot be treated as a sale; instead, it is accounted for as a secured borrowing (because the receivable is not recognized on the balance sheet to begin with). The boards discussed whether to permit sale treatment at transition. Requiring it was seen as onerous; permitting it as an option would reduce comparability. The boards decided to permit it on a prospective basis only.

First-time adopters of IFRS generally would apply the same transitional rules as other companies, except that they are to use fair value determinations for a right-to-use asset.

Fighting on the expense profile

According to a Wall Street Journal article in yesterday's edition (available online only by subscription), most companies are resigned to the new lease accounting standard putting leases on the balance sheet. The primary issue they're pushing back on is the front-loading of expenses (which happens because interest is higher in the early years of a repayment schedule, while the depreciation remains straight-line throughout the lease term). The boards briefly considered, then rejected, a proposal earlier this year to make the expense profile straight-line by making the depreciation expense equal to the obligation repayment in each payment period; they didn't like the way the depreciation would look, and felt it was inconsistent with other aspects of accounting.

However, the topic hasn't died, and the article says that the FASB & IASB staff plan to revisit the issue with the boards, perhaps next month.

The article notes that the front-loaded profile is particularly problematic for retailers, who typically have lower revenues in the first years a store is open. Chains that are rapidly opening up new stores would be especially hard hit. The article indicates that investors also consider the expense front-loading unhelpful.

The article speculates that companies might shorten the life of their leases to reduce the impact of front-loading, but notes that that could cause problems for landlords who depend on long-term leases to guarantee their loans.

In other news, I realized I missed commenting on a November 1 meeting:

The boards worked through lessor disclosures, including:

• A table of all lease related income items, listing separately profit at lease commencement, interest income on the receivable, interest income on the residual, variable payments, and short-term lease income.
• Information about variable lease terms, renewal options, and purchase options
• A reconciliation of the right to receive payments and residual assets (showing beginning balance, additions, payments or residual accretion, terminations, and ending balance)
• A maturity analysis of future rent payments, by year for at least five years with the remainder as a lump sum
• Information about how the lessor manages risks on the underlying asset

The boards decided that a lessor doesn't need to disclose:

• Initial direct costs
• The weighted average or range of interest rates on leases
• "Fair values" of the receivable or residual (a term of art that requires determining a market price for sale)

Sale/leaseback transition

• An existing sale/leaseback transaction that resulted in a capital/finance lease will continue to be accounted for with no adjustments.
• A sale/leaseback with an operating lease or with no recognition of sale would be reevaluated based on the criteria for transfer of control of an asset in the proposed revenue standard (which presumably will be finalized no later than the leases standard; its exposure draft was put out Nov. 14). If met, the lease would transition like other operating leases.

Additionally, the FASB clarified that an exception from lease accounting under EITF 01-8, applicable to certain transactions entered into before May 2003, will not be retained, and such transactions will need to be accounted for as leases under the new standard.

This month's boards meeting

On Oct. 19, the FASB & IASB again met to discuss the new lease accounting standard. In a marathon session (scheduled for 5 hours), they reached a number of decisions in several areas. (Note: in the discussion below, and elsewhere in discussions about this standard, "effective date" is the date companies must start reporting under the new standard, while "date of initial application" is the date, normally two years earlier for U.S. companies, as of which leases must be treated as capital once the new standard takes effect, due to the requirement to restate years shown as comparables in the annual report.)

Lessee transition

• All existing capital leases will be carried over with no changes required. Previously, they had planned to require restatement of capital leases with variable payments or renewal options that would be treated differently under the new standard. They decided the benefit wasn't worth the cost, because in most cases the differences would be small (particularly given recent decisions to reduce recognition of variable payments and options).
• The incremental borrowing rate to use for operating leases to be capitalized will be a single company-wide rate, not based on the individual characteristics of each transitioning lease.
• Operating leases can be recalculated using either a "full" or a "modified" retrospective methodology. The same methodology must be chosen for all leases. Full means going back to lease inception and calculating the lease as capital. Modified is different from what was in the original Exposure Draft; I described it last month. They have clarified that the difference between asset and liability generated by this method is to be booked to retained earnings (no P&L impact).
• The simplifications ("reliefs") mentioned last month were all confirmed: leases that terminate before the effective date of the new standard won't have to be restated, even if they start after the date of initial application; initial direct costs are excluded during the same period; and preparers may use hindsight to set up the leases.

Lessor transition

• Capital leases other than leveraged leases can be carried over with no adjustments.
  
• Leveraged lease accounting is eliminated. Such leases will have to be restated.
• Current operating leases will have a receivable and residual set up using the present value of the rents and expected residual value at date of initial application, the interest rate being the rate charged in the lease as of lease inception; the underlying asset is derecognized. Lessors also have the option of full retrospective application.

Lessor receivables held for sale

• A proposal to report receivables held for sale at fair value was rejected. While this would superficially be consistent with IFRS 9 and the FASB's Accounting for Financial Instruments project, it was felt that it added complexity, was inconsistent with the rest of the leasing standard, offered opportunities for structuring, and would add more variability in profit and loss. Instead, any gain or loss would be recognized when a sale of the receivable is completed.

Variable payments for lessors

• If the rate a lessor charges a lessee assumes "reasonably assured" variable lease payments will be made, the residual asset (which by default contains the value of those payments, since the value is not in the receivable) will be adjusted by recognizing an adjustment to the residual. The adjustment is the variable lease payment divided by the fair value of the underlying asset, times its carrying amount.

Lessor receivable and residual

• Investment property is excluded from the lease standard scope. This keeps those properties under IAS 40 for companies using IFRS. The FASB is working on a project to create the same standard for the U.S. (which presumably will be complete by the time the lease standard takes effect).
• Profit on the residual will not be recognized until the asset is sold or re-leased.
• The residual is initially booked at the present value of the residual. The value is accreted, with interest income recognized for the accretion, using the same interest rate as for the receivable.
  

Exposure Draft delayed to 2012

The FASB & IASB have updated their project schedules to indicate that the revised exposure draft (RED) will be released in Q1 2012. That's another delay of three months from what was expected when they announced in July that a RED would be released. The Equipment Lease and Financing Association is reporting that the comment period will be a full 120 days; there had been speculation that the comment period might be shorter the second time around. That means that the comment period won't end until near the end of Q2. With time for redeliberation, that suggests that the final standard won't be out until late in 2012.

It's yet the latest delay in an oft-delayed project. When originally announced back in 2006, the boards expected to be done in 2009. The latest delay could affect the implementation date; speculation recently has focused on 2015 as the implementation date, but given the planned requirement to restate the prior two years of comparable financials, that means there could be just weeks between the release of the standard and when (1/1/2013) leases will effectively need to be reported under it. During those two years until actual implementation, bookings will be done under current standards, but companies will need to make sure they keep complete information on their leases to enable recreating their accounting under the new methodology. Of course, with the active consideration of full retrospective accounting (though probably not to be required, just optional), it would be good to be keeping information right now on any leases that you expect to remain active into 2015. (It is expected that leases that expire before implementation won't need to be recalculated.)

The boards held a lengthy meeting this week on leases, but I don't have time to review the 5 hours of recordings, and my normal sources haven't yet posted summaries of the events.

Boards get back to work, timeline slips further?

When the FASB and IASB decided in July to prepare a second Exposure Draft for the proposed new lease accounting standard, they expected to finish all the loose ends in September and release the RED (Revised Exposure Draft) soon after. Oops, here we go again. The whole history of this new standard has been one of delays: when the project was announced in 2006, it was supposed to be completed in 2009.

Even before the meeting, the boards realized they weren't going to be able to do everything this month. (There was no joint meeting in August; it's not clear whether the month off was considered in their July timeline.) But the agenda for this month included the plan to bring "all remaining redeliberation issues to the boards in the October joint board meeting." Now Asset Finance International is reporting that the boards want more time to redeliberate the remaining issues, and that it might take until next February to issue the RED, with a final standard of course being several months after that (to allow time for public comment, then redeliberation). It's not clear what their basis is for this projection; the FASB's Technical Plan still has a Q4 estimated publication date for the RED (with the notation that this was updated 9/23/11), though it doesn't list any date for the final standard. However, some decisions due this month were either completely deferred or have loose ends dangling.

Decisions made at the Sep. 19 and Sep. 21 joint board meetings:

Scope - inventory
Some people had suggested that the right-of-use asset for a lease could in some cases also meet the definition of inventory, and would be subject to potentially conflicting standards. The boards decided that the situation doesn't really seem possible, and therefore there's no need to prepare guidance to distinguish.

Financial asset guidance application to lessor's right to receive payments
A major concern of the boards is keeping accounting consistent between different types of transactions. The lessor's right to receive rent payments could be considered a financial asset. The boards decided that such standards (specifically, IFRS 9, IAS 39, and US GAAP Topic 825) should not apply to regular measurement of the receivable, but would apply to impairment. This also confirms the previous decision that fair value measurement/revision is not permitted for the receivable.

Lessor impairment
For the lessor receivable, the impairment standard for the applicable GAAP environment (Topic 310 for U.S. preparers, IAS 39 for IFRS) applies. For the residual asset, IAS 36 and Topic 360 apply; for US preparers, this indicates impairment is handled in a manner congruent with property, plant, & equipment, rather than intangibles. This is basically the same as lessee treatment.

Lessor balance sheet presentation
Lessors will be required to report all their leased assets, both receivables and residuals, as a "Lease Assets" line in PP&E. Lessors may choose whether to separate the receivables and residuals in the balance sheet, or footnote the detail. Sublease assets should be shown separately.

Subsequent adjustments of variable rents, lessor
The recalculation of variable rent payments due to changes in a rate or index (such as changes in LIBOR or the CPI) can result in a gain or loss. That is to be recognized immediately in profit & loss, rather than being rolled into the asset (as is largely the case for lessees).

Lessor accounting for residual value guarantees
The boards agreed that a residual value guarantee would not be separately recognized (whether provided by the lessee or a third party). It would be taken into account in determining the value of the residual asset, including testing for impairment.

Lessor cash flow statement
Lease payments are classified as operating (not investing) activities. An exception was made, however, for cash flows related to securitized receivables, which would be accounted for under existing guidance.

Transition, lessees
The ED called for lessees to capitalize the remaining rents on all operating leases, with an equal asset and liability set up at the date of initial application. (Note: the effective date is when the standard takes effect; the date of initial application is the date, two years prior for most US companies, as of which leases have to be treated as capital for comparison purposes.) The problem with this for the income statement is that because it treats all (formerly operating) leases as new on the date of initial application, all of those leases will be at the beginning of the interest amortization curve, when the interest recognized is highest. This means that all lessees would face considerably higher expenses than rent payment as of initial application (with expenses dropping over time, as the principal is paid down and interest correspondingly declines).

It was recognized that this results in artificial swings in expenses. For a lessee with a mix of leases starting and ending roughly evenly from year to year, the overall lease expense profile should be relatively flat, even as each individual lease shows more expense in the early years and less in the later years.

In looking for ways to mitigate this, the staffs presented to the boards two alternatives:
1) full retrospective approach
2) modified retrospective approach (distinguished from the ED's "simplified retrospective approach")

Full retrospective is seen as theoretically preferable. However, it is recognized that for some preparers, this may be difficult to execute. One particularly challenging scenario is leases that have been acquired in a business combination, where the original information for the lease may no longer be available. Long-lived leases may have similar issues. Therefore, the staffs proposed a modified methodology, where the liability would be calculated as the ED specified (present value of remaining rents, using the incremental borrowing rate at the date of initial application), and the asset would use the same calculation back to inception, then recognize the fractional amount of the lease term remaining.

Transition example (provided in Agenda Paper 2G/203):
(Please note: I calculate slightly different present values, using an HP12C or Excel, than the agenda paper presents. In the example below, I list first their calculation, then my calculation in parentheses with an asterisk.)
10 year lease, payments of 1000 CU (generic Currency Units) yearly in arrears
interest rate of 5.7%
date of initial application: beginning of 5th year (i.e., 6 years remaining)

present value of rents at inception: 7,472 (*7,466)
present value of rents at application: 4,967 (*4,964)
asset at application: 7,472 * 6 / 10 = 4,483 (*4,479)

The difference between the asset and obligation would be taken as a "cumulative catch-up adjustment." I believe this would be booked directly to retained earnings, not recognized in profit and loss. Because of the way the interest method works, every lease (except possibly a lease that has lower rents at the end of its life) will book a charge to retained earnings to be set up, so the cost of reducing the impact to the income statement is increasing the impact on the balance sheet (debt/equity ratios will balloon even further). Pick your poison.

The boards, however, didn't pick their poison. They deferred the decision to next month, asking to combine the decision with transition rules for lessors and subleases.

The staffs also suggested a few simplifications: 1) leases that terminate between the date of initial application and the effective date would not have to be restated; 2) exclude initial direct costs for leases that start before the effective date; 3) allow use of hindsight in estimating such lease characteristics as variable lease payments, renewals, and impairment. These will be considered as part of the entire transition package.

This kind of continued change is why no software publisher can claim to be compliant with the new lease accounting standard yet. It's a moving target. But we'll update EZ13 once decisions are finalized; in the meantime, EZ13 allows you to treat operating leases as capital, either from inception or as of a specified cutover date as specified in the original ED, to estimate what your exposure is.

Catching up on June results

June 13 meeting results:

Short-term Lessee Leases

The boards agreed to operating lease accounting for lessee leases with a maximum lease term (including renewal options) of 12 months or less. No asset or liability need be placed on the balance sheet, and rent expense is recognized on a straight-line basis over the lease term. (Lessees may choose to do full finance lease accounting if they wish. How likely is that?) Disclosure of current rent and how representative that's likely to be of the future was discussed.

Subleases

A head lease and sublease are to be accounted for as separate transactions, using normal lessee accounting for the head lease and lessor accounting for the sublease (using the right-of-use asset as the fundamental asset for the transaction, not the original underlying asset).

June 1 meeting results:

Foreign Exchange Differences and Impairment

Both of these are to be recognized in accordance with existing guidance, which is somewhat different between FASB and IASB.

Residual Value Guarantees

The new standard calls for recognizing only the portion of any residual value guarantee that is expected to be payable, rather than the maximum amount. If there is a significant change in the expected RVG payable, an adjustment is required; the portion that applies to current or prior periods is recognized in profit or loss, while the right-of-use asset is adjusted for the portion applying to future periods.