WLN Columns

Proposed new lease rules – where are we now?

As 2011 comes to a close with no final rules for lease accounting, nor a second exposure draft (“ED”) expected to be issued until perhaps the second quarter of 2012, many are wondering whether this project will ever be promulgated.   As a result of the extensive number of comment letters (approximately 800) on the first exposure draft and extended outreach by both the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) (“the Boards”), the re-deliberation process has been lengthy and at times circuitous.   But do not take the lengthy re-deliberation process or the announced issuance of a second exposure draft as a sign that operating lease liabilities will not be required to be reflected on a lessee’s balance sheet.  Those who have been following the project closely note that the proposed model for lessee accounting has remained largely unchanged since this past July and continues to call for virtually all leases to be recorded as a right of use asset amortized on a straight line basis and a lease liability amortized on the effective interest method.  Recent deliberations have focused on the lessor accounting model and transition issues to assist in making the one-time implementation adjustment less onerous for lessees and lessors.

The basic lessor approach agreed upon by the Boards is a model referred to as the “receivable and residual” model.  In summary, this model requires a lessor to derecognize the underlying leased asset and replace it with a rent receivable and residual asset.  If the present value of the rent payments is greater or less than a portion of the carrying amount “sold,” gain or loss is recognized at lease commencement.  The cost basis of the portion sold is determined by dividing the present value of the lease payments by the fair value of the underlying asset and multiplying that proportion by the asset’s current carrying value.   There is no gain recognized related to the retained residual as it remains on the balance sheet at its allocated cost basis with any inherent profit “deferred”.  This treatment is a significant departure for those manufacturers or dealers that sell their products through sales type leases.  For financial institutions and leasing companies that typically purchase the to- be- leased asset at fair value, the proposed receivable and residual model is substantially similar to today’s accounting for direct finance leases.   The following example illustrates the lessor model where fair value is in excess of the lessor’s carrying value:

Lessor example:

A lessor manufactures a machine for $7,500 with a fair value of $10,000 and enters into a 3-year lease with annual rent of $2,400 paid at the end of each year. The expected fair value at the end of the lease term is $4,770. The present value of the lease payments and expected fair value of the underlying asset at the interest rate implicit in the lease (approximately 7.9%) are $6,200 and $3,800, respectively.

^A                Calculated either as difference between the gross residual and the residual asset ($3,800 – $2,850) or as the profit not recognized ($2,500 – $1,550)

^B                Initial measurement of residual asset: $2,850 = $7,500 – $7,500 * ($6,200/$10,000)

^C                At commencement: $1,550 = $6,200 – ($7,500-$2,850). Represents 62% of total profit.

^D                Calculated using the rate the lessor charges the lessee (7.9%)

Lessors that own investment property will not follow the receivable and residual model.  Investment property within an investment property entity, as discussed in the October Exposure Draft, “Real Estate Investment Property Entities” (“Investment Property ED”), is not within the scope of the lease project and is required to be accounted for at fair value.  The Investment Property ED would define  “Investment Property” to include property improvements or integral equipment which is held for investing purposes rather than for its own use in the production or supply of goods or services or administrative purposes, or the development for sale upon completion.

For Investment Properties that are not within an Investment Property Entity and  as a result do not qualify for fair value accounting under that guidance, the Boards were concerned that the application of the receivable and residual model would be cumbersome in situations where there are multiple tenants and varying lease terms.    Consequently, the Boards decided that Investment Property not carried at fair value would apply accounting similar to present day operating lease accounting.  However, by addressing this exception to all Investment Property (and not just multi-tenanted Investment Property) not held by an Investment Property Entity, it appears to apply in situations where there may be a single tenant and not apply in a situation where a primary reason for investing is the delivery of services or output.  Because there was some diversity in views among the Board members as to what properties may or may not fall within the proposed definition of Investment Property as described in the Investment Property ED, the Boards agreed that they would likely need to adapt the Investment Property definition within the context of the lease guidance itself in order to ensure that the appropriate properties would be included and excluded from this scope exception to the receivable and residual model.

In response to preparers’ concerns that the transition rules proposed in the August 2010 ED were overly burdensome and caused a front-end loading of expense for lessees and income for many lessors, the Boards have provided additional alternatives with respect to transition.  The ED provided that companies would be required to apply a simplified retrospective approach to all existing leases (except capital leases with no renewal or purchase options).  A simplified retrospective approach requires lessors and lessees to determine the appropriate remaining lease term and lease payments as of the opening comparative reporting period and discount the payments at the original implicit lease rate for lessors and the incremental borrowing rate at the transition date for lessees.   It also requires lessors to determine the fair value of the residual as of the transition date.  In an effort to make the transition easier, the Boards have agreed that companies may apply a modified retrospective approach which will permit the use of hindsight in making transition date assessments and assumptions.  Additionally, in an effort to lessen the impact of the front-loading effect on the income statement caused by the application of the effective interest method, the Boards have tentatively concluded that a lessee may recognize a right-of-use asset equal to the proportion of the liability to make lease payments at lease commencement calculated on the basis of the remaining lease payments.  This decreases the right of use asset at transition in comparison to the lease liability and lessens the amount of straight line amortization that will be required over the remainder of the term.   This adjustment will better reflect what the amortization of the right of use asset would have been had a full retrospective method been applied.  And companies that want to apply a full retrospective approach where all leases that exist at transition are recast as if the new rules had been in effect at original commencement will be permitted to do so.  Lessors with large portfolios of numerous leases may decide that determining the fair value of each residual as of the transition date is too cumbersome and elect to apply a full retrospective approach.   Lastly, existing finance and sales type leases of lessors and capital leases of lessees will not be required to be remeasured.

The Boards had expected to complete their redeliberations in 2011 and to publish a second Exposure Draft in the first half of 2012 with a final standard expected in late 2012 or early 2013.  However, at their most recent joint meeting in December, the Boards agreed that further discussion will be necessary regarding the definition of Investment Property to determine which leased assets will be scoped out of the receivable and residual model.  The FASB and IASB staff also noted that at a future meeting they plan to present additional feedback raised by constituents relating to the application of the proposed lessee model.   As previously announced, the final standard will include a requirement to show the impact on the financial statements with prior periods presented under the new rules as a comparison.  For example, if there is an effective date that is for years beginning after January 1, 2016, for purposes of preparing the financial information reported for year-end 2016, a calendar year public company would recognize in its 2016 financial statements lease-related assets and liabilities on its balance sheet as of January 1, 2014. Based on this expected timing, companies with significant lease activities that haven’t already should not wait to begin inventorying their leases and analyzing the effects that the proposed lease model will have on their businesses.