WLN Columns

The IASB/FASB Boards React to Feedback

After receiving over 750 comment letters and conducting numerous roundtable discussions and field studies worldwide, the IASB and FASB (the Boards) are making significant changes to their previously issued August 2010 exposure draft on proposed new rules for lease accounting. To be sure, operating lease payments (except for leases less than 12 months) will still be reflected on a lessee’s balance sheet, but the previously proposed guidelines around how to measure the leased asset and liability (by both lessees and lessors), how lease expense and income will be recognized, and even what meets the definition of a lease, has been revised during the Boards’ deliberations since the beginning of this year.

While many respondents agreed with (or at least acquiesced to) including operating lease payments on the balance sheet, many also believed the proposed rules to be too complex and unworkable. Of particular concern was the Boards’ proposed definition of the lease term for accounting purposes which would require companies to make a judgment about the longest lease term that was more likely than not to occur. And a requirement to reassess that judgment was mandated if facts and circumstances changed throughout the life of the lease. The Boards have now tentatively decided that the lease term would include the non-cancellable period plus any options for which there is a significant economic incentive to extend or not terminate the lease. This revised definition is more in line with the concept used in current accounting for defining lease term though some measure of judgment is still inherent in the assessment. The Boards did retain the requirement to reassess the term, but only if there is a significant change to the factors relevant to determining if a significant economic incentive exists.

Another significant area of relief is the Boards’ change in its view of measuring variable lease payments, including contingent rentals, term option penalties and residual value guarantees. The exposure draft would require companies to determine the asset and liability to be reflected on the balance sheet using an expected outcome technique, which is a method that uses the probability-weighted average of the present values of the cash outflows for a reasonable number of outcomes to estimate the expected amount. Responding to significant criticism relating to the level of effort and reliability of this approach, the Boards retreated on this point and are substantially back to where current accounting is today. That is, contingent rentals that are based on performance or usage would be recognized when incurred. Contingent rentals based on an index would be measured using the spot rate.

In what may be the most surprising change, the Boards have agreed that from an income statement perspective there are two types of leases, those with a significant financing component – finance leases, and those without a significant financing component – other-than-finance leases. And it appears that the guidance for distinguishing between the two types would be very similar to today’s US GAAP without the bright lines (e.g., “major part” of economic life versus 75% and “substantially all” of the fair value versus 90%). The current expectation is that the Boards will provide indicators of a finance lease similar to those found in IAS 17, the current international standard for lease accounting. Leases classified as finance leases would be accounted for similar to the model proposed in the August exposure draft, with the liability accounted for under the interest method and asset amortized over the lease term; whereas the expense for other-than-finance leases would be accounted for similar to operating leases under current lease rules, on a straight-line basis where the liability would be amortized on the interest method but the asset would be reduced by the difference between the straight-line rental amount and interest expense. The amortization of the asset and interest expense in an other-than-finance lease would be presented in the income statement as a single line item such as rent expense.

Of particular interest to those involved with leasing real estate, and assets that also include the delivery of service and other elements, the Boards are proposing to refine their views of how to separate non-lease elements from the lease accounting model. This is of particular importance as items that are ascribed to lease elements will be on the balance sheet, whereas those that are not considered lease elements are typically accounted for as off balance sheet executory contracts. Under the exposure draft, where items cannot be separated, all of the payments would be included with lease payments and capitalized on the balance sheet. The exposure draft prescribed that both lessors and lessees look to the proposed rules relating to revenue recognition to determine which elements would be distinct and accounted for outside of the lease model (i.e., not required to be included as part of the on balance sheet lease payments). If the service or other element being provided did not meet the criteria to be considered distinct, it would be accounted for as part of the lease. Real estate lessees were particularly concerned with this proposed guidance as it appeared to result in a conclusion that certain executory costs paid by lessees, such as property taxes, were not distinct and would be subject to capitalization with the lease payments. The Boards recently decided that, for contracts that contain both lease and non-lease components, all non-lease components, including services and executory costs, would be separated from the lease components. Executory costs have not been defined but, consistent with current guidance, would likely include insurance, maintenance and property taxes. Companies would not be required to consider whether these are distinct in determining lease payments to be capitalized.

The Boards also determined that lessors would apply different guidance from lessees in separating lease and non-lease components. Lessors would allocate payments on a relative selling price basis. Lessees would use a relative purchase price basis, assuming the purchase price for each component is observable. For lessees only, the Boards agreed that a lessee could use a residual method in allocating its total payment. That is, if a lessee can determine an observable purchase price for one component, they can assume the remainder applies to the other component. If there are no observable prices then, consistent with the exposure draft, a lessee would be required to consider all of the payments under the lease model and capitalize the present value of the total on its balance sheet.

The Boards also further clarified their views around the definition of a lease and what constitutes control over the use of an asset such that it is likely that certain contracts considered leases under current standards would no longer be leases under the new proposal. In particular, an arrangement where a customer has the ability to both direct the use of the asset and receive the benefit from its use would be the subject of a lease. An arrangement where a customer obtains all of the use of the asset, but does not direct its use would only be considered a lease if the asset is separable from the services provided. The Boards agreed to provide additional guidance for identifying when an asset is separable using an approach consistent with guidance developed as part of the revenue recognition project.

Other items that the Boards have discussed are: 1) The removal of the provision excluding leases that are in-substance purchases and sales from the scope of lease accounting. They will now be included. 2) Change in recognition of a sale in a sale-leaseback transaction from the previously restrictive criteria of current rules relating to sale-leasebacks of real estate to the rules for sales treatment under the proposed revenue recognition guidance. This would likely result in many more transactions qualifying as sales than current guidance. 3) Short-term leases (those with maximum terms of 12 months or less) may be reported similar to current operating lease accounting. 4) Decision to include tenant incentive allowances as a reduction in the lessee’s right to use asset. 5) Additional clarity would be provided relating to the appropriate discount rate that should be used by lessor and lessees and that the rate will be set at the commencement of the lease (the date the lessor makes the asset available for use by the lessee).

Many other important issues have yet to be addressed, including more detail around the changes to the lessor model, as well as lease modifications, subsequent measurement, leasehold improvements, subleases, transition and disclosure. The Boards have not yet discussed whether they will re-expose a revised proposal before adopting a final standard. However, they have recently announced that there would be a delay of “a few months” in their original second quarter 2011 target date for the issuance date of a leases standard and other top priority projects. Stay tuned, as there will be more to come on this project over the next several months.