Lease Accounting: FASB/IASB Project Update
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have completed their re-deliberations on the Lease Project with two recent meetings during which they made key decisions. The FASB/IASB staff is now in the process of writing the new exposure draft (ED). This article presents a timetable, project summary and implications of the key decisions made at the last two meetings. The news is not good for the equipment leasing industry, but there is hope for a better result if comments received are significant enough to change their minds.
The likely timetable is as follows:
- New ED issued Year End 2012
- Comment letter period March/April 2013
- Review comments Through 2013
- Issue new rule 2014
- Transition date 2017
The timeline can be shorter or longer depending on the amount and nature of the comment letters and the degree to which the boards see fit to re-deliberate and change decisions. Of course the number and quality of comment letters depend on the equipment leasing industry and its customers.
Key Decisions and Implications
At their June meeting the boards decided that certain leases should record lease expense as rent expense, now called Single Lease Expense leases (SLE), and other leases now called Interest and Amortization (I&A) leases should record lease expense on a front-ended basis with imputed interest expense on the capitalized lease liability and amortization expense of the capitalized right of use (ROU) asset. This decision was a political decision needed to break a deadlock as the IASB had been refusing to allow a straight line cost recognition pattern. They reintroduced risks and rewards-based classification tests that surprisingly are different for real estate and equipment leases that apply to both lessees and lessors. The new tests are as follows:
- For equipment leases it is presumed that the lease is an I&A (front-ended cost) lease for lessees and an R&R lease for lessors, unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset. The new tests are vastly different, in a negative way, than under existing GAAP and for legal and tax purposes causing more equipment leases to have front-ended costs and causing equipment lessees to still keep records under the existing rules for tax compliance purposes. This is the major advocacy issue for our industry. Because of the forced symmetry in lessee and lessor lease classification, equipment lessors will have fewer operating leases, which is good news for financial lessors like banks, but not as good for operating lessors like full-service lessors.
- For real estate leases it is presumed the lease is a SLE (straight line method) lease for lessees and operating leases for lessors, unless the lease term is for the major part of the economic life of the underlying asset, or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset. This line is virtually the same as the line under existing GAAP, so the real estate industry and its customers will be happy and likely will not comment strongly against the new ED or possibly not comment at all.
This decision ironically means that except for equipment leases, the project is re-adopting most of the lease classification concepts of FAS 13 that had been rejected as the “old” way of thinking. Remember that leases, which meet the definition of a sale under their Revenue Recognition Project, that is, where the lease transfer control of the asset through a transfer of title or bargain purchase option, are not considered leases. It is important for lessors to understand the issues behind the decision to have symmetry in lease classification for lessees and lessors. If the equipment leasing industry wins the argument that equipment leases should be treated the same as real estate leases, there will be more operating leases for financial lessors and fewer sales-type leases for captives and dealers.
The major advocacy issue for lessors is to have the lessor’s business model define its accounting method so financial lessors would use the Receivable & Residual (R&R) method (very similar to current GAAP direct finance lease accounting) and operating lessors would use the existing operating lease method. As a result, their financial statements would reflect the economics of their respective businesses.
At their July meeting, the boards decided how to change previous decisions on presentation, disclosures and transition to adjust for the inclusion of SLE leases in the proposed standard. Most of these decisions were to tie up small issues, but there are three outcomes of note. First, the current GAAP presentation rules show rent expense and cash paid for rent in the P&L and cash-flow statements, which are key information for many readers of financials, but under the proposed rules those numbers will have to be derived using information from various places in the financials and footnotes.
Second, current GAAP presentation and disclosures of capital leases versus operating leases allow readers to understand which leased assets are owned and which lease assets and liabilities survive bankruptcy, but those amounts will not be available under the proposed rules. Last, the transition rules for I&A leases require complicated lease-by-lease retrospective calculations and they will apply to most equipment leases that are small dollar value contracts but large in number. One of the board members pointed out that at outreach meetings two large lessees said they had over 80,000 and 110,000 leases respectively.
At the July board meeting, the final discussion was on whether the individual board members would dissent. Five board members said they would dissent and one said he might dissent. Notably two of those who will dissent are former analysts, and the prime stakeholders the project is designed to satisfy are analysts/users of financials. Some of the reasons cited for board members’ dissent were:
- The financial reporting benefits of giving analysts all the important information they need are not achieved. Specifically, analysts will not have rent expense or cash paid for rent without analysis of footnotes and calculations.
- The costs of compliance are high, especially considering the questionable benefits. Variable lease payments are not capitalized.
- They prefer a simpler one lessee lease model.
- Lessor accounting may conflict with Revenue Recognition rules regarding licenses of intangibles.
- The exceptions in the tentative decisions means the standard does not follow the principles established for accounting for the lease contract rights and obligations.
- The standard requirements are too complex.
- Lessee/lessor symmetry is not necessary.
- There is no conceptual basis for allowing straight line expense and the decision was made merely to gain convergence.
In its current state, the standard is unsatisfactory. Although it does capitalize operating leases as the SEC report in off balance sheet arrangements recommended, it changes lessee accounting in ways that have high compliance costs, provide less key information regarding operating leases for lenders/analysts and tax compliance, and ignores their economic effects, legal treatment and tax treatment. It does not improve lessor accounting; in fact, the failure to follow a business model approach and the elimination of leveraged lease accounting and its tax affected accounting (treating tax credits as revenue) mean that the economics of leases to lessors will not be reflected in their financial results.
My personal recommendation considering the dissenting board members’ views is to retain the basic structure and principles of FAS 13 but:
Find a way to justify SL P&L when discounting the payments when capitalizing the lease. One alternative idea that would balloon balance sheets but is simple is to capitalize operating leases for lessees at the undiscounted sum of the lease payments so that the idea of an interest component to lease expense is eliminated. The lease cost would be the straight line amortization of the average of the lease payments. Present the undiscounted ROU asset and obligation as separate balance sheet items so that readers know they are not owned tangible assets nor are the liabilities debt or interest bearing.
Improve lessor accounting by changing the FAS 13 classification tests for lessor to the business model approach and retaining leveraged lease accounting or at least including tax credits in the recognition of revenue.
In the end, the content of the final rule will depend on the quality and quantity of comment letters submitted by the equipment leasing industry and its customers. m
Bill Bosco is the principal of Leasing 101, a lease consulting company. Bosco has over 36 years experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the EFLA accounting committee since 1988 and was chairman for ten years. He is a frequent author and speaker on leasing topics. He has been selected to the FASB/IASB Lease Project working group. He can be reached at firstname.lastname@example.org, www.leasing-101.com or 914-522-3233.