The FASB/IASB jointly issued a discussion paper titled: Leases: Preliminary Views in March, inviting the public to comment by July 17, 2009. The paper is available on the FASB’s website, www.fasb.org. The project direction shifted to a point where much more will be capitalized by lessees due to capitalizing certain options and contingent rents. The impact to the industry will be far reaching if certain positions are not changed. Although the project is significantly behind schedule the boards still have 2011 as the target for issuance of the new lease accounting standard. The following is a synopsis of the discussion paper with my commentary in italics.

Scope and Overall Approach
The project will initially focus on the accounting for lease arrangements within the scope of existing lease accounting literature. The scope of the project will include arrangements that are leases in form but in substance are an acquisition of the leased asset. FASB/IASB decided not to exclude leases that are financings (where the rights conveyed by the lease contract are ownership rights). The boards do not plan to give any threshold for what might constitute immaterial leases, and do not plan to exclude short-term leases or leases of “noncore” assets.

The IASB decided to remove the existing requirement to classify a lease as a finance lease (in-substance purchase) or an operating lease. Thus, the same overall approach would apply for all leases. The FASB discussed whether there should be criteria to distinguish between leases that are, in-substance, purchases and leases that are a right to use an asset, and decided that the classification should potentially remain for lessor accounting (sales-type leases) subsequent measurement and presentation depending on feedback to the discussion paper from financial statement users and preparers.

The failure to recognize that there are leases that are financings and leases that merely allow a temporary right to use the asset is a major flaw as the economic effects on a lessee’s business between the two types of leases are very different.

The boards also decided on an overall approach that would apply the existing IAS 17 finance lease model, adapted where necessary, to all leases — meaning those leases that were capital leases and those that were operating leases under current GAAP. All material leases will be capitalized. The concepts behind the approach are:

Applying the existing finance/capital lease model to all leases means that all leases will be accounted for in the same manner. Specifically all will be accounted for as though the asset was purchased and financed with a loan. The P&L pattern of lease expense will be front-ended with straight-line rent expense replaced by depreciation and imputed interest. This will accelerate lease expense for lessees. The accelerated expense increases as the lease term increases, for example lease expense is higher by 7% in the first year of a three-year lease and 21% higher in the first year of a ten-year lease. The cumulative expense distortion in a ten-year lease reaches 63% in the fifth year of the lease term. The increase in expense is large.

The boards decided to defer the development of a new accounting model for lessors, but the boards decided to include a high-level discussion of lessor accounting issues in the discussion paper. This decision does not change the scope of the project.

The boards will have a difficult time defining sublease accounting rules not having included lessor accounting in the scope, but they think that they can’t finish the project by the 2011 deadline if the boards attempt to include lessor accounting in the scope.

Options to Extend or Terminate a Lease
The boards decided that the lessee should not recognize options to extend or terminate a lease or options to purchase the leased asset as separate assets. Instead, the assets and liabilities recognized by the lessee should be based upon the estimated lease term and the estimated payments (rent, renewals and purchase options).

This is a reversion to current GAAP for options where, as an example, a purchase option that is a bargain is considered a minimum lease payment.

The boards decided that the determination of the lease term should be a recognition decision. For example, for a ten-year lease with an option to renew for five years, the lessee must determine if it is recognizing a ten-year lease or a 15-year lease, and then the lessee would recognize a right-to-use asset and obligation to pay rentals at the present value of the expected lease payments over that term. For leases with renewal, termination and/or purchase options, the lessee would make a determination of the most likely lease term based on its own assessment of all contractual, noncontractual and business factors.

This is a reversion to current GAAP for the lease term where, as an example, if it was judged that there was a penalty if the lessee failed to renew, the lease term considered for classification was extended. In my opinion, the direction the boards are taking will cause more auditors’ judgment to be applied as the new rule will be more explicit than current GAAP.

Contingent Rentals and Residual Guarantees
The boards decided to develop a new approach for contingent lease payments and residual guarantees. FASB/IASB decided that the lessee is obligated to pay contingent rents and residual guarantees as part of the contract — the issue is how to measure the amounts.

The FASB decided that a lessee would measure contingent rentals and any residual value guarantees based on the lessee’s best estimate of the expected lease payments over the term of the lease. A lessee would determine its best estimate by considering the range of possible outcomes and the likelihood of each, but the lessee is not required to probability-weight the various possible outcomes in determining the expected lease payments. However, if lease rentals are contingent on changes in an index or rate, such as the consumer price index or the prime interest rate, the lessee would measure the contingent rentals using the index or rate existing at the inception of the lease in its initial determination of the best estimate of expected lease payments.

The IASB decided that a lessee would measure contingent rentals and any residual value guarantees based on an expected outcome (probability-weighted) calculation of the expected lease payments over the term of the lease.

Capitalizing estimated contingent rents is a major negative change as usage-based contingent rent is common in some equipment leases. Contingent rents do not seem to meet the definition of a liability, yet the decision is to estimate amounts and capitalize them.

Initial Measurement
The boards decided that a lessee should initially measure both its right-of-use asset and its lease obligation at their present value of the expected lease payments and that a lessee should discount the estimated lease payments using the lessee’s incremental borrowing rate for secured borrowings.

Subsequent Measurement
The boards decided that a lessee should amortize/depreciate the right-of-use asset systematically over the shorter of the lease term and the economic life of the leased asset, but for leases of items in which it is expected that the lessee will obtain title at the end of the lease term (but they don’t tell you how to determine whether the lessee will obtain title at the end of the lease), the amortization period would be the economic life of the leased item. Amortization would be based on the pattern of consumption of economic benefits embodied in the right-of-use asset. The lessee should apportion the lease payment between a finance charge and a reduction of the outstanding liability, with interest expense and amortization/depreciation presented on the income statement.

However, some board members of the FASB believe that there are differences between leases that are in-substance purchases and leases that only convey a right to use that may merit differences in the subsequent measurement or presentation. Accordingly, the FASB instructed the staff to include questions for financial statement users in the discussion paper to assess whether users believe that leases that are in-substance purchases should be measured or presented differently from leases that only convey a right to use.

This is a major issue; that is, it is important to have lessee accounting reflect the economics of an operating expense. Using sinking fund depreciation versus straight-line depreciation is a possible solution. It would cause the P&L to net to a straight-line pattern and it would cause the lease asset to have the same balance sheet value as the liability, that is, the PV of the remaining lease payments (economic reality). If the lease expense is front ended for accounting purposes it will create the need for lessees to account for deferred taxes as the IRS tax deduction for most operating leases is, and will continue to be, straight-line.

Re-measurements
The boards decided that a lessee would be required to reassess the lease term and its lease obligation using its current assumptions at each reporting date.

The boards decided that a lessee should subsequently measure its lease obligation at the present value of its current estimate of expected lease payments over the revised lease term. The FASB decided to discount the expected lease payment at the effective interest rate determined at lease inception. The IASB decided to discount the expected lease payment at the current interest rate. The IASB did not reach a view on whether the interest rate should be revised at each reporting date or only when there is a change in estimated lease payments.

The FASB decided that a lessee would recognize changes in the lease obligation through a corresponding adjustment to the carrying value of the right-of-use asset to the extent that the change arises from updated expectations about the lease term (for example, a revised assessment of the likelihood that the entity will exercise a renewal option) and through profit or loss to the extent that the change arises from updated expectations about the measurement of contingent rentals or residual value guarantees.

The IASB decided that a lessee would recognize all changes in the lease obligation through a corresponding adjustment to the carrying value of the right-of-use asset.

This is complex and burdensome, adding little value for our customers as most equipment lease terms are short, the dollar volumes are not high and the adjustments will be insignificant.

Presentation
The boards decided that leases should be presented separately from, but adjacent to, owned assets on the statement of financial position. Some FASB board members believe that leases should be presented as either in-substance purchases or right-to-use assets. The IASB decided that all leases should be presented based on the nature of the underlying asset.

The FASB decided that the obligation to pay rentals should be presented separately from other financial liabilities on the statement of financial position. The IASB decided that the obligation to pay rentals should not be required to be presented separately from other financial liabilities on the statement of financial position.

The boards think that the balance sheet treatment should drive the income statement presentation, thus they decided that no rent expense should appear in the income statement. Instead interest expense and depreciation/amortization are the lease expense, although some FASB members think that rent expense may be the appropriate expense for some leases (right-of-use leases).

The boards have not decided on the presentation in the cash-flow statement, however if the balance sheet treatment drives the cash-flow statement presentation, it is likely that a lease will be considered a capital expenditure and a financing for cash-flow purposes.

The theory that the balance sheet should drive the P&L and cash-flow treatment will cause the front ending of P&L expense and treat the lease as a capital expenditure and a loan for cash-flow statement purposes. This will not present the true economic effect of a lease rather the asset should amortize as the liability does, rent should be the expense and rent should be an operating cash outflow. The FASB/IASB should consider a new accounting approach for leases rather than try to apply existing theory from other similar transactions. The asset and liability in a true lease are linked as one and cannot be settled without the other being settled. Therefore the balance sheet values should be the same over time, absent impairment. If they come to that view then having the balance sheet drive the accounting will have logical results.

Lessor Accounting
The discussion paper included a high-level discussion of lessor accounting. It includes two approaches as possible models. One is a direct finance-like model where the lessor derecognizes the leased asset and records a receivable and residual asset as unearned income. The other approach is to leave the leased asset on the books but record a receivable being the lessor’s right to receive payments, and record an offsetting liability representing the lessor’s obligation to allow the lessee to use the asset. No clear details of revenue recognition are provided.

The second possible approach will double up on assets, which they discussed at one of their public meetings and seem to have no problem with it. It seems illogical.

Some board members think that sales-type lease accounting is appropriate for certain leases, but many don’t think so.

Unless they recognize that finance-type leases exist and that there should be a classification mechanism, there is a danger of losing sales-type leasing.

Regarding sublessor accounting, the boards discussed, but did not reach a preliminary view on, three possible ways of addressing how an intermediate lessor should account for the sublease. The boards could:

They are finding that the decision to split lessor accounting out of the project scope is causing major problems in the development of sublessor accounting as one cannot be done without the other. Their statements in the discussion paper on sublessor accounting are sparse and confusing.

There was no mention of leveraged lease accounting or adopting IAS 17 for lesser accounting.

The real danger is that they adopt IAS 17 for all lessors as a way to get lessor accounting converged by 2011. If they don’t do that, both IAS 17 and FAS 13 will have to be maintained as GAAP for just lessors that seems illogical.

Items Not Covered
The discussion paper did not include any decisions on timing of initial recognition, sale-leasebacks, initial direct costs, leases with service arrangements or disclosures.

Impact
The new developments in the Lease Accounting Project are a negative for the industry as:

Recommended Action
We should all submit comments to the FASB/IASB Lease Accounting discussion paper. The deadline is July 17, 2009. Your influence counts, so use it. If you don’t vote on this historic change, don’t complain about it when it is implemented.

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Bill Bosco is the principal of Leasing 101, a lease consulting and training company. He has more than 34 years experience in the leasing industry, with expertise in accounting, tax, structuring and pricing. He has product development and strategic marketing experience as well. He has been on the ELA accounting committee since 1988 and was chairman for ten years. He is a frequent speaker and author of articles on leasing issues. Bosco has been selected by the FASB/IASB to be a member of the Lease Accounting Project Working Group. He can be reached at [email protected].