The FASB/IASB held a joint meeting regarding the Leases Project on March 18 and 19, 2014. It was a pivotal meeting as the boards appear to be split; there are also prospects of a non-converged project. The direction the FASB appears to be taking is good news for the vendor leasing segment of the leasing industry and its customers. The FASB has listened to the industry feedback and is moving back to many of the concepts in current GAAP. The IASB seems stuck in its views that all leases are the same and will not accept negative comments that, as an inconvenient truth, are in the majority. I have to caution you that what I am reporting is the apparent direction the project is taking, but it’s not over ‘till it’s over, so things may change.
The boards remain at odds on the key issue of how lessees should account for all leases once leases are recognized on balance sheet. The debate is over using one method (capital lease Type A accounting) to account for all leases (favored by the IASB) or using two methods, which would retain current GAAP’s distinction between capital and operating leases for expense purposes (favored by the FASB). Under this approach, the former operating leases, although capitalized, would retain straight line rent expense accounting.
The two boards are also at odds as to whether to extend lessee exemptions for small leases and leases of non-specialized assets, and they differ on the approach to lessor accounting, but are much closer on that topic (and are closer to a converged answer) than they are on lessee accounting. Most importantly, they agree that lessor accounting is not broken, so the current framework will be retained with some tweaks.
They differ on how a dealer or manufacturer lease would qualify for sales type lease accounting. The FASB favors allowing sales type lease accounting only if the lease transfers control (as defined by their Revenue Recognition project) to the lessee; the IASB favors current GAAP which allows sales type accounting if substantially all of the risks and rewards in the asset are transferred by the lessor. The FASB approach would significantly reduce the number of sales type leases.
The boards will continue to work towards a conclusion of the project, but it appears they may end up with important differences. We may see two standards issued that are converged for day one lessee accounting — that is that all leases are capitalized — but not converged on subsequent accounting for lessees, with exemptions for certain small non-specialized asset leases. I certainly would like to see the FASB issue a separate standard as they have listened to our comments. The next step will be for the boards to meet again, but no date was set for a meeting.
FASB and IASB agreed that current lessor accounting was not in need of significant overhaul. This is very good news for vendor lessors. Specifically, there would continue to be two types of leases for lessors — finance and operating leases with classification based on a risks and rewards analysis. Both boards propose changing the classification tests to be more in line with IAS 17 (FAS 13’s criteria without “bright lines”). The classification tests/criteria (taken from IAS 17) proposed are:
A lessee would effectively obtain control of the underlying asset when any one of the following three criteria is met at lease commencement:
Both boards propose to continue to use existing direct finance and operating lease accounting. This is good news as it means no significant systems changes.
They have not gotten into the details as to whether third-party transactions, like residual insurance or residual guarantees, will impact the present value test so that a lessor might convert an operating lease to a direct finance lease. Hopefully they will carry forward current practice.
Another possible good news item for vendor and third-party lessors may be that U.S. captives may be less willing to keep leases for their account that do not result in sales type up front gross profit accounting. Rather they may use a vendor lessor or sell their leases to a third party lessor to recognize the gross profit immediately.
Classification
The objective of our vendor leasing customers will continually be to have the lowest capitalized present value of the payments under the lease. They will also want the leases to qualify for operating lease accounting, even if capitalized, as it is simpler than capital lease accounting and the average rent is the (level) expense versus a front loaded expense pattern for capital leases. The concern here is how the proposed IAS 17 based tests will be applied. It will be good news if the auditors continue to use the FAS 13 bright lines (90% present value and 75% useful life) as a guide for their judgment. If not, it may mean having to take more residual risk to achieve operating lease classification for customers.
Short Term and Small Ticket Exemptions
The FASB does not favor granting any exemption to capitalizing leases except for short term leases. The IASB is looking for a to-be-defined exemption for small ticket, non-specialized asset leases due to pressure to limit the amount of operating leases to be capitalized. Both boards are looking to reduce the complexity and compliance burden for lessees.
The FASB and IASB decided the definition of short term for an exemption is a term of 12 months or less while including only renewal options that rise to the level of creating a “significant economic incentive” to exercise. Formerly, they had decided that any renewal must be included in the term used to qualify as a short term lease. This is good news as more leases will qualify for the short term exemption from capitalization. They also decided not to reassess the lease term unless there is a lessee controlled event that causes an option to be considered a minimum lease payment. This significantly reduces the compliance burden for lessees.
Caution
As a word of caution regarding the use of interim rents – the fact that all payments, including interim rents, will be capitalized means the lessee will better understand the impact of an interim rent. Under current practice, interim rents are generally ignored when performing the 90% present value test. That will no longer be the case.
The center-of-the plate customers for our industry are the small- and medium-sized companies that are capital constrained. They lease because you provide 100% financing of the use of needed assets while delivering a fixed rate level payment that presents values to less than the cost of the asset. In addition, the lease obligation is not debt and the rent expense is in the operating budget. They have debt limit covenants and have limited ability to borrow to buy.
I continue to be optimistic, as I believe the FASB will not agree with the IASB on the key lessee issues that will cause the FASB to go its own way. The industry has made a difference as the FASB has changed its mind based on our comments. We cannot ease up on following and commenting on the project as we still need to make sure capitalized operating leases are presented separate from other assets and debt to reflect their substance in lessee financial statements.
In my opinion, the project will be completed in late 2014 with an implementation date of no sooner than 2017.
Bill Bosco is the principal of Leasing 101. He has more than 37 years of experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the ELFA accounting committee since 1988 and was chairman for ten years. He is a frequent author and speaker on leasing topics and has been selected to the FASB/IASB Lease Project working group. He can be reached at [email protected], www.leasing-101.com or 914-522-3233.
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