FASB Meeting on Lease Implementation Issues: Results Are a Bad Omen
by Bill Bosco January/February 2017
Bill Bosco reports on the FASB’s first meeting on Leases Topic 842, which concerned a consequential lessor classification issue. Although this issue results in bad accounting practices, Bosco is concerned because the board seems unwilling to resolve the issue through a revision of the standard.
The FASB had its first meeting on Leases Topic 842 implementation issues at the end of November. The FASB staff has been receiving questions from many parties and they teed up four issues for the board to discuss. Three of the issues, more important to the real estate industry, were not very consequential to the equipment leasing industry, but one issue raises some serious questions and the discussion set an ominous tone for future issues. The FASB took no action on any of the issues but, in my opinion, one unaddressed issue needs attention.
The issues of little consequence to equipment leasing were:
For lessees, should an operating lease that was part of a prior period impairment of an asset group be re-opened and allocated to the operating lease? In keeping with efforts to keep transition and implementation simple, the decision was no. This, in my opinion, was a good “no action needed” result.
For lessees, in testing for impairment, should the imputed interest component of the lease payment be included as a cash outflow? The board decided to allow the preparer to set their own policy to do it either way. In my opinion, this was the right decision.
For lessees, how should the lease term of a head lease be evaluated when the terms are the same as the sublease? The board decided to allow current practice, which is to include only options controlled by the lessor and the clarity of the guidance at 842-10-30-1(c). In my opinion, this was the right decision.
The consequential issue concerns lessor classification. There are alternative energy transactions with variable payments based on performance, and the lease term is for a major part (75%) of the asset’s useful life. The result is a transaction classified as a sales-type lease, yet as the payments are variable, they are not lease payments to be booked by the lessor. This results in writing off the asset and a day-one loss, which does not reflect the economics of the transaction, since sufficient usage to create lease payments that will result in a profit is demonstrable.
The board heard this previously as a sweep issue but did not deal with it prior to the issuance of the standard. At the time, the board was unsure if it affected real world transactions by a significant amount. Now the board is finding this is a significant issue for certain leased assets, particularly in the renewable energy space. One board member suggested that the lessor should structure the deal as a sale to avoid the day-one loss, which shows the board does not understand these leases are structured to maximize tax benefits for the lessor who then passes the benefit on in the form of lower rents. A change in the structure changes the economics in an unfavorable way.
This issue exists in current GAAP. Today, lessors generally account for leases with significant variable payments as operating leases in accordance with paragraph 840-10-25-42(b). This provision precludes sales-type or direct finance classification as there are important uncertainties. The rule states: “No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.” This item was not carried forward to Topic 842.
This is an acceptable outcome under current GAAP, since the variable rents recognized as incurred would match the depreciation expense of the operating lease asset. The problem is, the board did not retain this clause in Topic 842, despite its objective of keeping lessor accounting unchanged. The IASB version does not have this issue, as it carried over the risks and rewards classification tests as-is from current GAAP.
The core issue is Topic 842 uses certain concepts in the new revenue recognition standard, Topic 606, for lessor accounting but does so in a way that leaves gaps in the literature. Under Topic 606, the probable variable payments could be recognized as receivables, which Topic 842 does not allow. The IASB version does not have this issue since it did not conform lessor accounting to its revenue recognition standard.
We now have a standard with some flaws due to the mixing of Topic 606’s control approach with the traditional risks and rewards model in leasing (Topic 842). When discussed at the meeting, the board acknowledged the conflicts but decided not to fix the flaw. They certainly have the power to carry over the topic 840 clause or conform 842 to 606 for probable payments. Three of the board members were in favor of a fix as they recognized that the existing rules result in a day-one loss that does not reflect the economics of the transactions and realized the control versus risks and rewards conflict.
I always thought Topic 842 should stand alone from revenue recognition as a “broad transaction” due to the uniqueness of lease accounting and lease structures. The majority’s view to stay with the existing guidance under Topic 842 was principally grounded on preserving symmetry in the accounting for variable lease payments between lessee and lessor, which arose from the decision made to exclude variable lease payments from capitalization. This decision, which led to board members’ dissent to the standard, was controversial. However, as a board member pointed out in the discussion about preserving symmetry, in today’s purchase sale accounting, such as a transaction where one party sells an asset to another for variable consideration, only the seller — not the buyer — accounts for variable consideration at the time of the sale. Therefore, a change to the leasing literature would only improve the comparability of lease and purchase transactions.
Fixing Bad Accounting
I see a major problem, but the other four board members said the rules are clear and they would not change them. They even said this request was a result of stakeholders disliking the answer and asking for a reopening of deliberations. One board member said he dissented because of the treatment of contingent rents, so he would not vote to redeliberate. It almost sounded like he did not accept responsibility for the new standard because of his dissent. In my opinion, all board members, regardless of dissent, should correct issues where the accounting does not reflect the economics.
This issue is not a question of disliking an answer; it is a question of fixing bad accounting. The four board members who would not agree to fix the issue said they did not want to open up the process to all who did not like the answers from Topic 842. They did not want to give the impression that it was “open season” for changing what stakeholders do not “like.”
The outcome of the discussions on this issue was very surprising. While the board was willing to consider the practical issues arising from the standard, as long as they could be addressed in a public meeting, it conveyed a clear message that the core standard was done and no more actions would be taken to fix issues through a revision of the words contained in the standard.
Some of the problem may be due to changes in the composition of the board. There seems to be a line of professional accountants on one side that see the issues in financial reporting problems and the need to fix them differently than the balance of the board. Previous boards continually entertained questions and issue related to FAS 13. There were more than 50 changes to FAS 13 through new standards, FINs, FTBs and EITFs to deal with issues that arose from new structures or other improperly addressed items.
In all of my interactions with the board, I have taken a high-ground approach of only arguing to improve financial reporting. Although the board previously agreed that the FASB staff should continue to interact with stakeholders on Topic 842 issues, it does not seem open to addressing issues that require a change to the rules.
Leases can be complex, and structures change as the business world reacts to changes to tax laws, technology and innovation. When preparers implement new rules, uncontemplated issues will inevitably arise. In my opinion, the board has a deliberated and done attitude. Accounting rules are not static; they are hard to get right, and possible changes should be addressed with an open mind to keep financial reporting as meaningful to users as possible.