Lease Accounting Changes Will Call for Software Systems Upgrades

by Madhu Natarajan and Joe Sebik July/August 2010
With an exposure draft expected this summer, lease accounting changes brought about by FASB and IASB convergence that once seemed distant are now becoming more and more real. It is therefore prudent for leasing companies to prepare for the expected impact to their policies, processes and software systems. At a minimum, lease management systems must be reviewed, modified and tested for compliance.

Just as we begin to emerge from one of the most significant recessions in history, the biggest changes to U.S. and international lease accounting since the mid-1970s, when FAS 13 and IASB 17 were issued, are on the horizon. Since 2002 the Financial Accounting Standards Board (FASB) in the U.S. and International Accounting Standards Board (IASB) in Europe have been working on various projects to converge certain standards of accounting on a global basis.

In 2006, the FASB and IASB jointly announced that one of the projects to be undertaken would be the reconsideration and convergence of the standards of accounting for leases. Much of the focus of these discussions since that time has been on lessee accounting issues. With the recent shifting of focus to the lessor side of the equation and the ensuing developments, it is very prudent for leasing companies to begin preparing for the expected impact to their existing accounting policies, credit decision processes and financial statements. At a fundamental level, the underlying lease management systems that manage their operations and accounting need to be reviewed, modified and tested for compliance.

An exposure draft of the new standard is anticipated to be issued in July or August 2010, with a four-month comment period. It is expected that final standards will be released during 2011 with tentative implementation starting in 2012. Based on the most recent joint FASB/IASB board meetings in April, May and June, the following is a summary of the key changes related to lessor accounting:

  • Lease transactions will no longer be “classified” as a direct financing lease, leveraged lease, sales-type lease or operating lease.
  • Lease transactions will be reported as a “sale and financing” (in essence a direct financing lease or a loan) under the “derecognition approach,” if the agreement:
    • includes an automatic transfer of title;
    • includes a bargain purchase option that is reasonably certain to be exercised;
    • is for a term that will cover the expected useful life of the asset and where any risks or benefits concerning the retained residual value are expected to be trivial or
    • provides for a fixed return or yield to the lessor.
  • Leases accounted for under the derecognition approach will follow the effective interest method. Any reassessment of the expected lease term would be treated as a new recognition or derecognition event, essentially derecognizing or reinstating a portion of its residual interest.
  • Lease transactions not treated as a “sale and financing” would be reported at the inception of the agreement under the “performance obligation approach” in the following manner:
    • The lease term will be the longest lease term that is “more likely than not” to occur, including as it may be, the contractual term of the lease plus or minus any term adjustment for early terminations or lease renewals meeting the “more likely than not” criteria.
    • The lessor will report a lease receivable asset equal to the right to receive rental payments, presented at the present value of the lease payments discounted at the rate the lessor is “charging” the lessee plus any initial direct costs incurred by the lessor.
    • The lease receivable will include amounts due under contingent rent arrangements and residual value guarantees provided by the lessee, if such amounts could be reliably measured.
    • Third-party residual value guarantees will be accounted for in accordance with accounting for other guarantees and presumably treated differently than lessee guarantees.
    • The finance income associated with the lease receivable will be recognized over the lease term using an effective interest approach.
    • The lessor will report a performance obligation initially equal to the lease receivable determined above.
    • The performance obligation will be recognized to income over the lease term in a systematic and rational manner based on the pattern of use of the underlying asset as the performance obligation is satisfied, generally under a straight-line approach.
    • A performance obligation that includes the anticipated exercise of a lessee purchase option will not include the recognition of the purchase option until the purchase option is exercised.
    • The lessor’s conclusion pertaining to the “more likely than not” characterization of the lease term or exercise of a purchase option will be reassessed at each reporting date and subsequent changes will act to adjust the lease receivable and performance obligation amounts, albeit using the original interest rate charged in the lease.
    • The lease components will be recorded at the inception of the lease, even if the commencement of the lease occurs at a future date.
    • The asset being leased will be recorded at cost and depreciated over the life of the asset, likely in a straight-line manner or in a systematic and rational manner based on the pattern of use of the asset.
    • Impairment to the lease receivable would be recorded as an adjustment to both the lease receivable and the performance obligation, with any difference reported in profit or loss.
    • Impairment to the leased asset will likewise be reflected as an adjustment to the asset value.
  • Further, lease transactions — treated under the performance obligation approach — will be subject to the following footnote disclosures:
    • Lessors must disclose the leased asset, lease receivable, initial direct costs and performance obligation separately in the statement of financial position, totaling to a net lease asset or net lease liability.
    • The lessor must disclose the effect of the difference between the contractual lease term and the lease term and amounts included when recording and accounting for the lease. For instance, if the lessor includes amounts for the exercise of a lease renewal or a purchase option based on the more likely than not criteria, the lessor must disclose these amounts separately to enable the reader to understand the nature of the estimates.
    • Lessors will be required to recognize and measure all outstanding leases as of the date of the initial application of the proposed new lease accounting requirements using a simplified retrospective approach by measuring the present value of remaining lease payments with an offsetting equal performance obligation. We believe that prior year balances presented in the financial statements would also be presented.
  • The materiality of the changes and system requirements are expected to create a substantial challenge to lessors and their lease management systems. The extent of modifications will depend on the particular systems currently being used, but the following is a list of potential changes and/or brand new functionality that may be necessary:
    • Since lessees will also be capitalizing leases, lessors will have to consider how restatements will affect existing credit criteria and score cards.
    • Additional accounting entries will be made for every transaction including for new leases, existing leases and previously “derecognized” leases.
    • Contractual terms and conditions of the lease versus the values recorded for financial reporting purposes will have to be tracked.
    • The “rate charged the lessee” must be captured and tracked, since the calculation of the implicit interest rate in the lease will no longer be required and information pertaining to the “residual value” as of the end of the lease term may no longer be relevant.
    • The initial direct costs will need to be amortized over the lease term using an interest methodology and the rate charged the lessee; this may mean rebooking previously recorded straight-line initial direct costs amortization under operating leases.
    • The lease will need to be recorded at the inception date even before the asset has been purchased with the subsequent ability to reclassify the performance obligation on the balance sheet from a contra-asset before lease commencement to a deferred income item (liability) after lease commencement.
    • The lease receivable and performance obligation will need to be recalculated based on actual changes in contractual terms of the lease as well as changes in the “more likely than not” determinations made by the lessor.
    • The income from the performance obligation will need to be recognized in a systematic and rationale manner (for example, other than straight-line) while also excluding the recognition of any income attributable to the estimated renewal options or purchase options until such options are actually exercised.
    • Changes in the estimate of the “more likely than not” characterization of contingent rental arrangement and/or lessee residual value guarantee will need to be differentiated and accounted for; such changes need to be allocated to a satisfied performance obligation (treated as revenue) and/or to an unallocated performance obligation (treated as an adjustment to the lease receivable and performance obligation balance).
    • Lessee-provided residual value guarantees versus third-party-provided residual value guarantees need to be separately tracked and accounted for since differences in their respective accounting may exist.
    • The multiple components of the lease and underlying asset need to be synchronized to ensure that the components are logically tied to the terms and conditions of the lease and the “more likely than not” decisions are made by the lessor; for instance, the asset should be depreciated to a value at the end of the lease to no more than the purchase option, if the purchase option is included in the lease receivable amount.
  • Final new standards will be adopted in the second quarter of 2011 and become effective as early as 2012. Enough is certain about the new accounting rules that lessors should get started analyzing their respective situation as soon as possible. Analysis should focus on answering the following questions:
    • What modifications will our system require?
    • What is the projected cost and time frame for making these modifications?
    • How will additional work associated with new requirements impact staffing and productivity?
    • What new training will be required?
    • What, if any, part of the modification costs is my company responsible for, and what is the responsibility of our software vendor?
    • Is our software vendor/IT staff capable and committed to delivering the modifications we require prior to the effective date?

The time and resources to perform this analysis will be significant and the cost to upgrade by making additional investment in existing software or new systems will need to be quickly incorporated into upcoming budget planning cycles for 2011 and beyond. In general, systems that employ a more configurable and flexible design (for example object oriented/templatized GL interface) should be able to support required changes in the least disruptive and most cost-effective manner.

The requirement for leasing software to be flexible and easily adapt to change will not end with the adoption of these new standards of lease accounting. Even more waves of change are on the way. As the FASB and IASB continue to work towards convergence, it is only a matter of time before U.S leasing companies will have to comply with the newly converged International Financial Reporting Standards and not merely U.S. GAAP. The impact of these new and ongoing changes on accounting policies and system requirements is an additional topic of discussion for another day.

Madhu NatarajanMadhu Natarajan is the chief executive officer of Odessa Technologies, Inc. Natarajan has been with Odessa since 1998 and brings extensive experience in software technologies, lease management and lease accounting. He has spoken on a wide range of leasing topics at various national and international forums. Natarajan graduated magna cum laude from Monmouth College with a degree in Computer Science and minors in Business Administration and Accounting.

Joe SebikJoe Sebik is a managing director of FinServ Advisors, LLC, an independent consulting firm that provides technical accounting and tax planning, transaction structuring and implementation support and consulting services to the leasing and financial services industry. Sebik is a CPA with over 25 years of leasing industry experience with major public accounting, banking and industrial leasing companies, has published numerous Accounting Policy and Practice reference texts for the Bureau of National Affairs and is a long-term member of the ELFA’s accounting committee.

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