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Lease Accounting

by Bill Bosco March/April 2011

As things continue to heat up on the lease accounting front, Bill Bosco is here to remind leasing industry stakeholders to take an active role in having their collective voices heard by the accounting boards. Having received a flood of negative input to the recent Exposure Draft makes a difference … and with an April deadline looming, time is of the essence.

As that noted leasing expert Yogi Berra said, “It’s not over ‘til it’s over!” The accounting Boards (FASB and IASB) received 781 comment letters to their Exposure Draft (ED) on Leases, and held numerous outreach meetings of a cross section of users, lessees and lessors through January. The overwhelming negative feedback in the comment letters and at the meetings made such an impression on the Boards that they are changing their direction to accommodate much of the criticism. This shows that your influence counts, and they listen to feedback.

The only thing the comment letters agree on is that it is a good idea for lessees to capitalize material operating lease contractual obligations. However, the majority of the feedback cited several issues that the Boards will address in their re-deliberation work plan. The Boards held their first meetings in early 2011 and made some tentative decisions. They instructed the staff to field test these decisions and get feedback though outreach to stakeholders. This outreach and field testing process will be very important, especially if they choose not to re-expose the rule before issuance. The U.S. leasing industry stakeholders should take an active role in the outreach to insure their positions are addressed by the Boards. The Boards want to make final decisions in April so they can still make their 2011 target for issuance.

Issues to Be Addressed By the Boards	Tentative Board Decisions Subject to Feedback
Definition of a lease versus a service contract	The Boards agreed to tentatively confirm the “specific asset” notion versus a notion that assets could be substituted as long as they met specs, but they are looking for feedback by taking both approaches out for targeted outreach. Allowing substitution of assets could expand the amount of contracts that would be considered leases. They will also seek feedback to determine how to treat leases of non-physical assets like capacity in a fiber optic cable. They did not conclude on, but are in favor of, concepts such as not including in lease accounting assets that are incidental to the provision of a service or insignificant to the services provided. They also could not conclude on whether to consider control based on the Revenue Recognition concepts or the EITF 01-08 concepts. The last three issues could reduce the amount of contracts considered to be leases if the ultimate conclusions are favorable to the industry.
Definition of a lease term	The lease term is the contractual term plus renewals where the lessee has a “clear economic incentive” to exercise the options. This is essentially current U.S. GAAP, and will limit the amounts capitalized versus what was as proposed by the ED. The requirement to adjust estimates will be reduced when the event occurs that causes the renewal option to become economically compelling. This is good news.
Defining which variable payments are capitalized	Variable lease payments will be included in the lessee lease capitalization and a lessor’s lease receivable, but limited versus what was proposed in the ED to include: variable lease payments that depend on an index or a rate; variable lease payments that are “reasonably assured/certain,” (to be defined); variable payments that are disguised minimum lease payments in leases where the fixed rents are off-market; disclosure within the notes of contingent rent leasing arrangements, (to be determined later). Estimates are reviewed and adjustments are made if material. Because the threshold is increased, there will be fewer variable payments included in the lessee lease capitalization. This is favorable for the equipment leasing industry as the most common variable payment is usage based (cost per copy or excess miles driven). It does not look favorable for the real estate leasing industry as it does not give it significant relief. They reiterated their conclusions that: a third-party residual guarantee is not a minimum lease payment for the lessor; lessees should only record the likely payment under a residual guarantee — not the full amount of the residual guarantee.
Defining which leases get straight line P&L for lessees	No conclusions were reached, but their discussions indicate the likely direction, and it is not good. They propose that there are two types of leases — those that have a “finance” element similar to a finance lease and those that don’t, such as an operating lease using classification criteria similar to those in IAS 17. Those leases that are financings would have capital lease accounting with a front-ended cost pattern. Those that are not financings would have a straight line P&L cost pattern, possibly called rent expense. They are considering applying similar concepts to lessor accounting when they get to it at a later date. Thus, there will likely be derecognition leases that are financings with a form of direct finance accounting, and other leases would be treated as either operating leases, investment property leases or some other derivation of the performance obligation model. The implications for equipment leases is lessees will not have many leases that qualify for straight line P&L and, lessors may not have as many direct finance leases and sales type leases as under current GAAP.
Revisiting changes to lessor accounting	They did not spend much time on lessor issues, as they decided to wait for the Revenue Recognition project to progress to help define how lessor accounting should work. This may not be good news unless they revise definitions in the Revenue Recognition project to recognize the uniqueness of leases.