Although the initial goal of the lease accounting project was to create a global set of rules, the FASB and IASB could not agree on everything, which resulted in some disparity. Bill Bosco discusses the key differences between the two sets of rules and the resulting implications.
The lease accounting change project began with the objective of converging on a worldwide set of rules. When the FASB and IASB took different views on whether all leases were the same for lessee accounting, the idea of convergence was dropped. However, the boards continued to meet jointly, and the rules are not far apart in most areas. The major objective of capitalizing most operating leases was achieved.
In the end, key differences between FASB ASC Topic 842 and IASB IFRS 16 affect lessors and the structuring of leases to meet customer objectives.
Lessee Accounting Model
Both models require operating leases to be capitalized as an asset and liability, the value of both at lease commencement being the present value of the lease payments as newly defined. Topic 842 recognizes the substance of leases for lessees — operating leases, being executory contracts, do not create a debt obligation or ownership of the leased asset as a finance/capital lease does. As a result, the basic accounting and presentation principles of FAS 13 are retained. The right of use (ROU) asset and lease liability are reported separately, the liability is labeled an operating liability (not debt) and the P&L cost is the straight-line average rent. IFRS 16 treats all lessee leases as finance/capital leases — the operating lease liability is considered debt and the P&L cost is front ended.
Business implications: All lessees will want the lowest amount capitalized since return on assets (ROA) will deteriorate due to the addition of the new capitalized operating lease assets. The new rules’ definition of lease payments to be capitalized creates structuring opportunities that lessors can use to lower capitalized lease payments and, as a result, reduce the value of the capitalized asset, resulting in less negative impact to ROA.
Operating lease classification will continue to be important to FASB companies for two reasons. First, the lease liability is not debt, resulting in less impact to financial ratios, measures and covenants. Second, the lease cost is straight line, instead of front loaded as for IASB companies. Operating lease classification may be important to IASB companies that need to break out the operating-versus-finance lease balance sheet amounts to provide information to regulators, lenders or other users. I have commented on this issue of added compliance complexity to the IASB and in other articles to no avail. The CFOs of IASB companies will probably have to keep a second set of records.
Lessee Recognition and Measurement Exemption
IFRS 16 has a lessee recognition and measurement exemption for leases of assets with values of less than $5,000. The Topic 842 Basis for Conclusions allows the adoption of reasonable capitalization thresholds, below which lease assets and liabilities are not recognized. This would be consistent with many entities’ accounting policies in other areas of GAAP (such as capitalizing purchases of property, plant and equipment).
Business implications: Small-ticket lessors will benefit. The IASB lessee automatically receives this benefit. FASB lessors may point out the ability to set a reasonable capitalization policy to allow the exemption to continue to account for small item leases off balance sheet as operating leases.
Lessor Accounting Model
Since IFRS 16 does not distinguish between sales-type and direct financing leases, IFRS 16 permits recognition of selling profit on sales-type/direct financing leases at lease commencement, even if third-party residual insurance is used to convert an operating lease to a sales-type lease.
Topic 842 follows the new concept of what qualifies as a sale in the revenue recognition standard. This means that third-party involvement like a residual guarantee or residual insurance to achieve finance lease classification will not result in sale treatment and/or recognition of selling profit at commencement, even though its classification has been converted. Instead, a lessor could account for the finance lease by amortizing the unearned income, including the selling profit, over the lease term via an implicit rate that reflects the cost at the present value rather than the fair value. In other words, the implicit rate used will be very high.
Business implications: FASB manufacturers and dealer lessors who need residual insurance to achieve sales-type gross profit recognition under current rules will suffer under the new rules with a deferral of revenue, and the gross sales profit will be reported on a different line. For operating leases, it will appear on the income statement as reduced depreciation expense. For finance leases, it will appear as additional lease revenue/interest revenue.
The longer the lease terms, the more severe the P&L issues will be because of timing differences — longer lease terms will take longer to turnaround. Lessors will have to weigh the options. The issues include where the profit appears in the P&L (geography) and when it shows up (timing). Lessors may record a profit by selling the asset to a third-party lessor or non-consolidated joint venture partnership while continuing to provide service, ensuring a close proximity to the customer and re-marketing participation to capture some of the upside. Lessors may stop buying the insurance and accept the consequences of operating lease treatment. They may buy the insurance, have a more accelerated revenue pattern than operating leases and then sell/transfer the receivables to generate a gain on sale of the receivables, although it will be reported as other income. Each choice has income tax issues not addressed in this article.
Variable Lease Payments
Both sets of rules change the definition of payments to be capitalized by lessees to include variable payments based on a rate like LIBOR or an index like CPI based on the “spot” rate and only the amount expected to be paid under a residual guarantee. Current rules would include the full amount of the residual guarantee as a lease payment.
IFRS 16 requires reassessment (re-booking) of variable lease payments that depend on an index or a rate when cash flows change as a result of a reference index or rate change (when an adjustment to the lease payments takes effect).
Topic 842 only requires re-booking of variable lease payments that depend on an index or a rate under certain conditions such as when a lease is modified or when a lessee’s actions permanently change variable lease payments. Another reason could be a significant event or change in circumstances within the lessee’s control that directly affects whether the lessee is reasonably certain of its decision in regard to exercising an option to extend or terminate the lease or to purchase the underlying asset.
Business implications: This means, in general, FASB lessees will not have to re-book a lease with variable payments based on a rate or index unless something in the lessee’s control causes lease payment assumptions to change. FASB lessors may choose to create structures with variable rents based on a rate or index and structures with residual guarantees that have lower “fixed” payments in exchange for the variable payment or residual guarantee. Residual guarantees have tax issues. Variable rents structures have risk issues.
Both sets of rules do not allow sale treatment in a sale-leaseback that allows a fixed purchase option in the leaseback. The FASB will allow a fair market purchase option to avoid negating sale treatment only if there are alternative assets, substantially the same as the transferred asset, readily available in the marketplace.
Business implications: The fixed-price purchase option negating sale treatment is an issue that lessors and lessees will have to deal with in the logistics of the sale-leaseback. If the lessee is merely acting as an agent, effectively putting the lessor and original seller of the asset together, then the lease can have a fixed-price, non-bargain purchase option and still qualify as a sale (operating lease back).
I would seek legal advice in documenting the fact the lessee is an agent in the transaction. Transactions with a long construction/acquisition process like aircraft need special attention in determining when the lessee is considered the owner in the process. I would seek advice of the lessee’s audit firm in advance. The other option is to create the “agent” documentation before ordering the asset or committing to purchase. The “alternative asset readily available” fair market value purchase option allowed by the FASB is a high hurdle and the lessee’s auditor should clear the issue in advance. This won’t work for real estate as the rules specifically state that all real estate is unique. But it should work for non-specialized equipment (anything that has a used equipment market).
There are other issues where there are differences in the sets of rules, such as transition and impairment, which do not have business implications for lessors in structuring leases to meet customer needs. In any case, lessors should understand the rules changes in detail so they understand changed lessee business concerns and how they should or may adjust their product offerings. New rules equal new ideas and opportunities!