In a summary of the latest meeting of the FASB and IASB on April 23, 2014, Bill Bosco reports good news for lessees, particularly RE industry lessees, if the FASB continues to hold on their split with the IASB on when you re-book for a change in variable rents due to a CPI adjustment. “I say if because the FASB chairman was not pleased that they could not agree with the IASB (and I was surprised the FASB took their view) on that important issue and I think he will try to get the FASB in line with the IASB. Most of the discussions led to predictable conclusions,” Bosco reported.

Highlights from Bosco’s summary are found below.

FASB and IASB are converged on all but one very important item – when (for a lessee) to re-book a lease when variable rents change due to variation in rate or index.

The FASB and IASB discussed 4 items:

1. Modifications

Official text from FASB website: Lease Modifications and Contract Combinations

The Boards decided to define a lease modification as any change to the contractual terms and conditions of a lease that was not part of the original terms and conditions of the lease and that the substance of the modification should govern over its form.

The Boards decided that both a lessee and a lessor should account for a lease modification as a new lease, separate from the original lease, when (1) the lease grants the lessee an additional right-of-use not included in the original lease and (2) the additional right-of-use is priced commensurate with its standalone price (in the context of that particular contract).

Bosco’s commentary: No surprises here. For both the lessee and lessor: FASB and IASB decided to re-book a lease when the contract is modified, as a new lease occurs when a modification occurs.

2. Reassessment for changes in variable payments due to rate or index

Official text from FASB website: Variable Lease Payments

The Boards decided that only variable lease payments that depend on an index or a rate should be included in the initial measurement of lease assets and lease liabilities and that an entity should measure those payments using the index or rate at lease commencement.

The FASB decided that a lessee should reassess variable lease payments that depend on an index or a rate only when the lessee remeasures the lease liability for other reasons (for example, because of a reassessment of the lease term).

The IASB decided that a lessee should reassess variable lease payments that depend on an index or a rate when the lessee remeasures the lease liability for other reasons (for example, because of a reassessment of the lease term) and when there is a change in the cash flows resulting from a change in the reference index or rate (that is, when an adjustment to the lease payments takes effect).

The Boards decided that a lessor should not be required to reassess variable lease payments that depend on an index or a rate.

Bosco’s commentary: For the Lessee: The IASB decided to reassess/re-book when an event occurs to trigger a change in variable lease payments but the FASB (to my surprise) decided to reassess/re-book only if the lessee reassesses due to another reason, like a change in term or booking a purchase option. For the lessor: No need to adjust payments (the object is to keep the lessor accounting unchanged, except for tweaks). The FASB decision means that changes to contractual rents due to variable rent changes will rarely be booked to the balance sheet but rather will flow through P&L on a cash basis and it means significant liabilities could continue to be off balance sheet. Although they did not discuss this I think it also means disclosed future lease payments will not be consistent with the payments capitalized lease obligations on balance sheet for any lease that has had a variable rent change but has not been reassessed for another reason. On the plus side, it will make lessee compliance much simpler.

3. Variable payments that are in substance lease payments

Official text from FASB website: In-Substance Fixed Payments

The Boards decided (1) to retain the principle that variable lease payments that are in-substance fixed payments should be included in the definition of lease payments and provide additional clarifying guidance and (2) to note in the Basis for Conclusions that the concept that some variable lease payments are in-substance fixed payments exists under current practice.

Bosco’s commentary: No surprises here. Both Boards agree that current practice as to when a variable payment is in substance lease payment works effectively and should be left as is. A principle will be stated to the effect that an estimate of the variable payment must be included in lease payments if it is remote that no payment will be due under the formula to calculate the variable payment. An example is if a lessee entity has historically and consistently had significant sales and the lease requires no minimum payment, but does include a variable payment based on sales where the trigger point is a very low level of sales. In that case, an estimate of the variable rents must be capitalized as it is expected that sales will exceed the trigger point.

4. Discount rate

Official text from FASB website – Discount Rate

With respect to the determination of the discount rate, the Boards decided:

• To clarify in the implementation guidance what “value” refers to in the definition of the lessee’s incremental borrowing rate, but otherwise make no changes to the definition in the May 2013 Exposure Draft.
• To describe the rate the lessor charges the lessee as the rate implicit in the lease, consistent with existing lessor guidance.
• To include initial direct costs of the lessor in determining the rate implicit in the lease.

With respect to reassessment of the discount rate, the Boards decided:

• To require a lessee to reassess the discount rate only when there is a change to either the lease term or the assessment of whether the lessee is (or is not) reasonably certain to exercise an option to purchase the underlying asset.
• Not to require a lessor to reassess the discount rate.

Bosco’s commentary: Both agree that the lessor should use the implicit rate in the lease and it is easy to calculate. Both agree that the lessee should use the implicit rate if known (but they know it is rarely known to the lessee) or use its incremental borrowing rate. The Boards went round and round in a confusing discussion. They do not realize that leases are fixed rate instruments with a balloon and few SMEs can easily determine their incremental borrowing rate, as they do not borrow on fixed rate amortizing term basis. I agree with the Boards as to when to change the discount rate. When there is an extension or renewal or exercise of an early buyout option, there is a change in duration. Also when there is a modification there is a re-pricing factor and also likely changes in duration that should mean a new incremental borrowing rate is appropriate.