In a prior post covering the forthcoming FASB changes to lease accounting, we reported that the FASB and IASB (the ?Boards?) were more concerned with the quality of their final decision than the proposed timing.? According to industry chatter, it is looking quite likely that the Boards plan to ?put their money where their mouth is? as they continue to re-deliberate crucial issues based on the steady flow of industry opinion and data received from comment letters, roundtables and outreach initiatives.? This article will focus on some of the more substantive decisions made (or re-made) in lessee accounting to date.
Timing
For the better part of a year, the real estate community has been highly anticipating the pronouncement of the final standards by Q4 2011, subsequently to come into effect sometime in 2013.? Concerns surrounding the complexity of implementation have pushed the probable date back further to 2015.? However, there now is word that the Boards may take the Leases proposal down the same road as the Revenue Recognition project and re-expose the draft of the proposed new rules.? While this is not yet a certainty, a re-exposure would essentially take us back to day one and substantially elongate the implementation timeline.
One or Two Accounting Approaches for Lessees?
The Boards, after receiving many comments regarding this controversial portion of the proposal, had tentatively agreed to recognize the fact that not all leases are entered into as a financing vehicle for an asset purchase. Accordingly, they established two forms of leasing ? ?finance leases? and ?other-than-finance? leases.? The latter, while not completely devoid of some financing element, recognized that the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.
Perhaps the Boards felt that determining which leases were to be considered a finance-type as opposed to an other-than-finance-type was too onerous because, for whatever reason, they have reverted back to a single accounting approach for all leasing transactions.? This current approach, which is the same as the approach originally provided for in the Exposure Draft (?ED?), requires lessees to:
- Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.
- Subsequently measure the liability to make lease payments using the effective interest method.
- Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.
Because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.
Options are In,? ?More Likely Than Not? is Still Out
As previously reported, the Boards have recognized the near administrative impossibility of determining when it is ?more likely than not? that an option will be exercised. To recap, the revised definition now reads:
?The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.?
Therefore, at initial measurement and/or subsequent re-measurement, the determination as to whether a ?significant economic incentive? exists will include, among other factors, the economics of the option compared to current market conditions, as well as whether significant commercially advantageous terms exist.
Reassessment
Reassessment of the lease term would only occur when there is a substantial change in relevant factors that would impact whether a lessee would have, or no longer have, a ?significant economic incentive? to exercise any options to extend or terminate the lease. A lessee should take contract-based, asset-based and entity-based factors into consideration when reassessing whether a ?significant economic incentive? exists.? These factors, when coupled with the tentative suggestion that in making this determination lessees should not consider changes in market rates after lease commencement, seems to suggest that the Boards are leaning toward a more subjective form of decision-making process ? relying on external forces ?as well as internal business decisions ? as opposed to a more objective one whereby a ?significant economic incentive? is measured by market forces and current pricing models (somewhat like valuing an ?in the money? option).
In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the??significant economic incentive? becomes apparent, notwithstanding that the lease required notice date has not yet arrived.
The Separation of Lease and Non-Lease Components
The Boards? more definitive stance now dictates that an entity be required to identify and separately account for the lease and non-lease contract components.? Lessees are instructed to allocate payments as follows: if the purchase price of each component is observable, payments should be allocated on the basis of the relative purchase price of each distinct component; however, if purchase prices are not observable, all payments required by the contract should be accounted for as a lease.
The Boards have noted that, in consideration of the relevance of guidance in other projects such as revenue recognition, application guidance on how a lessee should determine what would constitute an observable price shall be provided.
When to Start: Inception versus Commencement
In response to questions concerning when to begin measuring lease assets and liabilities, the Boards have tentatively proposed that both lessee and lessor should recognize assets and liabilities (and derecognize any corresponding assets and liabilities) using a discount rate calculated at the date of lease commencement. The lessee should use the discount rate the lessor charges the lessee or, in the alternative, the lessee should apply its own incremental borrowing rate.
Furthermore, the Boards aim to capture Initial Direct Costs (those costs directly attributable to negotiating and arranging a lease that, but for the lease transaction, would not have been incurred) by requiring lessees to capitalize such costs by adding them to the carrying amount of the leased asset.
Lessees with leases which, at the date of commencement have a maximum possible term (including options to renew) of 12 months or less, need not recognize the lease asset or liability.? The Boards have tentatively decided that these short-term lease payments should be recognized in profit or loss on a straight-line basis over the lease term.
Looking Forward
While the ultimate decision may be a long-way off, there are sure to be more substantive changes, and changes to those changes, in the future; we will diligently keep you apprised of the path of the FASB/IASB Lease Proposal.
Additional Resources
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