Lease accounting standard delayed

The FASB & IASB have decided that they cannot complete the new lease accounting standard (as well as standards on revenue recognition and financial instruments) by their target of June 30, 2011. Instead, they will continue to work on the standard into the second half of 2011. The FASB Current Technical Plan page suggests a Q3 final standard, but notes that they expect to release a new Exposure Draft, because of the magnitude of changes from the original Exposure Draft released in August 2010. The boards have not officially committed to re-expose, but if they do not, they will do an enhanced public review, making a draft standard available for review, with outreach to interested parties.

Other decisions made this month:

Contingent (variable) payments: The boards stepped back further from their widely criticized ED proposal to capitalize contingent rents. Now the only contingent rents that are to be included are 1) those dependent on an index or rate, and 2) those that are "in-substance fixed lease payments but are structured as variable lease payments in form." This is essentially an anti-abuse provision; it is unlikely that any normal lease would be affected by this. The boards haven't yet decided whether contingent rents based on an index or rate need to be reassessed when the reference number changes; that will be decided at a future meeting. If they decide not to reassess, it would mean a complete reversion to the current standard.

Definition of a lease: There has been substantial discussion over the requirement for a "specified asset." This month's deliberations concluded that a physically distinct portion of a larger asset (like a floor of a building) qualifies, but a capacity portion (like partial usage of a pipeline) does not. The asset can be explicitly or implicitly identifiable.

Other-than-finance leases: Operating leases are back as a category, with the primary difference being that they will now be on the balance sheet. But on a divided vote (with 7 IASB members opposed, plus 1 FASB member), the boards decided to have two accounting approaches for lessees, with the distinction being basically the same as IAS 17 (the IFRS leasing standard, which is similar to FAS 13 but doesn't use the 75% and 90% "bright lines" to differentiate between operating and capital leases). They're using the awkward term "other-than-finance," presumably because they want to differentiate it from current operating lease accounting, which doesn't hit the balance sheet. Maybe somebody will come up with a better name before the standard is released. Such leases will have their expenses recognized as rent expense in the operating section of the income statement, rather than as a financing activity. The liability will still be amortized using the interest method, but the asset will be amortized so as to keep the combined periodic expense level over the life of the lease.

There will similarly be two accounting approaches for lessors, but the boards reached no conclusions on application.

They hear you

Anyone who had any doubts that the FASB and IASB seriously consider responses received during their "due process" steps need only look to last week's meetings and the decisions reached on lease accounting. In addition to the previously reported complete reversal on the lease term, the boards have made an almost complete reversal on contingent rents, and are planning to substantially alter the standard to respond to the desires of those who want level recognition of expenses over the life of a lease. These three topics were probably the most strenuously argued in comment letters to the Exposure Draft.

The boards aren't backing down on putting lessee leases on the balance sheet. But they're showing that they are willing to work with preparers and accountants to make the standard more workable and less onerous.

Contingent rents

The Exposure Draft called for all contingent rents to be included in the capitalized lease payments using a probability-weighted estimate, based on a "reasonable number" of estimates. Rents based on an index or rate were to use forward rates when "readily available." Estimates would need to be revised as often as once a quarter, with changes in future rents booked as upward or downward adjustments to both the asset and the obligation (changes affecting current or prior periods would be immediately expensed).

Preparers howled. The work involved would be enormous, and would often involve forecasting well beyond normal planning horizons (a 20-year lease with a percent of sales kicker would require forecasting sales out that far, when few companies go past 5 years in their regular forecasting). The requirement for quarterly reassessment, even if softened by stating there needs to be a "significant change," would add measurably to the load of releasing statements. Much of this could not be automated, because contingent rents have immense variability in terms.

The boards have now almost completely reversed themselves. The new plan agreed to last week is that contingent rents need to be included in the capitalized rent stream in just the following cases:

* they are based on an index or rate--and in that case, the current rate is used, with no use of forward rates, though it will need to be updated each reporting period (unlike current GAAP, where the rate at lease inception is used throughout the life of the lease)

* they are "reasonably assured," with the definition to be determined later

* the base rent is below market rates

Other contingent rents will be subject to disclosure, but not capitalization.

Expense recognition pattern & placement

Many respondents to the ED complained about the income statement effect of capitalizing all leases. They didn't like two different aspects of this:

* Amortizing the obligation using the interest method, while amortizing the asset on a straight-line basis, means that expenses are greater in the early months & years of a lease, then decline over time.

* Lease payments and interest expense would classified as financing activities. Both interest and depreciation expense are excluded from EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an important measure of earnings for many companies.

Those who objected felt that level expense recognition was more reflective of economic reality, and that leasing should be considered operational rather than financing activity.

The boards concluded that there are two types of leases. Some leases truly are financing transactions (such as most current capital/finance leases). For those, the boards believe the current plan of interest and depreciation is appropriate. But others, they conclude, do not have a strong financing component, and a level expense pattern would be more appropriate.

Can you say "classification"? One of the big reasons for the new lease accounting standard was supposed to be eliminating classification of leases into two types, because of the concern that similar leases are being accounted for differently (those just on either side of the dividing line). The stories about leases with a present value of 89.9% of the fair value (just below the 90% line that makes a lease capital) have been around for a long time. Just because the bright lines are going away doesn't mean that there won't be structuring.

But the boards seem to be accepting that different reasons for leasing merit different accounting treatment. They may also be swayed by the fact that different ways of recognizing expenses can have collateral impact--companies that depend on expense reimbursement from government medical and other contracts, for instance, noted that rent expense is often reimbursable, while depreciation and interest on debt are not. They may also be concluding that the effect of possible structuring in these cases isn't as egregious as making things disappear entirely from the balance sheet.

Of course, once you say that there are two types of leases, the question becomes, how do you tell which is which? The new standard is supposed to be "principles based" rather than "rule based," so we won't have a 90% or 75% test. Instead, the boards are looking to prepare a list of factors which would be considered. Some of them are (a) residual asset, (b) potential ownership transfer, (c) length of lease term, (d) rent characteristics, (e) underlying asset, (f) embedded or integral services and (g) variable rent (thanks to Deloitte for its notes on the meeting that had this list). The boards will be discussing in the future how these factors interact, as well as proper presentation of leases considered "other than financing."

Lease vs. Service Contract

The boards spent considerable time continuing to try to differentiate between leases and service contracts (when a contract has elements of both). One conclusion they reached is that if an asset is incidental to a service, it doesn't have to be accounted for separately. (So, for instance, when you get a cable TV subscription that includes a cable box, the box doesn't have to be treated as a lease.) They also tentatively decided that the requirement for a specified asset is still met if the lessor has the right to swap out an equivalent item assuming no disruption of service (such as replacing a copier with another of the same model).

Most discussion was focused on lessee accounting. The boards have decided to discuss that primarily at this point, with the intention to get back to lessor accounting to keep things as symmetrical as possible.

A number of the decisions and issues will be reviewed with preparers, users, and accountants, with a report back to the boards at a later date.