The pendulum swings again

The big news last month was that the FASB & IASB decided to reinstate a close cousin of operating lease accounting for lessees, with a level expense recognition pattern (though the leases would still be reported on the balance sheet). It was a sharply divided vote. Now, a few members of each board have switched sides, and in another divided vote, the boards have decided to ditch the "other-than-finance" lease category and account for all lessee leases the same way, as finance leases. This means a forward-leaning expense profile (depreciation is equal over the life of the lease, but interest is higher at the beginning of the lease, just like with a mortgage), which many respondents to the Exposure Draft vehemently protested. One reason given was that board members didn't like the options for how to account for the level expense recognition.

The boards also informally voted to eliminate the exemption of short-term leases (12 months or less maximum lease term, including renewal options) from the requirements of the standard that was agreed to in March. However, that will be reviewed and finalized at a later meeting.


Options

In another backtrack that most lessees won't like, the boards have increased the likelihood that options will need to be included in the lease term. In deciding whether to include an option, one must decide if there is a "significant economic incentive" to renew. A prior meeting decided that only economic factors should be considered in this determination (including contract-based factors such as below-market rents or penalties for non-renewal, and asset-based factors such as the existence of large leasehold improvements that would normally be amortized over a longer period). The boards have now decided to include "entity-specific factors," such as historical practice of the company or industry and management intention. The boards noted that a single factor does not have to be determinative, but the door is still opened up to an increase in subjectivity and need for ongoing review.

Lessor accounting

The boards haven't decided if lessors will use one or two approaches to accounting for their leases. So they made decisions for either possibility:

One approach

If all leases are treated the same way, the partial derecognition model will be used, with the residual value accreted over the life of the lease. This is, I believe, basically the same as current finance lease accounting (sales type accounting under FAS 13).

Two approaches

If two methods of accounting are used, leases will be distinguished based on whether the lease transfers substantially all of the risks and rewards incidental to ownership of the underlying asset. This is the concept underlying both FAS 13 and IAS 17. The boards clarified that among the indicators would be comparing rent to fair value and the existence of variable rent (the latter would be an indication that risks have been transferred to the lessee). Existence of embedded or integral services would not be considered in the determination.

For leases that transfer substantially all of the risks and rewards of ownership, the entire asset would be derecognized, with the residual initially measured at its present value and accreted over the life of the lease.

For other leases, the boards could not come to an agreement. The IASB preferred derecognition, while the FASB preferred current operating lease accounting. This will be revisited at a future meeting. (Neither board, though, preferred the Performance Obligation (PO) method that was presented in the Exposure Draft. That seems to be dead.)

Lease modifications

The boards decided that a "substantive change" in a lease agreement would result in treating the modified agreement as a new contract. This applies if the new terms would change the determination of whether the contract is or contains a lease, or the determination of whether substantially all the risks & rewards of ownership are transferred to the lessee. A change in circumstances (not of the contract itself) can cause reassessment of whether the contract is or contains a lease, but not whether risks & rewards of ownership are transferred.

Discount rate

The interest rate used to present value the rents and amortize the principal (obligation or receivable, depending on whether it's the lessee or lessor) will not be reassessed if the lease payments don't change. However, if a lease is extended because an option needs to be included (either because an option is exercised, or it is deemed to be includible because of a newly recognized "significant economic incentive"), the discount rate (which is typically the incremental borrowing rate for lessees) is to be reassessed, using the current rate, and the present value of the remaining rents is then recalculated.

More decisions, summarization so far

The FASB and IASB met again last week to further deliberate on leases. Among the decisions reached:

Start of accounting: A lease may be signed well in advance of when the lessee takes possession of the property (particularly with property, which may need extensive construction before occupancy). The boards have affirmed that the lease does not hit the books until the "commencement" of the lease, which is normally when possession is granted. Payments made between the "inception" (signing) and "commencement" will be accounted for as prepayments (an asset that is then folded into the ROU asset at commencement). If the lease meets the definition of an "onerous contract," it is to be accounted for during the inception to commencement period according to the Contingencies accounting standards: IAS 37 and FASB Topic 450.

Tenant incentives: Lessees are to subtract these from the right-of-use asset.

Sale & leaseback: Rather than a series of tests in the Exposure Draft to determine whether a transaction qualifies for sale and leaseback accounting, the boards have now decided that as long as the sale part of the transaction meets the existing accounting requirements (under the Revenue Recognition standard) to recognize a sale, it qualifies for SLB treatment. In general, if control of the asset has passed to the buyer/lessor, it qualifies. One change from current SLB accounting is that if the seller/lessee has a gain or loss on sale, that is to be recognized immediately, rather than amortized over the life of the lease.

Leases with service components: When the service component is not clearly identified separately in the agreement, the FASB in the ED called for capitalizing the entire contract as a lease (the IASB favored split recognition). Both boards have now decided that if the purchase price of one component (lease or service) is "observable," you can calculate the split based on that.

Discount rate: FAS 13 calls for the interest rate on lessee capital leases to be based on the lease's implicit interest rate, if known, or the lessee's incremental borrowing rate (IBR). In many cases, the lessee doesn't know the lessor's implicit rate, because the expected value of the asset at lease expiration (the "unguaranteed residual") is not stated, so the IBR tends to be used. (The rate may be higher if the present value of the rents using these rates is more than the fair market value; in that case, a rate is calculated to make the PV of the rents equal to the FMV.)

The ED introduced a new term: "the rate the lessor charges the lessee." This is to be used when available, a decision now confirmed. Finally, though, the boards have defined what they meant; this can be (from the observer summary) "the lessee's incremental borrowing rate, the rate implicit in the lease, or, for property leases, the yield on the property. When more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used." The lessor always by definition knows this rate. If the lessee does not, the IBR is to be used.

Initial direct costs: The boards defined this as "Costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made." The intent is to have a consistent definition for a series of standards (including insurance and revenue recognition, which are at similar stages of development), though there may be slight modifications to meet specific needs of the different standards. Any such differences are intended to be explained by the boards, to maintain the overall consistency.

IDCs are to be capitalized by both lessees and lessors, by adding them to the right-of-use asset and right to receive lease payments, respectively.

Summarization: The IASB staff has prepared a detailed description of the impact on the ED of the new decisions by the boards. This describes both the confirmed decisions and the changes, with links to IASB observer notes for each.

Thanks to the IASB for their podcast and to Asset Finance International for their summary.

Ownership transfer leases, update

In my March 17 post, I said that it wasn't clear how the scope change affected leases with an ownership transfer. Based on the IASB Update just released regarding last week's meeting, it seems clear that they are also to be considered leases. The boards have decided to simply eliminate the language that took leases with bargain purchase options and ownership transfers out of scope of the leasing standard.

Purchase options and short-term leases

The FASB & IASB met this week for continuing discussions, on leases as well as other topics. In their meetings on March 14 & 15, they reached the following conclusions for the new lease accounting standard:

• The ED had scoped out (excluded) leases with bargain purchase options and ownership transfers (also called "in-substance purchases") from the new lease accounting standard, stating that they should be treated as a sale & purchase and handled according to the revenue recognition standard (which is also at the ED stage). However, this decision was left over from when the boards had briefly planned to treat all lessor leases according to the "performance obligation" model, which would have been inappropriate for these transactions. With a derecognition model for lessors now in place, the need to separate out these types of leases is less evident. The boards agreed that leases with a bargain purchase option should be returned to the scope of the leases standard. It's not yet clear if leases with ownership transfer will be considered leases or sales.
• Relatedly, the boards are adjusting the treatment of purchase options. In the ED, these did not need to be accounted for until exercised. Now, they must be accounted for if there is a "significant economic incentive" to exercise them. It remains to be determined how the accounting will work if the conclusion of a significant economic incentive changes in the middle of the life of the lease (in either direction), though the boards concluded that they would not permit a switch between the "finance" and "other than finance" categories they set up last month.
• Short-term leases: The boards have decided that leases with a maximum lease term of 12 months or less, including renewal options, can be treated like current operating leases. They will not be shown on the balance sheet for lessees; income and expense will be shown on the income statement as currently (with rent leveling as needed). This will be an option; lessees & lessors can choose to treat short-term leases like other leases. However, the option must be chosen for all leases in an asset class, rather than lease by lease.

Thanks to Deloitte's IAS Plus and Asset Finance International for their reviews of the meetings, which were the basis for this entry.

2015 implementation?

The new leasing standard is one of several major standard revision projects the FASB & IASB have underway. Others include revenue recognition and insurance contracts, which are considered heavily interrelated with the leases, and other comprehensive income, fair value measurements, financial instruments with characteristics of equity, and financial statement presentation, which are considered more independent of other standards.

The boards put out a separate Exposure Draft asking for comments on implementation dates. While the volume of comments wasn't nearly as high as for the leases ED, the consensus response was that the impending changes are major, and financial statement preparers need substantial time to update their systems. At the boards' combined March 2 meeting, the boards didn't decide whether to implement the three linked standards (leases, revenue recognition, and insurance contracts) at the same time or in staggered order, but stated that they "will provide adequate time for stakeholders to apply the new requirements." Several members of the IASB stated a preference for 1/1/2015 as the implementation date, while most FASB members didn't want to make a commitment to a date at this time, and several expressed a preference for a staggered implementation.

Note that since U.S. companies typically report two years of comparables, and the leases ED says those comparable years will need to be restated on implementation, that means that effectively companies would need to apply the standard effective 1/1/2013, even though they wouldn't be reporting the results accordingly until later. It's not clear yet whether earlier implementation will be encouraged or permitted.

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.

"More likely than not" is dead

At yesterday's meeting (Feb. 16), the IASB and FASB agreed to withdraw the proposal to include lease renewal options in the lease term when judged "more likely than not" to be exercised. This was the proposal in the Exposure Draft, which was almost universally opposed by respondents, particularly preparers of statements. Asset Finance International's summary of the meeting notes in addition to complaints of difficulty of implementation and subjectivity, another persuasive argument for board members was that real estate lease renewals frequently are not actually implemented as stated in the original option, but are subject to negotiation like a new lease, so the stated option doesn't necessarily reflect what the terms will be even if "exercised."

Rather than reinstating current terminology on when to include options (when "reasonably certain" or "reasonably assured" of exercise due to various economic factors), the boards have tentatively chosen the phrase "clear economic incentive." The boards didn't seem to think there was a substantial difference in impact, so it seems to be more a stylistic choice.

Reassessment of lease terms, which previously was required on a quarterly basis, is now to be required only when there is a significant change in circumstances, such as an addition or removal of a "clear economic incentive" on a renewal option.

Contingent rents will be discussed today.

ED response reviews

Deloitte & Touche has released a "Heads Up" summary of responses to the lease accounting exposure draft.

Asset Finance International (an association of lessors primarily focused on Europe) has its own summary.

Death knell for "more likely than not"?

The IASB & FASB will be meeting next week. On the agenda on Feb. 16 meeting: the definition of the lease term. The staff briefing paper for the discussion, noting the almost universal rejection of the proposal to include lease options in the lease term if they are judged "more likely than not" to be exercised, recommends that the lease term be defined essentially the same way as it is now under both IAS 17 and FAS 13: the contractual minimum, plus options that are reasonably certain to be exercised. The staff's recommendation is that "reasonably certain" be determined solely on economic factors (such as bargain renewal options, penalties for cancellation, presence of long-lived leasehold improvements, etc.), with no weight given to past practice or management intention, which the majority of the staff considers too subjective. They do list that as an option for the boards, though, along with keeping the "more likely than not" criterion.

Given the vehement rejection of "more likely than not" in the comment letters and other outreach activities, this was, I think, expected by most observers. But assuming it comes through, it'll be a very clear indication of the significance of participating in the boards' due process.

Also on the agenda for the boards' meetings next week is variable (contingent) lease payments.

The majority staff position is that only contingent rents dependent on an index or rate should be included in the lessee's liability to make payments, with the valuation based on the prevailing (spot) rate. A minority would add all payments that are "probable" or "reasonably certain." Additional disclosures would be required, but those won't be discussed at this meeting.

This is again a pretty thorough repudiation of the Exposure Draft, which called for probability-weighted estimates of all contingent rents, including those based on usage and percentage of sales. Combined with the original proposal to include "more likely than not" options, it raised the potential of needing to estimate business and economic conditions for 50 years, an exercise that was unlikely to bear any significant connection to reality.

With these two changes, the complexity in the ED is greatly reduced. There is still the inherent complexity of capitalizing the leases, but that's far less challenging to deal with.

First redeliberation session

The IASB & FASB met in joint session last week. On the agenda, as previously noted, was the first round of reconsideration of the new lease accounting standard, reacting to the responses received on the Exposure Draft.

The separation of leases from service contracts is a major issue, including the question of service contracts that include physical assets. One example is a cable TV subscription; if the cable company gives you a cable box, does that make the whole transaction a lease rather than a service? Does the box need to be accounted for separately as a lease? Or should some small amount of physical assets be ignored in this situation? (How small?)

The boards also discussed whether all leases should be considered a form of financing (which merits the accounting proposed with delinked asset and obligation), or if some aren't really financing and should be recognized with a straight-line expense/income pattern.

Lessor accounting was also discussed in detail. Some respondents suggested putting off lessor accounting, but the boards agreed to keep discussing both sides of the transaction, particularly issues that are relevant to both. There is a wide range of views on whether there ought to be one or two kinds of lessor accounting, and if one, which one, though the boards seem to have considerable sympathy for the idea that there are two different business models for leasing that ought to be accommodated.

A number of respondents complained about the lack of symmetry between lessee and lessor accounting (sauce for the goose, sauce for the gander?); the boards directed the staffs to consider two approaches to accounting for both lessors and lessees, one based on the financing concept and the other using straight-line recognition. (One challenge, of course, will be how to differentiate.)

FASB Chairman Leslie Seidman held a webinar on Jan. 25, providing her views on what the board is doing. She noted that the count of comment letters on the lease accounting Exposure Draft is now over 750. She sees general agreement with the concept of placing lease obligations on the lessee balance sheet, but recognizes that many are concerned about the complexity of the current model, especially with regard to options and contingent rents. She also noted that there is "general disagreement" with the front-loaded expense pattern as it affects leases that are currently considered operating, and the classification of the expense in financing rather than operating activities. While she didn't officially back off from a June 30 due date for this and the other current projects, she noted that the boards have been stating that the target dates are subject to the nature and extent of the feedback received. Their goal is standards that are understandable and implementable at a reasonable cost, and "if it takes a little longer to reach that comfort level, we will take that time."

In the webinar's Q&A period, someone asked how the FASB decides when to re-expose a standard if changes are made from the exposure draft. She said their general question is: How significant are the changes from both the original exposure draft and from current accounting? The implication is that if their new plan is significantly different from both an ED and current GAAP, they would re-expose. It is, of course, too soon to tell whether that would happen to the lease accounting standard.

Redeliberations starting, comment letter summary

The FASB & IASB will have a joint meeting in London on Wednesday, January 19, when they will begin to discuss comments received on the Exposure Draft, and their plan for redeliberations. On Wednesday and Thursday, they will discuss 1) distinguishing leases from services, and 2) lessor accounting. They are not planning to make decisions on those topics.

The IASB meeting page for January has agenda papers for the leases discussions. These include a list of the major issues that the staffs feel should be thoroughly reconsidered, and a secondary list of additional possible issues for reconsideration. Five major issues are noted:

1) Definition of a lease (particularly differentiating from service/executory contracts)
2) Lessor accounting model
3) Lease term (i.e., when to include renewal options)
4) Variable lease payments (i.e., contingent rentals)
5) Profit & loss recognition pattern (whether asset amortization should be adjusted so that overall expense/income for leases is straight-line rather than front-loaded)

A laundry list of other items is listed as potentially needing reconsideration, including scope exclusions, short-term leases, foreign exchange, disclosure, fully retrospective application, lease incentives, and leasehold improvements, among numerous others.

The staffs' comment letter summary notes the "very high" number of responses (760 letters as of Jan. 12), and the fact that the boards have had contacts with several thousand people through various outreach activities. They note that very few financial statement users sent in comment letters, but outreach events included over 500 users.

The summary indicates that almost all comment letter writers disagreed with defining the lease term as the longest possible term more likely than not to occur. Respondents generally suggested either the current standard of including options that are "reasonably assured/reasonably certain" (current US GAAP/IFRS terminology), or "virtually certain" (seen as an even higher threshold), or the Alternative View listed in the IFRS Exposure Draft, to include options only when there are incentives to exercise those options.

The summary indicates likewise almost total disagreement with the contingent rent proposal. Alternative approaches suggested included 1) capitalizing only contingent rents based on an index or rate, 2) including only those that are outside an entity's control, or 3) using a different estimation approach (such as "best estimate" rather than "expected value" with multiple scenarios).

The summary is 70 pages long, so trying to fully recap it here would be tedious. Suffice to say that every question that the boards asked in the ED received lots of comment, with numerous alternatives presented.

Over half of the respondents were preparers of financial statements, with sizable numbers of industry organizations, individuals, and professional organizations. Half came from North America, a bit more than a quarter from Europe. The largest industries represented were financial services (almost 1/4), retail, real estate, and transportation.

Volume of comment letters

How does the volume of comment letters on the proposed lease accounting standard compare to other recent exposure drafts? The following list may be of interest:

Leases: 746 (and counting)
Fair value measurement: 95
Comprehensive Income: 72
Accounting for Financial Instruments: 2814
Derivative Instruments and Hedging Activities: 127
Amortised Cost and Impairment: 179
Revenue Recognition: 971
Troubled Debt Restructuring: 117

So leases isn't the biggest, but it's up there.

"It's not a done deal."

That was the statement of Larry Smith, FASB board member, at last Thursday's (Jan. 6) afternoon roundtable discussion on the proposed new lease accounting standard. He was responding to one participant's comment that people in the leasing industry he's talked to thought there was no point in submitting a comment letter or otherwise participating in the boards' outreach activities, because they thought the standard was "a done deal" and the process was just for show. Smith was emphatic in denying that. New FASB Chairman Leslie Seidman concurred, adding, "I've already decided that I will change my position on one or two matters," and suggesting that she may make further changes based on additional review of the comment letters and discussion with interested parties.

The count of comment letters is now up to 746 (including letters received after the deadline, which are still being posted to the FASB website). I can't possibly read them all (I need to do my real job), but members of the FASB and IASB staff are. I spoke to one of the FASB staff who is personally reading every single comment letter on lease accounting, and commented that the letters are substantive (and lengthy); they're impressed by the thoughtful responses presented. I'm sure it'll be a few more weeks before they have compiled a summary for the boards, and the boards can begin redeliberations.

I attended the Thursday afternoon roundtable as an invited participant. Other participants included representatives of KPMG and Ernst & Young, lessors Xerox and International Lease Finance (one of the largest aviation lessors in the world), the CFA Institute (financial analyst, and thus a user of financial statements), Toys R Us, Transocean (the world's largest drilling rig operator, unfortunately now infamous as the driller of the BP well that blew up last year), and consultants to the leasing industry. Also present were all five members of the FASB board, as well as two IASB members and several staff members from both boards.

We had four planned topics of discussion: the definition of a lease, the lessor accounting model, the lease term, and variable lease payments (i.e., contingent rents). Most of the discussion of the definition of a lease centered on the distinction from service contracts. It was noted that the line is sometimes fuzzy even today, but because operating leases and service contracts are accounted for relatively similarly, differentiating them isn't a significant issue. With capitalization of leases, the difference becomes much more significant. Transocean is concerned that they may be seen as lessors, which they haven't been up to now, for contracts which include use of a drilling rig, but provide full crew and other services. Airlines similarly may lease aircraft with crew & maintenance included (a "wet lease") or just the aircraft alone ("dry lease"). Aviation lessees and lessors are concerned that fully capitalizing a wet lease will reduce comparability. No consensus was reached about how or whether to divide services and leases.

We also briefly discussed whether the scope exclusion for "in-substance purchases" should be maintained, with some feeling it was a leftover in the proposal: it was set up when the boards were planning to provide only a performance obligation approach to lessor accounting, and lessors wanted a way to recognize up-front profit if they were effectively selling an asset. With the inclusion of the derecognition model, there seems to be less reason to have a separate methodology for in-substance purchases.

For the lessor accounting model, some prefer performance obligation, some prefer derecognition, and some see a place for both. But a number of participants essentially felt, "If it ain't broke, don't fix it." They don't see significant problems with current lessor accounting, and suggested essentially keeping it in place, with removal of FAS 13's "bright lines" differentiating capital and operating leases (i.e., using IAS 17 terminology of "the lease term is for the major part of the economic life" and "the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset"). The boards seemed to be willing to seriously consider that. Some participants noted that it was important to make this a long-term rather than interim decision (i.e., don't just tweak it until they can revisit it in a few years; if a change is required, do it now).

We spent long enough on these topics that our discussion leader (the FASB staff project manager for leases) decided to combine the issues of the lease term and variable payments, feeling they were in many respects similar. I agreed; in both cases, the boards are calling for capitalization of amounts that don't meet their own definition of a liability. We discussed the operational difficulty of making and updating the estimates for portfolios of thousands of leases. One FASB board member brought up a suggestion, apparently received in another venue, of doing the estimates on a whole portfolio basis rather than lease by lease. Roundtable participants felt that would not be workable, since in many cases there is wide variation in types of leases or characteristics of leases (real estate leases in particular are rarely cookie-cutter). The accountants also felt that such estimates would not be auditable.

The financial analyst expressed interest in an "expected value" approach, but other participants were extremely negative about booking, for instance, fractional lease terms (like a 7.2 year lease for a 5-year lease with several yearly renewal options). I argued that there is a qualitative difference between a 15-year lease and a 1-year lease with 14 yearly renewal options, since the lessee has the flexibility to walk away with no penalty. The current proposal makes those look identical if the renewals are judged "more likely than not," which penalizes the lessee and understates the lessor's risk of nonrenewal (and a nonrenewal would inevitably result in a substantial hit to the lessor's income statement, meaning potential for substantial earnings volatility). Options aren't "structuring;" they provide choices.

For contingent rents, a best estimate was seen as more tolerable than the current "reasonable number of estimates" (what's a reasonable number? does the norm vary from country to country?), though still all the participants in the room other than the analyst were opposed to capitalizing most contingent rents as well as the "more likely than not" threshold for including renewal options in the lease term. People were also opposed to using forward rates to estimate contingent rents that are based on an index or rate, considering it needlessly complex (do you use a different estimated rate for each monthly payment out five years or more?).

The three hours went quickly. Larry Smith of the FASB commented at the end, "We will take time." While the boards' goal has been to complete the project by June 2011, he said that has always been subject to the extent and nature of comment letters and other outreach responses, and they will extend the schedule if needed to properly respond. Their goal is a "comprehensive, converged, improved, and able to be implemented standard."

I definitely felt the board members were listening with open minds. It remains to be seen how they will balance the various perceived needs, and the varying purposes of leasing. One of the fundamental issues they're dealing with is that sometimes leasing is equivalent to purchasing an asset (a computer lease is perhaps the best example, given the short economic life of a computer), while at other times it's closer to provision of a service (a copier lease with low fixed charges and a per-page price). A methodology that provides comparability to one form doesn't work well for the other. But there are so many gradations between that it's hard to define a principle, any more than a bright line, that differentiates them.

Many people are concerned that whatever change the boards make will mess up their current business operations. Yet doing nothing means that true liabilities of a company are largely hidden (as the financial analyst put it, "Disclosure is not enough"). I don't think the boards will back down from requiring lessees to capitalize virtually all leases. But the rest of the standard is certainly in question, and the deliberations this spring are likely to be lengthy and contentious. Stay tuned!

The flood of comment letters

As of today, 697 comment letters have been posted responding to the exposure draft on Lease Accounting. The IASB has decided that they couldn't host all the comment letters; instead, you need to go to the FASB's web site to view those numbered 248 and higher (letters 1-247 are available on both sites). Some of the letters were received after the deadline, but have still been accepted.

There are far too many comment letters for me to review them all. But I think it's fair to say that the overwhelming majority object to including renewal options in the calculated lease term using the "more likely than not to be renewed" criterion, and to including most contingent rents in the capitalized rent stream. Many respondents are concerned about the cost of initial and ongoing implementation of the new standard (particularly if lease term and contingent rents need to be estimated and capitalized); many also think the new proposed methodology is inconsistent with their business models. Many are also concerned about the impact of reclassifying rent expense into amortization and interest expense, since the new classification moves the cost out of EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an important metric for many companies. Other concerns expressed include the timing of expense recognition (front-loaded under the new model, as opposed to level under current operating lease accounting), potential for violation of debt covenants because companies will be reporting more debt, difficulty of getting expense reimbursements on cost-based contracts, and volatility of earnings (if the lease term & contingent rent proposals are maintained).

The lessor accounting proposal has varied reactions. Some agree with the proposal. Others think derecognition should be used for all lessor leases. One common complaint about the performance obligation approach is that it leads to double-counting (or even triple-counting) of assets: the lessor maintains the original asset on the books, sets up a lease receivable (another asset), and the lessee recognizes an asset for the right-of-use as well. The impact of double-counting for the lessor is mitigated by the proposal to report PO leases net (receivable minus PO), but it still seems conceptually strange to many people. It is also noted that the PO approach does not mirror lessee accounting.

The volume and vehemence of disagreement raises the bar, in my opinion, on review by the boards. We'll see what comes in the next few months.

More comment letters and other discussion

Comment letters on the proposed new lease accounting standard continue to come in to the boards. Tomorrow (Dec. 15) is the official deadline to submit a comment (though for the preliminary views document, they did continue to accept and post letters received later). Surprisingly, only a handful of letters have been posted since late last week. I have to think that reflects delays, not actual numbers of letters. As I write this, the count of letters posted is 114.

Few if any of the letters agree completely with the boards, and many vehemently oppose some or many of the provisions, on conceptual grounds (such as arguing that unexercised options are not liabilities), on practical grounds (complying will be burdensome for little perceived benefit), and for their implications (loan covenants will be breached, cost recovery contracts that are based on operating leases will be invalidated, etc.). Several are calling for delaying release until the standard can be thoroughly reviewed and reworked, particularly on the lessor side; others are calling for a lengthy implementation period (up to 5 years).

There are so many different objections it'll be a major task for the boards' staff to organize them, not to mention for the boards to consider them. A number of complaints refer to the impact on very specific situations of individual industries ("wet" vs. "dry" leases of planes and ships, for instance, meaning leases that do or don't include personnel to operate the vehicle). Many complain that the proposed standard will harm their business model; numerous letters suggest that the current economic downturn will be further extended because of it.

Asset Finance International reports that at a Nov. 5 meeting in London between lessors and members of the IASB, an IASB member stated that the boards weren't open to reconsidering the capitalization of lessee leases, but that they were willing to reconsider how to measure the asset, including the question of options and contingent rents.

The boards have indicated that they will consider carefully comments and suggestions made at the roundtable discussions scheduled for both in London & Hong Kong later this month and early January in the U.S. I will be participating in the afternoon session on Jan. 6, 2011, in Norwalk, CT (the FASB's headquarters).

Our comment letter posted

The count of comment letters on the lease accounting standard is now up to 60, with a little more than two weeks to go. Our comment letter is #58.

Notes from yesterday's FASB webcast

As previously mentioned, the FASB yesterday offered a one-hour webcast reviewing the proposed new lease accounting standard, for which the Exposure Draft was released in August. The webcast is now available for viewing if you weren't able to view it live (free registration required).

The webcast included both a basic description of the new methodology proposed, and intermittent commentary by Larry Smith, a FASB board member, regarding why particular decisions were made.

On requiring capitalization of options to renew, Mr. Smith said, "The boards wanted to ensure that entities would not structure a one-year lease with additional one-year options to renew with the full intent of a 15-year lease. We wanted to ensure that the lease amounts recorded reflected the true substance of the lease and therefore reflected the likely lease term, which we acknowledge impacts many aspects due to the discounting required. "

Similarly, for contingent rents: "We were concerned with entities in an extreme example having a fixed rent payment of $1, then various contingent and other variable payments which make the monthly expense closer to a million. We wanted to lay out a principle that would capture all expected lease payments to ensure that amounts recorded associated with leases were transparent and inclusive of all lease payments expected."

Obviously the boards are haunted by the structuring that has been common in leasing under FAS 13 (and IAS 17), and are doing everything they can to prevent something like that from happening again. But Mr. Smith says they're open to alternative ways of dealing with the situation; they recognize that they've chosen a method that's complex to implement.

They included preliminary feedback: They feel generally there is agreement with the right-of-use model, but concern about the complexity of contingent rents & determining the lease term, the income statement impact (rather than equal expenses over the life of the lease, depreciation plus interest gives front-end-loaded expenses), differentiating leases from services (and separating service components), applying performance obligation vs. derecognition for lessors, cost/benefit, and doing the transition.

They took questions from viewers of the webcast and answered some. Highlights:

* The boards plan to provide more guidance on distinguishing a service from a lease (and distinct services). They recognize that it will be more significant than it is under FAS 13.
* The FASB plans to consider whether investment property should be accounted for at fair value, as IAS 40 provides (either as an option or mandatory).
* Driving the project is a desire to provide better comparability (eliminating the bright lines between capital and operating leases) and more information to users, who they feel are already attempting to calculate balance sheet impacts on operating leases with limited information.
* While the initial focus was on lessees, they recognized a need to be consistent both between lessees and lessors, and between leasing and the concurrent revenue recognition.
* Mr. Smith: "If we did not provide for including an estimate of contingent rents, leases might be structured very differently to come up with an outcome that would record the minimum asset and liability, and we didn't want to provide those structuring opportunities."
* It is recognized that lessees and lessors will come up with different estimates of lease term, contingent rent, and the like. The lessee most often will probably have better information.

The IASB is also having a webcast, this coming Monday (Nov. 1), at 10 AM and 3 PM GMT. More information is available at the IASB website.

Investors' opportunity to comment

In September, the FASB & IASB invited lessees and lessors to fill out a survey about their leasing activities and how the proposed new lease standard might affect them. Now users of financial statements (investors, lenders, etc.) are given their own opportunity to comment through a survey. You may respond to the 25 questions any time between now and December 15 (which is also when comment letters on the Exposure Draft are due). No prior knowledge of the ED is assumed; summaries of major points are provided, with users asked whether they favor or oppose the decisions made.

FASB webcast discussion Oct. 28

The FASB will be holding a webcast to discuss the proposed new lease accounting standard on Thursday, Oct. 28, 11 AM to noon Eastern time. The webcast will both review the Exposure Draft and discuss initial reactions that the boards have gained from outreach activities that they have recently undertaken.

Anyone may register for free either to watch the webcast live, or to view it from archive after the fact.

What happened to executory costs?

Under FAS 13 accounting, executory costs (expenses such as insurance, taxes, and maintenance) that are billed by the lessor to the lessee are separated out from other rent before a capital lease's rent stream is capitalized. The proposed new standard calls for separating "service components" from the rest of the rent, if they are "distinct" (see exposure draft paragraphs 6 and B5-B8).

It's not clear, though, that "service components" aligns precisely with the old concept of "executory costs." While no doubt maintenance charges would qualify under each term, and probably insurance, what about taxes? Taxes aren't really a service (while one hopes that one gets services for taxes paid, the link is not direct, and failure to receive services is not a justification for not paying). Will this be clarified in the final standard?