As previously reported, on July 19, 2006, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) announced a joint project to reconsider their standards on accounting for leases (FAS 13 and the related pronouncements).

 

On August 17, 2010, the FASB and IASB released an Exposure Draft of the proposed new standard. We have been following the development of the proposal on our Lease Accounting blog, but The following is a complete overview of the Exposure Draft.

While most of the focus has been on the fact that the new proposal would make all leases capital, equally or perhaps even more significant is that the boards want to expand the rents that need to be reported. Under FAS 13 (and the very similar international standard, IAS 17), the concern is for the minimum lease payments, the base amount that a lessee is required to pay. The proposal calls for capitalizing the expected lease payments, including renewal options deemed “more likely than not” to be exercised plus an estimate of contingent rents. For retail chains in particular, the impact of this change could be massive. We recently did a study for a mid-sized retail chain, and found that when all of their renewal options (in some cases going out 40 years or more) were included, their estimated new asset and obligation under capitalized leases is greater than all their existing liabilities, and nearly as large as their total assets. The impact on financial ratios could be material for many companies.

This standard is part of a large package of standards that the FASB and IASB are working on in a convergence project (creating common standards for both U.S. and international reporting). There will be a few minor differences in the lease standard because other standards on, for instance, impairment differ; users reporting under each system would apply the relevant standard. There are a few areas of lease accounting where the FASB and IASB reached different conclusions, and both options have been presented in the Exposure Draft. It is expected that the boards will try to reach a common conclusion for the final standard, basing their decision in part on comment letters received.

The Preliminary Views document that the boards put out in early 2009 discussed only lessee leases. However, there was a strong push from users and preparers to revise standards for lessee and lessor leases simultaneously, and the boards agreed to do that, so the Exposure Draft includes both.

The following are major points of interest for both lessees and lessors in the new proposal:

• The lease term is to include renewal options (and reflect termination options) so as to make the longest term “more likely than not” to occur. Determining likelihood of renewal is to be based on both contractual and non-contractual factors, including past practice.

• Contingent rentals are to be estimated from inception and included in the capitalized value of the lease. Estimation is to use an “expected outcome” approach, which entails probability weighting different possible outcomes.

• Payments for residual value guarantees are also to be estimated (unlike the current standard, which requires recognizing the entire guarantee even if it is considered unlikely to be paid in full or in part).

• The lease term, contingent rentals, and residual guarantees are to be updated when changes in facts and circumstances indicate a significant change from the prior reporting period. Changes that apply to future periods result in adjustment of the asset and obligation; changes that reflect current or past periods are recognize immediately in the income statement. The interest rate for a lease doesn’t change when these changes are recognized.

• Where a lease includes services, the service component can be excluded from capitalization if it is “distinct.”

• A lease contract is considered a sale rather than a lease (and therefore out of the scope of the new standard) if it transfers control of the underlying asset and all but a trivial amount of the risks and benefits of ownership. A lease with ownership transfer or a bargain purchase option would normally meet this criterion.

• Sale/leaseback accounting is permitted only when the transfer of the property qualifies as a sale under the rules specified.

• The effective date is not yet determined, but we doubt it will be before 2013. (Several other new standards will probably go into effect at the same time; the boards have said they recognize that substantial work is required for implementation.) However, the date of application for setting up operating leases as capital will be the beginning of the first comparative period presented in the financial statements. So if you show three prior years in your financial statements and apply the new standard in 2013, your date of application is January 1, 2010.

The following are major points of interest for lessees in the new proposal:

• All leases are to be capitalized. There is no exclusion from capitalization for short-term leases, though the boards will permit leases with a total maximum lease term of 12 months or less to be capitalized at the undiscounted value of the rents, which provides a slight simplification of calculations (no interest needs to be calculated). The boards noted that materiality considerations apply to this as well as any other standard, but that even if an individual transaction might be immaterial, a large number of small transactions could be material. The asset is called a “right-of-use asset,” and is to be reported alongside, but separate from, owned assets according to the nature of the underlying asset.

• Initial direct costs are to be added to the asset, to be depreciated over the life of the lease.

• As with FAS 13, the liability is amortized using the interest method; the asset is amortized like other property, plant, and equipment. The interest and depreciation expense are reported separately from other interest and depreciation, but in the same place on the income statement.

• The interest rate used for present valuing the rents and recognizing interest expense is the incremental borrowing rate, except that the “rate the lessor charges the lessee” may be used if known. This is essentially what has been known as the implicit rate, though it is now to include contingent rents.

• Cash payments for leases are considered financing activities in the statement of cash flows.

• Existing operating leases will be capitalized by present valuing the remaining rents as of the date of application. Lessees will adjust the right-of-use asset for any existing deferred/prepaid rent liability or asset. Existing “simple” capital leases (with no contingent rent or renewal options) can be maintained with no changes.

• Disclosures include:

• A prose description of leasing activities, including assumptions and judgments for valuing contingent rentals and options, sale & leaseback transactions, and information about significant leases that haven’t yet started.

• Initial direct costs incurred during the reporting period.

• A reconciliation of opening and closing balances for right-of-use assets and lease liabilities.

• A maturity analysis of future rents, by year for five years and all remaining combined (like the existing future rent commitment disclosure, but with no requirement to report interest and obligation payments separately). Minimum lease payments are to be separated from contingent rentals, termination penalties, and residual guarantees.

The following are major points of interest for lessors in the new proposal:

• Capitalization of leases happens in two basic forms: If the lessor retains exposure to significant risks and benefits related to the asset, the lessor uses a “performance obligation” approach. Otherwise, the lessor applies a “derecognition” approach, which is similar to existing direct financing lease accounting.

• In either case, the lessor sets up a lease receivable, as the present value of the rents discounted at the rate the lessor charges the lessee (i.e., implicit rate) plus any initial direct costs.

• With the performance obligation approach, the lessor sets up a performance obligation equal to the lease receivable. The performance obligation is amortized over the life of the lease (straight-line unless there is another pattern of use). The underlying asset remains on the books.

• With the derecognition approach, the owned asset is removed from the books and replaced with the receivable and a residual asset. A gain or loss at inception (for the difference between the receivable and the proportional carrying amount of the underlying asset) is permitted.

• A lessor may elect not to recognize assets or liabilities for a short-term lease (12 months or less maximum term including renewal options) entirely. Rent would be recognized as income when received.

• On transition to the new standard, any existing capital leases that need to use the performance obligation approach will require reinstating the asset that was derecognized under FAS 13.

• Leveraged lease accounting is eliminated.

• Disclosures include:

• A prose description of leasing activities, including assumptions and judgments for valuing contingent rentals and options, sale & leaseback transactions, and information about significant leases that haven’t yet started.

• Initial direct costs incurred during the reporting period.

• A reconciliation of opening and closing balances for lease receivables, performance obligations, and residual assets.

• A maturity analysis of future rents, by year for five years and all remaining combined. Minimum lease payments are to be separated from contingent rentals, termination penalties, and residual guarantees.

This is only an overview of the highlights. For the complete text of the Exposure Draft, please visit the FASB’s web site.

Your response is welcomed by the boards in the form of a comment letter, sent by email to director@fasb.org, File Reference No. 1850-100. The comment letter deadline is December 15, 2010.

What FCS is doing

This is the first significant change to lease accounting since FAS 13 was released in 1976. (There have been small modifications in the years since, but nothing that affected the overall concepts and structure.) FCS has specialized in lease accounting for 35 years, and we remain committed to providing top quality lease accounting for our clients.

We will be updating EZ13 to meet the new requirements. There are significant changes in implementation required (assuming the final standard is essentially the same as the Exposure Draft), particularly to respond to the requirement that contingent rentals be recognized in the asset and liability, and that they and inclusion/exclusion of renewal options be updated during the life of the lease. We will expand the capabilities of our system to include these.

Right now, the Standard Edition of EZ13 can generate pro-forma reports that capitalize your existing operating leases at either a single interest rate for all leases or a specific rate per lease (such as a rate based on the remaining life of the lease). If you have information on renewal options that are currently not reported under FAS 13, and you wish to add them to the existing leases for analysis purposes, you can do that on a test database.