Lease accounting draft finally comes out
Friday, 17 May 2013 10:52
The two standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) - have issued almost identical versions of the proposal, consistent with the aim of a converged standard.
Most of the divergences between the two versions concern aspects of relatively minor importance, within the disclosure rules for notes to the accounts. Those mainly reflect areas of close interface with the accounting rules for property, plant and equipment (PPE) owned by the users, where the respective accounting standards (IAS 16 within international financial reporting standards (IFRS) and Topic 630 in US GAAP) are in many respects non-convergent.
There are, however, some significant “alternative views” released with ED2, covering some of the major issues, where minorities on each of the Boards have expressed dissent.
P&L expensing rules
The core objective of the new standard is to require on-balance-sheet recognition by lessees of all leases capable of running for more than 12 months. However, one of the most notable parts of the release is the section of the “Basis for Conclusions” document accompanying the main draft, addressing the most controversial lesse accounting issue that arose within the re-deliberation period after the first exposure draft (ED1) issued in 2010. This is the method for expensing leases in the profit and loss (P&L) account or income statement, where the Boards last June adopted a split model as between equipment and real estate leases.
What is proposed is described as a new lease classification system. Under current rules the split into finance and operating leases determines whether or not the asset goes on the balance sheet, and it is based on whether “substantially all of the risks and rewards of ownership” are passed to the lessee.
Under the new proposals all leases – except those that cannot run for more than 12 months – will go on-balance-sheet. The new lease classification split, into what the Boards are calling Type A and Type B leases, will determine the lessee's periodic expense profile – and the dividing line will be struck in a different place.
The proposal is that most real estate leases will be Type B. These will be expensed on a straight line basis, and presented as a single rental expense, like operating leases under existing rules (although the difference of course will be that the asset will now be on-balance-sheet). Nearly all equipment leases by contrast will be Type A - expensed on a front loaded basis, like current finance or capital leases (in fact a combination of heavily front loaded finance charges, and deprecation or amortization normally on a straight line basis).
There will be some exceptions on either side. Some of the longest property leases, like for example the 99-year leases sometimes used in UK real estate, will be Type A; and a very narrow range of equipment leases - where the residual value (RV) is exceptionally high and yet the lease period can run for more than 12 months so capitalization will be required - might be Type B.
The Boards are claiming that the underlying principle of the split will be consistent for both equipment and property leases. The stated principle is that a lease should be Type A, accounted for like a financing transaction, “if the lessee consumes more than an insignificant proportion of the benefits embedded in the underlying asset”. That is an intentional moving of the goal posts compared with existing lease classification. At present, there is in effect financing type treatment only if the lessee consumes substantially all the benefits of the asset; whereas the new proposal is for financing type treatment in any case where the portion consumed is significant.
Yet the starting point for the test will be whether the lease is for equipment or real estate. If it is equipment, it will be Type A, front loaded expense, unless either the lease term is insignificant in relation to the economic life of the asset, or the present value (PV) of the lease payments is insignificant in relation to the fair vale of the asset.
For real estate, it will be Type B unless either the lease term is a significant part of the asset's economic life, or the PV of lease payments represents substantially all of the fair value of the asset.
At first sight this appears not to be consistent, in that the Boards have not moved the goal posts for real estate leases (where that PV test at “substantially all” of fair value is in fact taken from the current IAS 17 international standard) as they have for equipment leases. However, the Boards argue that this is not truly inconsistent, because in the case of a commercial property lease the economic life part of the test will relate to the life of the building, which of course represents only a part of the value of the whole property including the land value.
They say that a property lessee is not truly consuming more than an insignificant portion of the benefits embedded in the property (including the land) unless the lease term is a major part of the remaining economic life of the building; whereas of course equipment lessees are using up rapidly depreciating assets.
The equipment vs real estate split in the P&L expensing model remains highly controversial. It has already attracted criticism before ED2 was released, and seems certain to attract widespread comment in the formal responses.
Dissenting views
Two of the 16 IASB members and three of the seven FASB members have entered “alternative views” on one aspect or another of ED2. Most of these are wholly or largely concerned with lessee rather than lessor accounting.
On the P&L expensing issue two IASB members and one from FASB favour a single model equivalent to Type A – i.e. no straight line expensing for real estate lessees. Another FASB member Tom Linsmeier favours what he calls a single model, though he is indifferent as between Types A and B.
However, Linsmeier's proposal would not be a true single model, if it were to be based on Type B. For in fact no member of either Board would support straight line expensing for contracts presently classified as finance or capital leases. If operating leases were brought on-balance-sheet with the same straight line P&L expensing as they have now, finance leases would be scoped out of the leasing standard altogether – a solution that Linsmeier favours in any event.
This is in fact what the joint Boards proposed for a brief period in 2011, when they accepted the case for what they now call Type B expensing for all operating leases. They soon reversed that position, and they never got as far as specifying exactly how scoping-out rules would be formulated for finance leases. However, the intention would have been that the substantive accounting rules would remain as they are for finance leases - but these would be described as “in-substance” or “constructive” purchases rather than leases, and the rules would be found through applying other standards.
For lessees the relevant standards for “scoped out” finance leases would have been the PPE accounting rules in IAS 16 or Topic 630. If the same principle were applied on the lessor accounting side, which does not necessarily follow, lessors would find the principles for finance lease accounting in the new converged revenue recognition standard which the Boards have recently agreed and will soon be issuing.
It would seem that some useful guidance for finance lease accounting could be lost if finance leases were to be scoped out from the leasing standard – though the Boards did not adhere to this “scoping out” idea for long enough to work out exactly how it would operate in practice.
Two FASB members and one IASB member disagree with the Boards' decisions to simplify the rules for variable rentals and optional continuation periods – i.e. essentially excluding estimated variations, and also excluding continuations except where there is a significant economic incentive to renew the lease.
All three of the dissenting FASB members say that if the equipment vs real estate expensing split is to go ahead, lessees should be required to adopt additional disclosure rules to those currently proposed by the Boards. They argue that this is necessary so that account users could make sense of the different line items in the accounts (i.e. rentals for Type B leases, and interest and amortization for Type A ones).
Bizarrely it would seem, one dissenting IASB member argues for capitalizing service charges as well as lease commitments in the case of service-inclusive leases (though without at this stage bringing any other kind of service contract on-balance-sheet for the user).
Perhaps the most interesting “alternative view” is expressed by Marc Siegel of FASB. He does not specifically oppose the split expensing model, but opposes the exclusions of variable and optional rentals so strongly that he suggests that any net benefits from the overall proposals would not justify the compliance costs of a change. At the same time he recognizes that including more variable and contingent rentals would be more onerous for lessees; and says that if that is not considered acceptable, then the best solution would be to make only limited changes to existing rules, and not to capitalize operating leases at all.
There are thus two dissenting Board members who would favour retaining the existing lease classification line for one or another lessee accounting purpose – for scoping out finance leases in Linsmeier's case, or possibly for leaving operating leases off-balance-sheet as suggested by Siegel. Although these are both FASB members, they would favour converging on the “principles based” IAS 17 version of lease classification, rather than the US GAAP version in Topic 840 (formerly coded as FAS 13) with its “bright line” numerical tests.
There are also some dissenting comments on the proposals for lessor accounting, where the Boards' main proposal would put most equipment lessors on the receivable and residual (R&R) model, giving a front-loaded income profile similar to finance lease accounting for lessors at present.
One FASB member favours leaving the lessor rules exactly as they are now. Another favours fully aligning lessor accounting with the new revenue recognition standard, instead of the main proposal for the R&R model for equipment lessors and straight line income recognition for many real estate lessors. It seems unclear whether this would much change the overall income recognition profile for most equipment lessors compared with R&R.
Two IASB members favour a single front-loaded income recognition for all lessors except those opting for fair value accounting under the IAS 40 standard for investment property. This, however, would tend to leave equipment lessors in the same position as the main proposal.
Other issues
Many of the ED2 proposals will be much more acceptable to the leasing industry compared with ED1. This is certainly true of the main lessor accounting model, but also of many other aspects affecting lessees and/ or lessors.
These include the proposal to exempt the most short term leases below 12 months' duration from lessee capitalization; the proposals on variable rentals and renewal options; the lessee transition rules for pre-existing operating lease; the sale and leaseback rules; the rules for identifying embedded leases within what would be regarded as pure service contracts if they were not service-inclusive leases; and also the guidance for what are more clearly service-inclusive leases.
Nevertheless there are some detailed proposals that could well be criticized. The Boards are refusing to clarify whether the lessee's “right of use” asset is to be regarded as a tangible or an intangible asset. Given the specific proposals in the draft, that would make no difference to accounting rules as such. Yet it could make a big difference to banks as lessees under new global regulatory capital rules due to be phased in over the coming years under the Basel III accord. The treatment of intangible assets for these purposes will be highly adverse compared with tangible assets.
Another issue is that leases with rental escalations based on a price index would appear to be under-valued compared with more typical leases with level rentals – although this results from a genuine attempt to simplify the rules. For the initial measurement of rentals subject to escalation will take no account of forecast index escalations, but will still then be discounted to a PV as with level rental contracts that cannot escalate.
On the lessor side of the transition rules for leases already running, there is an unfortunate quirk in proposals for operating lease portfolios that have previously been securitized. This would require full recognition of the lease receivables outstanding at the time of transition.
This is not consistent with the treatment of finance lease or loan receivables securitized at a comparable past date, nor with the future treatment under R&R of securitizations of leases that would be currently classified as operating leases. In all those cases the portion of receivables on which risk had been transferred to the funder would be de-recognized by the originating lessor.
The Boards' staff report on this subject at the deliberation stage recognized that this treatment was anomalous. As it commented, “it would be punitive to preclude a lessor from recognizing the [securitization] transfer when the only reason the sale was not recognized at the time of the transfer was that there were no financial assets to de-recognize”. The latter point is a reference to current operating lease accounting rules where the lessor recognizes the underlying asset rather than lease receivables. The staff had recommended a more equitable solution, but this was not adopted.
Timetable to completion
ED2 does not specify an effective date for the new rules. That will be decided by the Boards when the standard is being finalized. If, as is possible, that comes around the end of this year, the most likely general effective date of the new standard will be January 2017.
However, for most unlisted companies who are subject to IFRS it could be later, possibly January 2018 or even later still. Most of these are able to comply with a simplified IFRS standard for SMEs, first issued in 2009. The IFRS SMEs standard omits some of the general requirements from other specific standards, though it does currently include all the IAS 17 rules for leases. It seems likely that it will eventually be revised to include all the new leasing standard rules, but the crucial point on timing is that IFRS SMEs is only updated periodically.
The IASB is planning to update it within the coming months, and subsequent updates are planned at three-yearly intervals. Since the new leasing standard will still be out for comment at the time of this year’s update of IFRS SMEs, it will probably be only at the following update - perhaps to be issued in 2016 and to take effect from January 2018 - that the leasing rules in IFRS SMEs will migrate from the IAS 17 basis to the new leasing standard.
In US GAAP there are no separate accounting rules for SMEs or for unlisted companies; but FASB will probably allow a later effective date, possibly January 2018, for unlisted companies.
For accounting periods before the effective date, listed companies in many jurisdictions will be required to produce comparative figures on the new basis, alongside their main accounts under the existing lease accounting rules. For them, the date of initial application (DIA) will therefore be earlier than the effective date. For EU listed companies the DIA could be January 2016, and for American ones as soon as January 2015.
First reactions
All of the main leasing industry bodies will of course be returning detailed response comments to the Boards in due course. Some have issued public statements as a first reaction.
Stephen Sklaroff, Director General of the Finance & Leasing Association (FLA), said: “It is disappointing that once again the IASB has published a set of proposals for important new accounting rules which do not command the full support of its own members.” “While we are pleased that the Board’s original highly complex proposals have been simplified, we remain concerned that the revised draft rules will still be difficult for business users of leasing to implement. We will be urging the Board to make further changes to reflect the needs of the hundreds of thousands of businesses of all sizes which rely on leasing to fund their equipment investment.” While the FLA's comments concentrate on the lessee accounting side, the US Equipment Leasing and Finance Association (ELFA) expressed reservations on both the lessee and lessor sides. ELFA president and CEO William Sutton said: “[We support] FASB and IASB as they seek to establish a sound, workable accounting standard that applies to the assets and liabilities arising from lease transactions. We find, however, that the lease accounting model as proposed in the long-awaited exposure draft will not result in a significant improvement in the quality or reliability of financial information, will not faithfully depict the economics of equipment leases, is unduly complex and will impose a compliance burden on lessees.....”
“The primary issues [of our concern]relate to the new classification criteria for lessees and lessors, lease cost allocation for lessees, and revenue recognition for lessors that will not reflect the legal and economic nature of lease transactions in ... financial statements.”
comments powered by Disqus