Written by Andy Thompson, legal & regulatory editor

balance sheet

The major outstanding decision on the global lease accounting standard – the extent to which small ticket leases might be exempted from the proposed lessee capitalization rule - now seems likely to be addressed in about three weeks’ time at the standard setters' July meeting.

When they first re-deliberated the major issues after last year's second exposure draft (ED2) of the new lease accounting standard at their March meeting, the two Boards – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) – had hoped to receive a further staff report on small ticket exemptions in April or May. However, their staffs have been conducting some outreach consultations with lessees and lessors on this subject, and the process has taken longer than expected.

Initially it seemed that a possibly even more significant lessee accounting issue – that of the expensing rules in the profit and loss (P&L) account for all those leases that are to be capitalized – could be revisited, at least by FASB, in the light of the eventual decision on small ticket exemptions. The two Boards had failed to reach convergent decisions for the expensing model in March, with the IASB deciding to require front-loaded “Type A" expensing (i.e. current finance lease rules) for all leases and FASB deciding for operating leases to continue to be expensed on the present straight line or “Type B" basis.

However, FASB members appeared to feel then their initial decision on the expensing model could be reviewed if a substantial proportion of small ticket leases were to be excluded from capitalization.

That now seems rather less likely.

For over the past three months the Boards have been jointly re-deliberating a number of “second order" issues within the draft standard. Many of these decisions are affected by the main expensing model. All have been addressed on the basis that the non-convergent March decisions of the two Boards on the expensing model will stand; and in these discussions FASB members have not seemed to be actively contemplating a change in their expensing model, as had seemed possible in March.

In March the possibility of reaching consensus on the expensing model had been the main driving force for a further review of small ticket exemptions. Initially the question of small ticket reliefs was considered before the Boards reached their deadlock on the expensing model; and at that stage neither Board had been ready to accept very significant small ticket exceptions (though even on that point the two were not fully converged).

If convergence on the expensing model is now less likely, this may therefore remove some of the impetus for major small ticket reliefs. Nevertheless the staff report is likely to air a wide range of possible exceptions for small value leases, consistent with its original remit.

The global equipment leasing industry will no doubt be hoping for substantial small ticket concessions. At the same time, however, many lessees and lessors in the US market will have welcomed FASB's March decision on P&L expensing, and will be hoping that this will not change as a result of any substantial exemptions from capitalization at the small ticket end.

In June the Boards re-deliberated the proposed rules for lessee balance sheet presentation, cash flow statements and accounting for sub-leases.

Balance sheet presentation (lessees)

The Boards agreed rules for lessees' balance sheet representation which were broadly consistent with those proposed in ED2, but adapted for the non-convergent basic accounting models adopted by each Board in March.

The IASB, with its single model approach, was able to adopt a correspondingly simpler version of the presentation rules. On the assets side, in accordance with the staff recommendation the IASB agreed that lessees should either present the “right of use" (ROU) leased-in assets as a separate line item on the balance sheet or disclose such assets in the notes. Where they are not presented as a separate line item, they should be included in the same line items as if they were owned; and the notes should disclose which line items contain ROU assets.

FASB agreed broadly similar rules, but with differentiation between Type A (i.e. capital lease) and Type B (operating lease) ROU assets. FASB agreed to prohibit the mixing of material amounts of Type A and Type B ROU assets in the same ROU line item or disclosed amount (a point on which their staff view had been divided). In the case of the disclosure option, the “narrative disclosure" would have to specify which line items contain Type A, Type B or both types of ROU asset.

Similar non-convergent presentation rules were agreed for the liabilities side, in this case fully in accord with the staff recommendations. Thus the IASB agreed that lease liabilities should be either presented as a separate line item or disclosed in the notes with narrative as to which line items include lease liabilities. FASB agreed corresponding rules, but with differentiation between Type A and Type B line items or disclosures.

Both Boards agreed not to specify whether lease liabilities should be presented as financial or operating liabilities. In some jurisdictions where insolvency law treats current operating leases differently from debt, as in the US, this will permit lessees to present the relevant items as operating liabilities; though otherwise the Boards envisage that all lease liabilities would be characterized as financial ones.

In the course of re-deliberating the balance sheet presentation rules, some FASB members said they were unhappy with the terminology of Type A and Type B leases. They argued that in reality capital or Type A leases should be regarded as “in-substance purchases" (I-SPs) rather than leases. They did not appear to be arguing for these to be taken out of the scope of the leasing standard, which at a much earlier stage of the project had been proposed by both Boards.

However, FASB agreed to receive a further report from their staff on the implications of categorizing Type A leases as I-SPs. This seems to have the potential for creating further areas of non-convergence between the two Boards. For example, the logic of assimilating the accounting for finance or capital leases with that of outright purchases of property, plant and equipment (PPE) would seem to call into question the above decision to require separate presentation or disclosure of the former. For the present, that decision appears to stand. However, pending the completion of the re-deliberation process across all areas covered by the draft standard, all of the Boards' decisions technically have tentative status.

ROU: tangible or intangible?

The question of specifying whether the lessee's ROU asset should be classified as a tangible or intangible asset was not raised in the staff report on presentation issues. Prior to ED2 the Boards had made a specific decision not to clarify this point. This was criticized in some of the response comments.

This issue is of particular concern to banks as lessees (principally of real estate, which comprises the bulk of their leased-in assets by value). For intangible assets on banks' balance sheets are becoming subject to much more stringent capital requirements compared with their tangible infrastructure assets, under changes to the global Basel III rules which are currently being phased in. These will affect banks' ROU assets from the date when the new accounting standard becomes effective.

It seems that the Boards now have no plans to address this issue within their post-ED2 re-deliberations. However, it appears that the IASB's members and staff consider that under the single Type A lessee accounting model agreed by that Board, it should be clear that the ROU asset is a tangible PPE item.

Banks had significant concerns in this area even at the time of the first exposure draft (ED1) in 2010, when both Boards were proposing what is now called Type A lessee accounting for all leases. However, that was largely because the “Basis for Conclusions" (BC) document accompanying ED1 stated that ROU assets were analogous with intangibles. This was not repeated in the BC part of ED2 and is not expected to feature with the final standard.

On the other hand it is much less clear that Type B ROU assets within the FASB version of the current proposals would necessarily be regarded as a tangible asset. This may still therefore be a major concern for those large US banks who are affected by Basel III.

Cash flow statements

On the presentation of the cash flows for lessees, the two Boards agreed differing solutions reflecting the divergent accounting models agreed in March.

The current cash flow rules are not in fact convergent in respect of finance or capital leases. Under international financial reporting standards (IFRS), in the IAS 17 standard a lessee classifies the principal repayments under these leases within financing activities, but has a choice as to whether to classify interest payments as financing or operating activities (as permitted by the general rules for interest payments in the cash flow accounting standard IAS 7). However, under the US leasing standard Topic 840 (formerly coded as FAS 13), it is obligatory to classify the interest payments as operating, while the principal repayments are financing activities as in IAS 17. For operating leases, both standards require the rentals to be classified as operating expenses.

In ED2, where both boards were proposing a split lessee accounting model, the Boards proposed no change in the respective Type A and Type B rules compared with current finance and operating leases. They would thus not have converged in respect of Type A cash flow presentation, since that would have required either for the IASB to adopt rules in conflict with IAS 7, or for FASB to open up a new elective option, which in general is not an approach favoured by either Board.

For FASB, since it proposes to retain a split lessee accounting model, the decision was straightforward. Its members agreed to retain the ED2 recommendations, so that Type A cash ouflows are split between principal repayments within financing activities and interest within operating; while Type B cash payments are all operating.

For its single Type A model, the IASB agreed to adopt the current rules for finance leases (i.e. principal repayments as financing items, and with an elective choice consistent with IAS 7 for the interest payments). It also agreed on a disclosure item in the notes of a single cash outflow amount for all leases.

The IASB's cash flow presentation decision was not unanimous and had not been recommended by its staff. On transition to the new standard it will result in a substantial distortion through the principal repayment element (and in some cases, depending on the elective choice, all payments) on current operating leases shifting from the operating to the financing classification.

The staff had therefore recommended in favour of operating classification for all lease outflows. However, some two thirds of IASB members preferred consistency with current IAS 17 finance leasing rules and with IAS 7.

Some respondents to ED2 had suggested aligning the Type A lessee cash flow presentation approach with that for assets purchased outright, with consequent “day 1" recognition of investing cash outflows and financing cash inflows. This was noted in the IASB section of the staff report. However, the staff recommended against introducing any non-cash movements into the cash flow statement; and Board members agreed.

The Boards also decided the cash flow presentation rules for lessors. Here the decision was straightforward in view of the broadly converged decision in March to retain the existing main models for lessor accounting. Lessors currently classify all cash receipts within operating activities irrespective of the lease classification rules for other accounting purposes. This will continue.


The remaining issue considered by the Boards in June – that of accounting for sub-leases - was very much complicated for the IASB by its March decision to move to the single Type A model for lessees, while retaining (in convergence with FASB) the current split accounting models for lessors

Under the proposed ROU lessee accounting concept the difficult accounting issue within sub-leases is that for the intermediate party as sub-lessor. For the other parties in the transactions (i.e. head lessor and sub-lessee) the respective lessor and lessee accounting rules can be applied without any complications resulting from the existence of a sub-lease structure; and the same is true of the sub-lessor's position as lessee under the head lease.

The question is whether, for the purposes of classifying the sub-lease as Type A (i.e. finance/capital lease) or Type B (operating lease) under the lessor accounting rules, the sub-lessor should appraise the sub-lease in relation to its own ROU asset under the head lease, or in relation to the underlying asset subject to the head lease. In the case of real estate transactions in particular, the lessor's ROU asset under the head lease will normally be worth substantially less than the underlying asset held by the head lessor. Therefore the sub-lease would sometimes be classed as Type A for lessor accounting if assessed by reference to the sub-lessor's ROU as head lessee, but alternatively as Type B if done by reference to the underlying asset.

In ED2 it was proposed to specify the sub-lease classification by reference to the underlying asset; whereas in ED1 this had been proposed by reference to the ROU. This has remained a potentially live issue throughout the project since ED1, during which time split models (though of varying kinds at different stages) have consistently been envisaged on the lessor accounting side.

The staffs' recommendation on this was split. The decisions that were adopted, as recommended by some of the joint staffs, were non-convergent in consequence of the different rules in the main lessee accounting models affecting the sub-lessor's head lease. In the IFRS version of the new standard the sub-lessor will classify the sub-lease with reference to the ROU asset, while in the US GAAP version it will be classified with reference to the underlying asset.

This means that sub-lessors accounting under IFRS will more often account for the sub-lease as Type A (consistently with the head lease under the single IASB lessee model) than if they classified by reference to the underlying asset.

At the same time US sub-lessors will avoid the mismatched accounting that could frequently result from classifying the sub-lease as Type A, if this were done by reference to their head lease ROU asset, where their head lease was Type B (as will often be the case with real estate). Mismatches could have arisen particularly in relation to the performance measure of profit before interest, since in such a case the sub-lessor would have accounted for the head lease expense within operating expenses while having to account for the interest income on the sub-lease within financial rather than operating income.

Some staff had nevertheless recommended a converged solution, assessing the sub-lease by reference to the underlying asset in IFRS as well as US GAAP. Among the reasons put forward by these staff for opposing classification in IFRS by reference to the sub-lessor's ROU, as now adopted, were:

• that there will be mismatched P&L accounting in many cases even where the terms of the head lease and sub-lease are closely matched, with the head lease being Type A under the IASB single lessee model while the sub-lease would be Type B with straight line income recognition;

• that compared with current IFRS rules where there is no special guidance for sub-leases, some sub-leases now classified as operating leases will have to be re-classified on transition to the new standard as Type A (especially where the sub-lease is for most of the remaining term of the head lease but the asset's useful life is substantially longer) – thus conflicting with the general decision not to change current lessor accounting;

• that Type A lessor accounting, of which there will be a higher incidence under the adopted decision, is generally more complex for the sub-lessor compared with Type B.

However, the Boards overwhelmingly agreed on the divergent decisions as noted above.

The Boards concurred in several other decisions, in accord with staff recommendations, that will in general prevent any “netting" of the head lease and sub-lease contracts in accounting by the sub-lessor. The two contracts will have to be accounted for separately unless they meet the general “contract combination" rules agreed by the Boards in April this year.

Those contract combination rules apply only in the case where multiple contracts are agreed simultaneously with the same parties. Therefore in sub-leases they could potentially apply only to some “lease and leasebacks"; and these could in any case end up being addressed within the terms of specific sale and leaseback rules which have yet to be re-deliberated.

Under the general rules for accounting for financial instruments, in both IFRS and US GAAP, netting of financial assets and liabilities on the balance sheet is permitted where certain criteria are met, including that the reporting entity has a legally enforceable right to offset the debt against its receivable. This is potentially applicable to sub-leases, but only where the head lease and sub-lease are both Type A – i.e. financial items on the balance sheet – in addition to the other criteria being met. In IFRS both contracts will of course be Type A for the sub-lessor wherever the sub-lease is so, since the head lease is always Type A under the IASB's single lessee model.

The leasing standard will not set aside the general financial instrument standards' netting rules in the case of sub-lease structures that are Type A on both sides. However, the Boards agreed not to allow netting in any case where either head lease or sub-lease is Type B, so that the financial instruments rules do not apply. In any case it would seem unlikely that the conditions for netting could be met in practice, except in unusual contracts where the head lessor guarantees the sub-lease, or in “lease and leasebacks".

Under the new converged revenue recognition (Rev Rec) standard, an intermediate party is allowed to offset a specific expense against related revenue in the P&L account where this party is acting as an agent rather than a principal in the revenue-generating transaction. The Boards' staff do not consider that in practice a sub-lessor would in fact often be acting as an agent; and they noted that in any event this Rev Rec guidance could only apply where the sub-lease is Type B, so that the sub-lessor recognizes rental revenue rather than interest income.

The Boards agreed that a sub-lessor should not offset lease income and head lease expense except where it recognizes sub-lease income as revenue and acts as an agent under the “principal/ agent" guidance in the Rev Rec standard