I need to catch up on the boards' activity over the last two months. I've taken a summer hiatus, but they didn't...
The most important news is that at the July 21 meeting, the boards unanimously decided to release a second Exposure Draft. The changes to the proposed standard from the original Exposure Draft are so significant that they felt it important to get feedback from interested parties. Some decisions remain to be made before the new Draft can be released; they expect to complete those deliberations during Q3, with a new Draft released soon after. The wording seems to suggest that the Draft would come out in early October.
Additional decisions reached this month:
Lessor Accounting
The performance obligation model has been scrapped. All leases (except for short-term leases) will be accounted for using a "receivable and residual" model, which is essentially the same as the "derecognition approach" described in the Exposure Draft. Main points of this model:
* The lessor recognizes a right to receive lease payments (matching the lessee's obligation to make payments) and a residual asset.
* The discount rate to present value the payments is the "rate the lessor charges the lessee" (the internal rate of return, based on the asset's value).
* The residual asset accretes (increases using the interest method, same interest rate) over the lease's life.
* If the asset's carrying amount is lower than the lease's value, a profit (on the portion of the asset represented by the lease receivable) can be recognized at commencement of the lease if reasonably assured.
Short-term leases, defined as those with a maximum term of 12 months or less, will be accounted for as operating leases (no balance sheet effect, just income recognized over the lease term on a systematic basis, usually level). This will protect against needing to do convoluted accounting for things like rental cars and hotel rooms.
Operating lease accounting will also be permitted for leases of investment property measured at fair value. This is currently only available under IFRS (IAS 40). But the FASB is working on a proposed investment property standard which would be similar, with an Exposure Draft scheduled for Q3 2011.
Contingent Rents Dependent on an Index or Rate
While other contingent rents are excluded from the capitalized calculation of leases, those that depend on an index or rate have to be included. An example would be a lease whose rent is based on CPI or LIBOR. Such leases are to be initially measured based on the index/rate at the commencement of the lease, then recalculated at the end of each reporting period using the new index/rate. The change is booked to net income if it applies to the current reporting period, or as an adjustment to the right-to-use asset (for a lessee) for adjustments that relate to future periods. Lessors would recognize an adjustment in the receivable in profit or loss.
This is a potentially significant cause of recalculations on leases; many real estate leases have CPI escalators that adjust every year. The boards decided that the benefit of more accurate presentation of actual rents due outweighs the effort required.
Lessee disclosures
The boards approved a lengthy set of disclosures for lessees:
* Reconciliation of opening & closing balance of right-to-use assets, disaggregated by class of underlying asset
* Reconciliation of opening & closing balance of lease liabilities (no disaggregation required)
* Future rent commitments, similarly to current FAS 13 requirements (by year for five years, then all remaining, then subtracting interest to reconcile to the liability balance). Note that this is different from current IFRS requirements. Preparers would have the option to disclose by year for more than 5 years, if that would provide better information.
* Information about leases signed but not yet started if they create "significant" rights and obligations
* Information about contingent rentals and options
* A table of expenses: amortization, interest, variable payments, and short-term rents, plus a breakdown of principal and interest paid
* Information regarding any expected material changes in short-term rentals
However, they explicitly are not requiring disclosure of discount rates, fair value of liabilities, purchase options, or initial direct costs.
They also explicitly forbid combining interest and amortization expenses and presenting the total as lease or rent expense.
The boards split over whether or not to disclose future commitments for services and other non-lease components; the FASB wants such disclosure (which is already required by the SEC in the unaudited portion of the financial statements), while IASB does not. Presumably this will be reconciled at a later date (perhaps after the Exposure Draft is released and reviewed).
Lessee primary financial statements presentation
Lease right-of-use asssets and liabilities either must be presented separately in the Statement of Financial Position (balance sheet), or shown separately in footnote disclosures. The right-of-use asset is to be presented according to the type of underlying asset (land leases with land owned assets, etc.). They have decided not to define whether the right-of-use asset is tangible or intangible. This is a question that affects some regulated industries for tax and other purposes. The boards have decided to let the relevant regulatory bodies make the determination appropriate to their purposes.
The Statement of Cash Flows would show principal and interest payments in accordance with requirements for other financing. Variable lease payments (not capitalized) and short-term rentals are operating cash flows. New leases (creating a new asset & liability) would be an additional non-cash disclosure.
June meeting results in next post...
Showing posts with label Lessors. Show all posts
Showing posts with label Lessors. Show all posts
Tuesday, July 26, 2011
Wednesday, May 25, 2011
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.
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.
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