December meeting results

The FASB & IASB met again to discuss leases on Dec. 13 & 14. Significant decisions reached include:

Cancellable leases
If both the lessee and the lessor have the right to cancel the lease (without termination penalties) such that the minimum term, including any non-cancellable period and any notice period, is 12 months or less, it meets the definition of a short-term lease. The key here is that either side can cancel; if one side can require renewal, then normal lease accounting applies.

Investment properties
Rental income from property accounted for (under IFRS 40) as investment property will not be capitalized, as such property is out of scope of the new leasing standard. However, the boards still chose how to recognize rental income: straight line, or another systematic basis if more representative of use of the asset.

Disclosures for these lessor leases are to include:

• Maturity analysis of future rents (at least 5 years by year, then the rest combined). This is not to be combined with the maturity analysis for capitalized leases.
• Separate entries for minimum contractual rents and variable lease payments
• Cost, carrying amount, and accumulated depreciation on leases
• Narrative information about lease arrangement

Future meetings
The staff listed the following items to be redeliberated:

• the definition of investment property (which is scoped out of this standard)
• the "lessee accounting model"--as mentioned in a Wall Street Journal article that I commented on previously, the boards are going to discuss further a way to recognize level expense over the life of a lease, even though they rejected this earlier
• additional disclosure items
  

November meeting results

Sorry, I'm behind again. This is from a month ago; I'll post the results of December's meeting as quickly as possible. This is from the FASB & IASB joint board meetings of Nov. 15 & 16, 2011:

Leases in business combinations
An acquired lessee lease is set up as if it is a new lease at the acquisition date, except that the asset is to be adjusted for any "off-market" terms in the lease; that is, if the rent due is substantially above or below market rents, the difference between market (present valued) and contract is folded into the asset.

This is a significant change from current accounting, which calls for a fair value calculation for both the asset and the obligation at the date of acquisition, with the result that the two are normally different at the acquisition date. Now the normal case will be equal asset and liability at acquisition, unless the rent is considered off-market.

An acquired lessor lease, using the receivable & residual approach, is set up as if it is a new lease at the acquisition date for purposes of calculating the receivable. The residual is the difference between the receivable and the fair value of the asset.

An acquired lessor lease that is treated as investment property or a short-term lease (originally or according to the remaining life at acquisition) is handled according to current rules under IFRS 3 and FASB Topic 805 for acquired operating leases. (However, I don't actually see anything explicitly talking about operating leases in Topic 805 or its original source, FAS 141, so I'm not sure what that means.)

Transition
If a lessee has a previously recognized intangible asset or liability to reflect (un)favorable terms in an operating lease, that should be folded into the right-to-use asset.

Currently, the sale of operating lease receivables by a lessor cannot be treated as a sale; instead, it is accounted for as a secured borrowing (because the receivable is not recognized on the balance sheet to begin with). The boards discussed whether to permit sale treatment at transition. Requiring it was seen as onerous; permitting it as an option would reduce comparability. The boards decided to permit it on a prospective basis only.

First-time adopters of IFRS generally would apply the same transitional rules as other companies, except that they are to use fair value determinations for a right-to-use asset.

Fighting on the expense profile

According to a Wall Street Journal article in yesterday's edition (available online only by subscription), most companies are resigned to the new lease accounting standard putting leases on the balance sheet. The primary issue they're pushing back on is the front-loading of expenses (which happens because interest is higher in the early years of a repayment schedule, while the depreciation remains straight-line throughout the lease term). The boards briefly considered, then rejected, a proposal earlier this year to make the expense profile straight-line by making the depreciation expense equal to the obligation repayment in each payment period; they didn't like the way the depreciation would look, and felt it was inconsistent with other aspects of accounting.

However, the topic hasn't died, and the article says that the FASB & IASB staff plan to revisit the issue with the boards, perhaps next month.

The article notes that the front-loaded profile is particularly problematic for retailers, who typically have lower revenues in the first years a store is open. Chains that are rapidly opening up new stores would be especially hard hit. The article indicates that investors also consider the expense front-loading unhelpful.

The article speculates that companies might shorten the life of their leases to reduce the impact of front-loading, but notes that that could cause problems for landlords who depend on long-term leases to guarantee their loans.

In other news, I realized I missed commenting on a November 1 meeting:

The boards worked through lessor disclosures, including:

• A table of all lease related income items, listing separately profit at lease commencement, interest income on the receivable, interest income on the residual, variable payments, and short-term lease income.
• Information about variable lease terms, renewal options, and purchase options
• A reconciliation of the right to receive payments and residual assets (showing beginning balance, additions, payments or residual accretion, terminations, and ending balance)
• A maturity analysis of future rent payments, by year for at least five years with the remainder as a lump sum
• Information about how the lessor manages risks on the underlying asset

The boards decided that a lessor doesn't need to disclose:

• Initial direct costs
• The weighted average or range of interest rates on leases
• "Fair values" of the receivable or residual (a term of art that requires determining a market price for sale)

Sale/leaseback transition

• An existing sale/leaseback transaction that resulted in a capital/finance lease will continue to be accounted for with no adjustments.
• A sale/leaseback with an operating lease or with no recognition of sale would be reevaluated based on the criteria for transfer of control of an asset in the proposed revenue standard (which presumably will be finalized no later than the leases standard; its exposure draft was put out Nov. 14). If met, the lease would transition like other operating leases.

Additionally, the FASB clarified that an exception from lease accounting under EITF 01-8, applicable to certain transactions entered into before May 2003, will not be retained, and such transactions will need to be accounted for as leases under the new standard.

This month's boards meeting

On Oct. 19, the FASB & IASB again met to discuss the new lease accounting standard. In a marathon session (scheduled for 5 hours), they reached a number of decisions in several areas. (Note: in the discussion below, and elsewhere in discussions about this standard, "effective date" is the date companies must start reporting under the new standard, while "date of initial application" is the date, normally two years earlier for U.S. companies, as of which leases must be treated as capital once the new standard takes effect, due to the requirement to restate years shown as comparables in the annual report.)

Lessee transition

• All existing capital leases will be carried over with no changes required. Previously, they had planned to require restatement of capital leases with variable payments or renewal options that would be treated differently under the new standard. They decided the benefit wasn't worth the cost, because in most cases the differences would be small (particularly given recent decisions to reduce recognition of variable payments and options).
• The incremental borrowing rate to use for operating leases to be capitalized will be a single company-wide rate, not based on the individual characteristics of each transitioning lease.
• Operating leases can be recalculated using either a "full" or a "modified" retrospective methodology. The same methodology must be chosen for all leases. Full means going back to lease inception and calculating the lease as capital. Modified is different from what was in the original Exposure Draft; I described it last month. They have clarified that the difference between asset and liability generated by this method is to be booked to retained earnings (no P&L impact).
• The simplifications ("reliefs") mentioned last month were all confirmed: leases that terminate before the effective date of the new standard won't have to be restated, even if they start after the date of initial application; initial direct costs are excluded during the same period; and preparers may use hindsight to set up the leases.

Lessor transition

• Capital leases other than leveraged leases can be carried over with no adjustments.
  
• Leveraged lease accounting is eliminated. Such leases will have to be restated.
• Current operating leases will have a receivable and residual set up using the present value of the rents and expected residual value at date of initial application, the interest rate being the rate charged in the lease as of lease inception; the underlying asset is derecognized. Lessors also have the option of full retrospective application.

Lessor receivables held for sale

• A proposal to report receivables held for sale at fair value was rejected. While this would superficially be consistent with IFRS 9 and the FASB's Accounting for Financial Instruments project, it was felt that it added complexity, was inconsistent with the rest of the leasing standard, offered opportunities for structuring, and would add more variability in profit and loss. Instead, any gain or loss would be recognized when a sale of the receivable is completed.

Variable payments for lessors

• If the rate a lessor charges a lessee assumes "reasonably assured" variable lease payments will be made, the residual asset (which by default contains the value of those payments, since the value is not in the receivable) will be adjusted by recognizing an adjustment to the residual. The adjustment is the variable lease payment divided by the fair value of the underlying asset, times its carrying amount.

Lessor receivable and residual

• Investment property is excluded from the lease standard scope. This keeps those properties under IAS 40 for companies using IFRS. The FASB is working on a project to create the same standard for the U.S. (which presumably will be complete by the time the lease standard takes effect).
• Profit on the residual will not be recognized until the asset is sold or re-leased.
• The residual is initially booked at the present value of the residual. The value is accreted, with interest income recognized for the accretion, using the same interest rate as for the receivable.