FASB Issues Lease Accounting Discussion Paper Inviting You to Comment

Summary of Decisions and Preliminary Views

Scope and Overall Approach

The project will focus on lessee accounting for material lease arrangements of plant, property, and equipment ' basically the scope of FAS 13 and its amendments. They do not plan to give any threshold for what might constitute immaterial leases.

The IASB decided to remove the existing requirement to classify a lease as a finance lease (in-substance purchase) or an operating lease. Thus, the same overall approach would apply for all leases. The FASB is still undecided as to whether leases should be classified.

Commentary: The failure to recognize that there are leases that are financings and leases that merely allow a temporary right to use the asset is a major flaw. The IRS and UCC make the distinction as the economics to the parties is very different. It should also follow that the accounting for the two types of leases should be different.

The Boards also decided on an overall approach that would apply the existing IAS 17 finance lease model to all leases ' meaning those leases that were capital leases and those that were operating leases under current GAAP. All material leases will be capitalized. The concepts behind the approach are:

• A lease contract gives the lessee the right to use an asset and obligates the lessee to pay rent for the term;
• The rights to use the asset are assets and the obligations to pay rents are liabilities that must be capitalized;
• To account for the whole lease contract rather than its components (like rent, purchase options, renewal options, contingent rents, etc).

Commentary: Applying the existing finance/capital lease model to all leases means that all leases will be accounted for as though the asset was purchased and financed with a loan. The P&L pattern of lease expense will be accelerated with straight-line rent expense replaced by depreciation and imputed interest. The impact increases as the lease term increases, for example lease expense is higher by 7% in the first year of a three-year lease and 21% higher in the first year of a 10-year lease. The cumulative expense distortion in a 10-year lease reaches 63% in the fifth year of the lease term.

The Boards decided to defer the development of a new accounting model for lessors, but the Boards decided to include a high-level discussion of lessor accounting issues in the Discussion Paper.

Commentary: They know that this is not the best approach, but they need to do it to finish the project by their 2011 deadline.

Options to Extend or Terminate a Lease

The Boards decided that the lessee should not recognize options to extend or terminate a lease or options to purchase the leased asset as separate assets. Instead, the assets and liabilities recognized by the lessee should be based upon the estimated lease term and the estimated payments (rent, renewals, and purchase options).

Commentary: This is very close to current GAAP for options where, as an example, a renewal option that is a bargain extends the lease term, and the renewal rents are included in minimum lease payments.

The Boards decided that the determination of the lease term should be a recognition decision. For example, for a 10-year lease with an option to renew for five years, the lessee must determine if it is recognizing a 10-year lease or a 15-year lease, and then the lessee would recognize a right-to-use asset and obligation to pay rentals at the present value of the expected lease payments over that term. For leases with renewal, termination, and/or purchase options, the lessee would make a determination of the most likely lease term based on its own assessment of all contractual, non-contractual, and business factors. The IASB favors a complex probability weighted average method, while the FASB favors a simpler best estimate approach.

Commentary: This is close to current GAAP for the lease term where, as an example, if it was judged that there was a penalty if the lessee failed to renew, the lease term considered for classification was extended. In my opinion, the direction they are taking will cause more auditors' judgment to be applied as the new rule will be more explicit than current GAAP.

Contingent Rentals and Residual Guarantees

The Boards decided to develop a new approach for contingent lease payments and residual guarantees. The FASB decided that a lessee would measure contingent rentals and any residual value guarantees based on the lessee's best estimate of the expected lease payments over the term of the lease. A lessee would determine its best estimate by considering the range of possible outcomes and the likelihood of each, but the lessee is not required to probability-weight the various possible outcomes in determining the expected lease payments. However, if lease rentals are contingent on changes in an index or rate, such as the consumer price index or the prime interest rate, the lessee would measure the contingent rentals using the index or rate existing at the inception of the lease in its initial determination of the best estimate of expected lease payments.

The IASB decided that a lessee would measure contingent rentals and any residual value guarantees based on an expected outcome (probability-weighted) calculation of the expected lease payments over the term of the lease.

Commentary: Capitalizing estimated contingent rents is a major negative change as usage-based contingent rent is common in some equipment leases. Contingent rents do not seem to meet the definition of a liability, yet the decision is to estimate amounts and capitalize them.

Initial Measurement

The Boards decided that a lessee should initially measure both its right-of-use asset and its lease obligation at their present value of the expected lease payments and that a lessee should discount the estimated lease payments using the lessee's incremental borrowing rate for secured borrowings.

Subsequent Measurement

The Boards decided that a lessee should amortize/depreciate the right-of-use asset systematically over the shorter of the lease term and the economic life of the leased asset. The lessee should apportion the lease payment between a finance charge and a reduction of the outstanding liability, with interest expense and amortization/depreciation presented on the income statement.

However, some board members of the FASB believes that there were differences between leases that are in-substance purchases and leases that only convey a right to use that may merit differences in the subsequent measurement or presentation. Accordingly, the FASB instructed the staff to include questions for financial statement users in the Discussion Paper to assess whether users believe that leases that are in-substance purchases should be measured or presented differently from leases that only convey a right to use.

Commentary: This is a major issue; that is, it is important to have lessee accounting reflect the economics of an operating expense. Using sinking fund depreciation versus straight-line depreciation is a possible solution. It would cause the P&L to net to a straight-line pattern, and it would cause the lease asset to have the same balance sheet value as the liability, that is, the PV of the remaining lease payments (economic reality). Lease expense is front ended for accounting purposes. It will create the need for lessees to account for deferred taxes as the IRS tax deduction for most operating leases is, and will continue to be, straight line.

Re-measurements

The Boards decided that a lessee would be required to reassess the lease term and its lease obligations (contingent rents, renewals, residual guarantees, and purchase options) using its current assumptions at each reporting date.

Commentary: This is complex and burdensome, adding little value for our customers as most equipment lease terms are short, the dollar volumes are not high, and the adjustments will be insignificant.

Presentation

The Boards decided that leases should be presented separately from, but adjacent to, owned assets on the statement of financial position. Some FASB Board members believe that leases should be presented as either in-substance purchases or rights to use assets. The IASB decided that all leases should be presented lumped together.

The Boards think that the balance sheet treatment should drive the income statement presentation, thus they decided that no rent expense should appear in the income statement. Instead, interest expense and depreciation/amortization are the lease expense, although some FASB members think that rent expense may be the appropriate expense for some leases (right-of-use leases).

The Boards have not decided on the presentation in the cash flow statement; however, if the balance sheet treatment drives the cash flow statement presentation it is likely that a lease will be considered a capital expenditure and a financing for cash flow purposes.

Commentary: The theory that the balance sheet should drive the P&L and cash flow treatment will cause the front ending of P&L expense and treat the lease as a capital expenditure and a loan for cash flow statement purposes. This will not present the true economic effect of a lease; rather the asset should amortize as the liability does, rent should be the expense, and rent should be an operating cash outflow. The FASB/IASB should consider a new accounting approach for leases rather than try to apply existing theory from other similar transactions. The asset and liability in a true lease are linked, as one cannot be settled without the other being settled. Therefore, the balance sheet values should be the same over time, absent impairment. If they come to that view, then having the balance sheet drive the accounting will have logical results.

Lessor Accounting

The Discussion Paper includes a high-level discussion of lessor accounting. It includes two approaches as possible models. One is a direct'finance-like model, where the lessor derecognizes the leased asset and records a receivable and residual asset and unearned income. The other approach is to leave the leased asset on the books, but record a receivable being the lessor's right to receive payments and record an offsetting liability representing the lessor's obligation to allow the lessee to use the asset. No clear details of revenue recognition are provided.

Commentary: The second possible approach will double up on assets, which seems illogical.

Some Board members think that sales-type lease accounting is appropriate for certain leases, but many don't think so.

Commentary: Unless they recognize that finance-type leases exist and that there should be a classification mechanism, there is a danger of losing sales-type leasing.

Regarding sublessor accounting, the Boards discussed but did not reach a preliminary view on three possible ways of addressing how an intermediate lessor should account for the sublease. The Boards could:

• Provide additional guidance on how to apply the existing lessor accounting standards to subleases;
• Exclude the head lease from the scope of the new standard;
• Develop a lessor right-of-use model for subleases only.

Commentary: They are finding that the decision to split lessor accounting out of the project scope is causing major problems in the development of sublessor accounting as one cannot be done without the other. Their statements in the discussion paper on sublessor accounting are sparse and confusing.

There was no mention of leveraged lease accounting or adopting IAS 17 for lesser accounting.

Commentary: The real danger is that they adopt IAS 17 for all lessors as a way to get lessor accounting converged by 2011. If they don't do that, both IAS 17 and FAS 13 will have to be maintained as GAAP for just lessors, and that seems illogical.

Items Not Covered

The Discussion Paper did not include any decisions on timing of initial recognition, sale leasebacks, initial direct costs, leases with service arrangements, or disclosures.

Important Action Item

Every lessor should comment to the FASB/IASB on the Lease Accounting Discussion Paper. The deadline is July 17, 2009. Your customers should also be encouraged to comment, as their comments will be held in higher regard, as the Boards expect lessors to comment. I have found that customers are not focusing on the P&L impact and the fact that all their real estate leases are included in the accounting change. Real estate leases account for more than 75% of the dollars in the operating lease rents reported in footnotes. I have developed a lease capitalization calculator that I will send to any interested reader. E-mail me at [email protected]. It is an Excel model that takes the footnoted operating lease obligations, capitalizes them under the proposed model, and compares the accounting results to current GAAP. It is a good way for your customers to see what the impact is on their current leases and may motivate them to comment.

I think we can influence the outcome to be more logical and easier for our customers to deal with, as the arguments have merit. We need to make sure that the accounting reflects the economics of our business that our customers enjoy. If we don't preserve the differences in the accounting and the rules are complex and burdensome, customers may chose the easier approach ' buy rather than lease.

Bill Bosco is the Principal of Leasing 101, a lease consulting and training company. He has more than 34 years of experience in the leasing industry, with expertise in accounting, tax, structuring, and pricing. He has product development and strategic marketing experience as well. He has been on the ELA accounting committee since 1988 and was chairman for 10 years. He is a frequent speaker and author of articles on leasing issues. Bosco has been selected by the FASB/IASB to be a member of the Lease Accounting Project Working Group. He can be reached at [email protected].

Attention everyone ' you have the opportunity to influence your future. The FASB/IASB Boards issued a Discussion Paper titled Leases: Preliminary Views on March 19, 2009, inviting the public to comment by July 17, 2009. The paper is available on the FASB's Web site www.fasb.org. There are elements of the proposed new lease accounting rules that don't make sense and are detrimental to lessors and lessees. I think there is a good chance the Boards and their staff will listen and revise their approach, but it will only happen if they receive a good volume of substantive comment letters.

The project direction shifted to a point where much more will be capitalized by lessees due to capitalizing certain options and contingent rents. The impact to the industry will be far reaching if certain positions are not changed. Although the project is significantly behind schedule, the Boards still have 2011 as the target for issuance of the new lease accounting standard.

The new developments in the Lease Accounting Project are a negative for the industry as:

• “Fixing” the liability side of the balance sheet is a popular issue and will be accomplished by the proposed standard, but the asset, P&L, and cash flow treatment will not clearly represent the economic effects of a right-of-use lease to the lessee.
• Leases with very different economics will be accounted for the same. In many cases, the proposed rule will make a lease appear the same or worse than the accounting for a purchased asset financed by debt.
• More will be capitalized under a complex calculation with estimating the lease term, renewal payments, and contingent rents in the capitalization calculation. The requirement for continued adjusting of the estimates will be a burden.
• The proposed P&L treatment is complex and front ends lease expense.
• Complex deferred tax accounting will be required as the P&L treatment will not match the tax treatment.

The following is a synopsis of the discussion paper with my comments in italics.

Summary of Decisions and Preliminary Views

Scope and Overall Approach

The project will focus on lessee accounting for material lease arrangements of plant, property, and equipment ' basically the scope of FAS 13 and its amendments. They do not plan to give any threshold for what might constitute immaterial leases.

The IASB decided to remove the existing requirement to classify a lease as a finance lease (in-substance purchase) or an operating lease. Thus, the same overall approach would apply for all leases. The FASB is still undecided as to whether leases should be classified.

Commentary: The failure to recognize that there are leases that are financings and leases that merely allow a temporary right to use the asset is a major flaw. The IRS and UCC make the distinction as the economics to the parties is very different. It should also follow that the accounting for the two types of leases should be different.

The Boards also decided on an overall approach that would apply the existing IAS 17 finance lease model to all leases ' meaning those leases that were capital leases and those that were operating leases under current GAAP. All material leases will be capitalized. The concepts behind the approach are:

• A lease contract gives the lessee the right to use an asset and obligates the lessee to pay rent for the term;
• The rights to use the asset are assets and the obligations to pay rents are liabilities that must be capitalized;
• To account for the whole lease contract rather than its components (like rent, purchase options, renewal options, contingent rents, etc).

Commentary: Applying the existing finance/capital lease model to all leases means that all leases will be accounted for as though the asset was purchased and financed with a loan. The P&L pattern of lease expense will be accelerated with straight-line rent expense replaced by depreciation and imputed interest. The impact increases as the lease term increases, for example lease expense is higher by 7% in the first year of a three-year lease and 21% higher in the first year of a 10-year lease. The cumulative expense distortion in a 10-year lease reaches 63% in the fifth year of the lease term.

The Boards decided to defer the development of a new accounting model for lessors, but the Boards decided to include a high-level discussion of lessor accounting issues in the Discussion Paper.

Commentary: They know that this is not the best approach, but they need to do it to finish the project by their 2011 deadline.

Options to Extend or Terminate a Lease

The Boards decided that the lessee should not recognize options to extend or terminate a lease or options to purchase the leased asset as separate assets. Instead, the assets and liabilities recognized by the lessee should be based upon the estimated lease term and the estimated payments (rent, renewals, and purchase options).

Commentary: This is very close to current GAAP for options where, as an example, a renewal option that is a bargain extends the lease term, and the renewal rents are included in minimum lease payments.

The Boards decided that the determination of the lease term should be a recognition decision. For example, for a 10-year lease with an option to renew for five years, the lessee must determine if it is recognizing a 10-year lease or a 15-year lease, and then the lessee would recognize a right-to-use asset and obligation to pay rentals at the present value of the expected lease payments over that term. For leases with renewal, termination, and/or purchase options, the lessee would make a determination of the most likely lease term based on its own assessment of all contractual, non-contractual, and business factors. The IASB favors a complex probability weighted average method, while the FASB favors a simpler best estimate approach.

Commentary: This is close to current GAAP for the lease term where, as an example, if it was judged that there was a penalty if the lessee failed to renew, the lease term considered for classification was extended. In my opinion, the direction they are taking will cause more auditors' judgment to be applied as the new rule will be more explicit than current GAAP.

Contingent Rentals and Residual Guarantees

The Boards decided to develop a new approach for contingent lease payments and residual guarantees. The FASB decided that a lessee would measure contingent rentals and any residual value guarantees based on the lessee's best estimate of the expected lease payments over the term of the lease. A lessee would determine its best estimate by considering the range of possible outcomes and the likelihood of each, but the lessee is not required to probability-weight the various possible outcomes in determining the expected lease payments. However, if lease rentals are contingent on changes in an index or rate, such as the consumer price index or the prime interest rate, the lessee would measure the contingent rentals using the index or rate existing at the inception of the lease in its initial determination of the best estimate of expected lease payments.

The IASB decided that a lessee would measure contingent rentals and any residual value guarantees based on an expected outcome (probability-weighted) calculation of the expected lease payments over the term of the lease.

Commentary: Capitalizing estimated contingent rents is a major negative change as usage-based contingent rent is common in some equipment leases. Contingent rents do not seem to meet the definition of a liability, yet the decision is to estimate amounts and capitalize them.

Initial Measurement

The Boards decided that a lessee should initially measure both its right-of-use asset and its lease obligation at their present value of the expected lease payments and that a lessee should discount the estimated lease payments using the lessee's incremental borrowing rate for secured borrowings.

Subsequent Measurement

The Boards decided that a lessee should amortize/depreciate the right-of-use asset systematically over the shorter of the lease term and the economic life of the leased asset. The lessee should apportion the lease payment between a finance charge and a reduction of the outstanding liability, with interest expense and amortization/depreciation presented on the income statement.

However, some board members of the FASB believes that there were differences between leases that are in-substance purchases and leases that only convey a right to use that may merit differences in the subsequent measurement or presentation. Accordingly, the FASB instructed the staff to include questions for financial statement users in the Discussion Paper to assess whether users believe that leases that are in-substance purchases should be measured or presented differently from leases that only convey a right to use.

Commentary: This is a major issue; that is, it is important to have lessee accounting reflect the economics of an operating expense. Using sinking fund depreciation versus straight-line depreciation is a possible solution. It would cause the P&L to net to a straight-line pattern, and it would cause the lease asset to have the same balance sheet value as the liability, that is, the PV of the remaining lease payments (economic reality). Lease expense is front ended for accounting purposes. It will create the need for lessees to account for deferred taxes as the IRS tax deduction for most operating leases is, and will continue to be, straight line.

Re-measurements

The Boards decided that a lessee would be required to reassess the lease term and its lease obligations (contingent rents, renewals, residual guarantees, and purchase options) using its current assumptions at each reporting date.

Commentary: This is complex and burdensome, adding little value for our customers as most equipment lease terms are short, the dollar volumes are not high, and the adjustments will be insignificant.

Presentation

The Boards decided that leases should be presented separately from, but adjacent to, owned assets on the statement of financial position. Some FASB Board members believe that leases should be presented as either in-substance purchases or rights to use assets. The IASB decided that all leases should be presented lumped together.

The Boards think that the balance sheet treatment should drive the income statement presentation, thus they decided that no rent expense should appear in the income statement. Instead, interest expense and depreciation/amortization are the lease expense, although some FASB members think that rent expense may be the appropriate expense for some leases (right-of-use leases).

The Boards have not decided on the presentation in the cash flow statement; however, if the balance sheet treatment drives the cash flow statement presentation it is likely that a lease will be considered a capital expenditure and a financing for cash flow purposes.

Commentary: The theory that the balance sheet should drive the P&L and cash flow treatment will cause the front ending of P&L expense and treat the lease as a capital expenditure and a loan for cash flow statement purposes. This will not present the true economic effect of a lease; rather the asset should amortize as the liability does, rent should be the expense, and rent should be an operating cash outflow. The FASB/IASB should consider a new accounting approach for leases rather than try to apply existing theory from other similar transactions. The asset and liability in a true lease are linked, as one cannot be settled without the other being settled. Therefore, the balance sheet values should be the same over time, absent impairment. If they come to that view, then having the balance sheet drive the accounting will have logical results.

Lessor Accounting

The Discussion Paper includes a high-level discussion of lessor accounting. It includes two approaches as possible models. One is a direct'finance-like model, where the lessor derecognizes the leased asset and records a receivable and residual asset and unearned income. The other approach is to leave the leased asset on the books, but record a receivable being the lessor's right to receive payments and record an offsetting liability representing the lessor's obligation to allow the lessee to use the asset. No clear details of revenue recognition are provided.

Commentary: The second possible approach will double up on assets, which seems illogical.

Some Board members think that sales-type lease accounting is appropriate for certain leases, but many don't think so.

Commentary: Unless they recognize that finance-type leases exist and that there should be a classification mechanism, there is a danger of losing sales-type leasing.

Regarding sublessor accounting, the Boards discussed but did not reach a preliminary view on three possible ways of addressing how an intermediate lessor should account for the sublease. The Boards could:

• Provide additional guidance on how to apply the existing lessor accounting standards to subleases;
• Exclude the head lease from the scope of the new standard;
• Develop a lessor right-of-use model for subleases only.

Commentary: They are finding that the decision to split lessor accounting out of the project scope is causing major problems in the development of sublessor accounting as one cannot be done without the other. Their statements in the discussion paper on sublessor accounting are sparse and confusing.

There was no mention of leveraged lease accounting or adopting IAS 17 for lesser accounting.

Commentary: The real danger is that they adopt IAS 17 for all lessors as a way to get lessor accounting converged by 2011. If they don't do that, both IAS 17 and FAS 13 will have to be maintained as GAAP for just lessors, and that seems illogical.

Items Not Covered

The Discussion Paper did not include any decisions on timing of initial recognition, sale leasebacks, initial direct costs, leases with service arrangements, or disclosures.

Important Action Item

Every lessor should comment to the FASB/IASB on the Lease Accounting Discussion Paper. The deadline is July 17, 2009. Your customers should also be encouraged to comment, as their comments will be held in higher regard, as the Boards expect lessors to comment. I have found that customers are not focusing on the P&L impact and the fact that all their real estate leases are included in the accounting change. Real estate leases account for more than 75% of the dollars in the operating lease rents reported in footnotes. I have developed a lease capitalization calculator that I will send to any interested reader. E-mail me at [email protected]. It is an Excel model that takes the footnoted operating lease obligations, capitalizes them under the proposed model, and compares the accounting results to current GAAP. It is a good way for your customers to see what the impact is on their current leases and may motivate them to comment.

I think we can influence the outcome to be more logical and easier for our customers to deal with, as the arguments have merit. We need to make sure that the accounting reflects the economics of our business that our customers enjoy. If we don't preserve the differences in the accounting and the rules are complex and burdensome, customers may chose the easier approach ' buy rather than lease.

Bill Bosco is the Principal of Leasing 101, a lease consulting and training company. He has more than 34 years of experience in the leasing industry, with expertise in accounting, tax, structuring, and pricing. He has product development and strategic marketing experience as well. He has been on the ELA accounting committee since 1988 and was chairman for 10 years. He is a frequent speaker and author of articles on leasing issues. Bosco has been selected by the FASB/IASB to be a member of the Lease Accounting Project Working Group. He can be reached at [email protected].