Lease Accounting Project Update

The Boards changed their decisions on the following issues:

• Lessee P&L ' no leases will be allowed straight line rent expense treatment, but rather all leases will have front-ended lease costs equal to interest expense and depreciation of the right of use lease asset.
• Transition ' full retrospective accounting is being considered to alleviate the negative P&L hit on transition using a prospective method.
• Incremental borrowing rate – lessee will use its new incremental borrowing rate to calculate adjustments when lease term assumptions change.
• Short-term leases – will likely not be exempt from capitalization.
• Lessor accounting – still undecided between only using a derecognition method or having both an operating lease method and a derecognition method. They are considering accreting residuals in the derecognition method.

The author, Bill Bosco, will provide a thorough analysis of these changes in the July issue.

The high volume of comment letters (781) and numerous outreach meetings had common criticisms, causing the FASB/IASB Boards to re-deliberate issues in the Leases Project Exposure Draft (“ED”). Generally, the tentative decisions made in 2011 have been favorable to the industry. Those decisions along with my commentary are as follows.

Re-exposure

Likely to occur with a short comment period (60-90 days versus the standard 120 days).

Issuance Date

Still trying for 2011, but the Boards have said it will slip to late in the year ' re-exposure will likely delay the project completion to the end of 2011 or beginning of 2012.

Effective Date

Tentatively decided on 2015, but this may still not give lessees and lessors enough time for IT changes and implementation, especially if they stay with their choice of modified retrospective accounting for existing leases in transition. The transition year is more likely to be 2016.

Scope

Includes leases of assets that are property, plant and equipment. Although it excludes intangibles, the scope will be worded so that leases of intangibles such as software can be accounted for as leases by analogy. One Big Four firm thinks this may allow software developers to get sales-type lease profits.

Definition of a Lease (Need to Distinguish from Service Contract)

Regarding leases versus installment purchases, the Boards decided to eliminate the scope exclusion, but lease contracts should be accounted for in accordance with the leases standard, and lease contracts that represent a purchase or sale of an underlying asset should be accounted for in accordance with other applicable standards (e.g., plant and equipment and loan accounting by lessees). The Boards are seeking feedback on the definition of a lease versus an installment sale where the option is a bargain and how reassessment of the likelihood of exercise of a purchase option should be handled. The Boards recommended that further outreach activities should include the issue of installment sales in the definition of a lease.

The Boards agreed to tentatively confirm the “specific asset” notion versus a notion of an asset of a certain specificity. Physically distinct portions of a larger asset can be specified assets, and non-physically distinct portions are not specified assets. The description of “control,” as defined in the Leases ED, should be revised to be consistent with the revenue recognition project while including guidance on separable assets. The Boards agreed that the right to control the use of a specified asset is conveyed if the customer has the ability to both direct the use of the asset and receive the benefit from its use. The Boards decided to require an assessment of whether, in contracts where the supplier directs the use of the asset used to perform customer services, the asset explicitly or implicitly identified in the contract is an inseparable part of the services. If the asset is inseparable, the customer would be deemed not to have the right to control the use of the asset, and the arrangement would be accounted for as a service contract with no embedded lease of that asset. Under the newly proposed guidance, any one of the following may indicate the customer has obtained the right to control the use of a specified asset: 1) The customer controls physical access to the specified asset; 2) The design of the asset is customer-specific and the customer has been involved in designing the specified asset; 3) The customer has the right to obtain substantially all of the economic benefits from use of the specified asset throughout the lease term.

They did not conclude on, but are in favor of concepts such as not including in lease accounting assets that are incidental to the provision of a service or insignificant to the services provided. The decisions will mean fewer contracts are considered leases versus current GAAP, including EITF 01-08 (The revised guidance would result in certain contracts that are considered leases under current standards (e.g., certain take-or-pay contracts) to no longer be considered leases.).

Lessor Accounting Model

The Boards are considering IAS 17-like lease classification criteria to determine which leases would get derecognition treatment for lessors (it is undecided if full or partial derecognition will be the model ' the difference is the accretion of the residual to its expected fair value in full derecognition versus no accretion of the residual in partial derecognition). The preferred outcome in lessor accounting is that most equipment leases should get full derecognition treatment. Those that don't get derecognition treatment will either get a modified performance obligation method (book a receivable and offsetting obligation that may be netted on the balance sheet) or just use current operating lease accounting. Sales-type lease accounting will be available only to derecognition leases, and it is undecided whether the profit recognition will be limited compared with current GAAP.

Leveraged lease accounting will not be included in the new rule. There is a chance the Boards may allow grandfathering of existing deals. There is also a chance that netting will be allowed for new leveraged leases under a “Balance Sheet-Offsetting” project that they are separately working on. It is unlikely the Boards will allow tax affected yield revenue recognition because the Boards say they would have to take up a revision to income tax accounting which they do not have time for now.

Lessee P&L Pattern

Former operating leases (now called “other than finance” leases) classified using IAS 17-like criteria (still being developed) will have straight-line P&L cost pattern labeled as rent expense with details for calculation likely to be that the amortization of the asset is “plugged” to create the straight-line expense pattern. Other leases (now called “finance” leases) will result in capital lease-like accounting. This is good news except that the IAS 17 criteria are tighter than U.S. GAAP criteria (synthetic leases and “split TRAC” leases will not get straight-line rent expense as the P&L pattern). Short-term leases, as defined below, will be accounted for under current operating lease guidance.

Lease Term

The lease term is the contractual term plus renewals where the lessee has a “clear economic incentive” to exercise the options. If a lessee would be required to pay a penalty if it does not renew the lease and the renewal period has not been included in the lease term, then that penalty amount should be included in the recognized lease payments. This is essentially current U.S. GAAP and will limit the amounts capitalized versus as proposed by the ED. The requirement to adjust estimates will be reduced to when an event occurs that causes the renewal option to become economically compelling. This is good news except for the concern about reassessment and resulting complexity in adjustment accounting. It is hoped the Boards decide that a renewal or extension is a new lease to avoid complex adjustments, but that remains to be seen.

Purchase Options

Subject to feedback from outreach, the Boards decided the exercise price of a purchase option should be included in the lessee's liability to make lease payments and the lessor's right to receive lease payments only when there is a significant economic incentive to exercise the purchase option. If so, the ROU asset should be amortized over the useful life of the asset. Other purchase options are not considered lease payments to be capitalized. These conclusions are consistent with their conclusions on the lease term and renewals, so it is good news except for the concerns regarding reassessment. Further outreach is needed regarding when to reassess the purchase option and how reassessment affects lease classification now that the concepts of “finance” leases and “other than finance leases” have been reintroduced into the project for both lessors and lessees.

Variable Payments

Variable payments will be included in the lease payments to be capitalized by the lessee and to be included in the lessor's lease receivable, but the specific variable payments will be limited versus what was proposed in the ED. Details are as follows:

• All variable lease payments that depend on an index ( e.g., CPI) or a rate ( e.g., LIBOR-based floating-rate leases). This still means complexity for floating-rate equipment leases, like fleet leases, although they allow use of the spot rate rather than forward rate to calculate the future payments. It also means that the complexity of capitalizing and adjusting real estate leases with CPI variable rent clauses will still be extremely burdensome;
• Other variable lease payments based on usage ( e.g., cost per mile) or lessee performance ( e.g., rents based on sales) will not be capitalized unless they are deemed to be “disguised” minimum payments. This is good news for both the equipment and real estate leasing industries, as it will lessen the complexity and amounts capitalized. Guidance on determining when variable rents are disguised lease payments is to be decided. The object is to capture transactions structured to lessen capitalization by having below-market contractual rents but with variable rents that are virtually certain to occur and “make up for” under-market contractual rents;
• Disclosure will be required within the notes of contingent rent leasing arrangements (details to be determined later).

Residual Guarantees

The Boards reiterated their conclusions that:

• A third-party residual guarantee is not a minimum lease payment for the lessor ' this is not good news;
• Lessees should only record the likely payment under a residual guarantee ' not the full amount of the residual guarantee, but rather the amount it is in the money.

Short-Term Leases

Lessees use current operating lease accounting for leases, elected as an accounting policy by asset class. A short-term lease is defined as: a lease that at the date of commencement of the lease has a maximum possible lease term, including any options to renew or extend, of 12 months or less. This means that typical fleet/spilt TRAC/synthetic leases that have 12-month terms and month-to-month renewal options will not be considered short-term leases.

Sale Leasebacks

If the transaction is considered a sale under the revenue recognition standard (meaning that control of the asset has been transferred), account for the transaction as a sale leaseback, otherwise consider it a financing/loan. When the sales price and leaseback rents are at fair value, gains or losses arising from the transaction are recognized immediately. When sales price and rents are not at fair value, the assets, liabilities, gains and losses should be adjusted to reflect the current market. This is good news as the criteria for determining a sale are less onerous than current GAAP (FAS 98) and the profit recognition is upfront for most deals versus current GAAP that causes deferral and, in most cases, amortization of gains in sale leasebacks.

Lease Inception vs. Commencement

Lessees and lessors initially measure (calculate the amount capitalized) and recognize (book) the lease assets and liabilities at the date of lease commencement. Lessees use incremental borrowing rate at lease commencement to calculate the amount capitalized. This is good news as it simplifies the lessee accounting.

Pre-commencement Payment/Interim Rents

Interim rents are recognized as a rent prepayment, and at the date of the commencement the prepayments will be added to the right-of-use asset. Interim rents are now officially part of the capitalized lease amount and as a result, lessees will be more aware of the cost of the lease.

Lease Incentives

Cash payments received from the lessor reduce the lessee's ROU asset.

Bundled Lease Payments

Payments must be bifurcated by lessees and lessors. Bifurcate using observable stand-alone prices if known for all elements, consistent with the revenue recognition project; if only one element is observable, assume the cost of the other is the residual cost. Where no observable market prices are available, lessees capitalize the whole payment as a lease. This will mean that lessors will be forced to disclose the breakdown of elements in a full-service lease as lessees will not accept capitalizing the full bundled payments.

Initial Direct Costs

These are costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made.

Lessees and lessors should capitalize initial direct costs by adding them to the carrying amount of the right-of-use asset and the right to receive lease payments, respectively.

Rates for Lessee and Lessor Accounting

Lessees use their incremental borrowing rate, unless the implicit rate in the lease is known, to capitalize the lease and impute interest expense in the P&L. Lessors use the implicit rate in the lease to calculate the receivable and residual assets and to accrue revenue.

Conclusion

The industry has fared very well in the re-deliberations as the project has gotten simpler and closer to current GAAP on the lessee side. There still are major concerns with lessor issues. It has been proven that comment letters influence the FASB and IASB. I urge you all to stay current on the project process. You should all comment when the re-exposed ED comes out later this year. You may wish to provide unsolicited comments now on the potential lessor models, as the staff is in the process of writing papers for the Boards to make decisions on. Comment letters can influence their thinking and how they present the issues for the Boards to deliberate. Your influence counts. Use it!

Note: Bill Bosco is asking for golfers, hole sponsors and donors for his annual charity golf outing, which raises funds for scholarships in memory of his son Richard Bosco, who was killed in the World Trade Center Sept. 11, 2001 terrorist attack. The date of the outing is June 24, 2011. Details can be found at www.richboscomemorial.com/index. asp?info=history or by calling Bosco at 914-522-3233.

Bill Bosco, a member of this newsletter's Board of Editors, is the President of Leasing 101, a lease consulting company. He can be reached at 914-522-3233. His website is http://www.leasing-101.com/.

UPDATE

Subsequent to this article going to press, the FASB/IASB Boards conducted a meeting on May 19, 2011 at which they unexpectedly reversed some of their tentative decisions favorable to the industry. Although these tentative decisions were based on a high volume of common criticisms contained in comment letters (780+) and numerous outreach meetings, the Boards re-deliberated the issues and reversed course on some.

It appears that the project outcome is unsettled now. The Boards seemed to be listening to feedback, but now appear to be thinking that many of their decisions made in the Exposure Draft will stand. This is surprising to the author, as the feedback from users of financials (equity and debt analysts, lenders and investors) on the information they find useful in financial statements regarding leases is being ignored.

The Boards changed their decisions on the following issues:

• Lessee P&L ' no leases will be allowed straight line rent expense treatment, but rather all leases will have front-ended lease costs equal to interest expense and depreciation of the right of use lease asset.
• Transition ' full retrospective accounting is being considered to alleviate the negative P&L hit on transition using a prospective method.
• Incremental borrowing rate – lessee will use its new incremental borrowing rate to calculate adjustments when lease term assumptions change.
• Short-term leases – will likely not be exempt from capitalization.
• Lessor accounting – still undecided between only using a derecognition method or having both an operating lease method and a derecognition method. They are considering accreting residuals in the derecognition method.

The author, Bill Bosco, will provide a thorough analysis of these changes in the July issue.

The high volume of comment letters (781) and numerous outreach meetings had common criticisms, causing the FASB/IASB Boards to re-deliberate issues in the Leases Project Exposure Draft (“ED”). Generally, the tentative decisions made in 2011 have been favorable to the industry. Those decisions along with my commentary are as follows.

Re-exposure

Likely to occur with a short comment period (60-90 days versus the standard 120 days).

Issuance Date

Still trying for 2011, but the Boards have said it will slip to late in the year ' re-exposure will likely delay the project completion to the end of 2011 or beginning of 2012.

Effective Date

Tentatively decided on 2015, but this may still not give lessees and lessors enough time for IT changes and implementation, especially if they stay with their choice of modified retrospective accounting for existing leases in transition. The transition year is more likely to be 2016.

Scope

Includes leases of assets that are property, plant and equipment. Although it excludes intangibles, the scope will be worded so that leases of intangibles such as software can be accounted for as leases by analogy. One Big Four firm thinks this may allow software developers to get sales-type lease profits.

Definition of a Lease (Need to Distinguish from Service Contract)

Regarding leases versus installment purchases, the Boards decided to eliminate the scope exclusion, but lease contracts should be accounted for in accordance with the leases standard, and lease contracts that represent a purchase or sale of an underlying asset should be accounted for in accordance with other applicable standards (e.g., plant and equipment and loan accounting by lessees). The Boards are seeking feedback on the definition of a lease versus an installment sale where the option is a bargain and how reassessment of the likelihood of exercise of a purchase option should be handled. The Boards recommended that further outreach activities should include the issue of installment sales in the definition of a lease.

The Boards agreed to tentatively confirm the “specific asset” notion versus a notion of an asset of a certain specificity. Physically distinct portions of a larger asset can be specified assets, and non-physically distinct portions are not specified assets. The description of “control,” as defined in the Leases ED, should be revised to be consistent with the revenue recognition project while including guidance on separable assets. The Boards agreed that the right to control the use of a specified asset is conveyed if the customer has the ability to both direct the use of the asset and receive the benefit from its use. The Boards decided to require an assessment of whether, in contracts where the supplier directs the use of the asset used to perform customer services, the asset explicitly or implicitly identified in the contract is an inseparable part of the services. If the asset is inseparable, the customer would be deemed not to have the right to control the use of the asset, and the arrangement would be accounted for as a service contract with no embedded lease of that asset. Under the newly proposed guidance, any one of the following may indicate the customer has obtained the right to control the use of a specified asset: 1) The customer controls physical access to the specified asset; 2) The design of the asset is customer-specific and the customer has been involved in designing the specified asset; 3) The customer has the right to obtain substantially all of the economic benefits from use of the specified asset throughout the lease term.

They did not conclude on, but are in favor of concepts such as not including in lease accounting assets that are incidental to the provision of a service or insignificant to the services provided. The decisions will mean fewer contracts are considered leases versus current GAAP, including EITF 01-08 (The revised guidance would result in certain contracts that are considered leases under current standards (e.g., certain take-or-pay contracts) to no longer be considered leases.).

Lessor Accounting Model

The Boards are considering IAS 17-like lease classification criteria to determine which leases would get derecognition treatment for lessors (it is undecided if full or partial derecognition will be the model ' the difference is the accretion of the residual to its expected fair value in full derecognition versus no accretion of the residual in partial derecognition). The preferred outcome in lessor accounting is that most equipment leases should get full derecognition treatment. Those that don't get derecognition treatment will either get a modified performance obligation method (book a receivable and offsetting obligation that may be netted on the balance sheet) or just use current operating lease accounting. Sales-type lease accounting will be available only to derecognition leases, and it is undecided whether the profit recognition will be limited compared with current GAAP.

Leveraged lease accounting will not be included in the new rule. There is a chance the Boards may allow grandfathering of existing deals. There is also a chance that netting will be allowed for new leveraged leases under a “Balance Sheet-Offsetting” project that they are separately working on. It is unlikely the Boards will allow tax affected yield revenue recognition because the Boards say they would have to take up a revision to income tax accounting which they do not have time for now.

Lessee P&L Pattern

Former operating leases (now called “other than finance” leases) classified using IAS 17-like criteria (still being developed) will have straight-line P&L cost pattern labeled as rent expense with details for calculation likely to be that the amortization of the asset is “plugged” to create the straight-line expense pattern. Other leases (now called “finance” leases) will result in capital lease-like accounting. This is good news except that the IAS 17 criteria are tighter than U.S. GAAP criteria (synthetic leases and “split TRAC” leases will not get straight-line rent expense as the P&L pattern). Short-term leases, as defined below, will be accounted for under current operating lease guidance.

Lease Term

The lease term is the contractual term plus renewals where the lessee has a “clear economic incentive” to exercise the options. If a lessee would be required to pay a penalty if it does not renew the lease and the renewal period has not been included in the lease term, then that penalty amount should be included in the recognized lease payments. This is essentially current U.S. GAAP and will limit the amounts capitalized versus as proposed by the ED. The requirement to adjust estimates will be reduced to when an event occurs that causes the renewal option to become economically compelling. This is good news except for the concern about reassessment and resulting complexity in adjustment accounting. It is hoped the Boards decide that a renewal or extension is a new lease to avoid complex adjustments, but that remains to be seen.

Purchase Options

Subject to feedback from outreach, the Boards decided the exercise price of a purchase option should be included in the lessee's liability to make lease payments and the lessor's right to receive lease payments only when there is a significant economic incentive to exercise the purchase option. If so, the ROU asset should be amortized over the useful life of the asset. Other purchase options are not considered lease payments to be capitalized. These conclusions are consistent with their conclusions on the lease term and renewals, so it is good news except for the concerns regarding reassessment. Further outreach is needed regarding when to reassess the purchase option and how reassessment affects lease classification now that the concepts of “finance” leases and “other than finance leases” have been reintroduced into the project for both lessors and lessees.

Variable Payments

Variable payments will be included in the lease payments to be capitalized by the lessee and to be included in the lessor's lease receivable, but the specific variable payments will be limited versus what was proposed in the ED. Details are as follows:

• All variable lease payments that depend on an index ( e.g., CPI) or a rate ( e.g., LIBOR-based floating-rate leases). This still means complexity for floating-rate equipment leases, like fleet leases, although they allow use of the spot rate rather than forward rate to calculate the future payments. It also means that the complexity of capitalizing and adjusting real estate leases with CPI variable rent clauses will still be extremely burdensome;
• Other variable lease payments based on usage ( e.g., cost per mile) or lessee performance ( e.g., rents based on sales) will not be capitalized unless they are deemed to be “disguised” minimum payments. This is good news for both the equipment and real estate leasing industries, as it will lessen the complexity and amounts capitalized. Guidance on determining when variable rents are disguised lease payments is to be decided. The object is to capture transactions structured to lessen capitalization by having below-market contractual rents but with variable rents that are virtually certain to occur and “make up for” under-market contractual rents;
• Disclosure will be required within the notes of contingent rent leasing arrangements (details to be determined later).

Residual Guarantees

The Boards reiterated their conclusions that:

• A third-party residual guarantee is not a minimum lease payment for the lessor ' this is not good news;
• Lessees should only record the likely payment under a residual guarantee ' not the full amount of the residual guarantee, but rather the amount it is in the money.

Short-Term Leases

Lessees use current operating lease accounting for leases, elected as an accounting policy by asset class. A short-term lease is defined as: a lease that at the date of commencement of the lease has a maximum possible lease term, including any options to renew or extend, of 12 months or less. This means that typical fleet/spilt TRAC/synthetic leases that have 12-month terms and month-to-month renewal options will not be considered short-term leases.

Sale Leasebacks

If the transaction is considered a sale under the revenue recognition standard (meaning that control of the asset has been transferred), account for the transaction as a sale leaseback, otherwise consider it a financing/loan. When the sales price and leaseback rents are at fair value, gains or losses arising from the transaction are recognized immediately. When sales price and rents are not at fair value, the assets, liabilities, gains and losses should be adjusted to reflect the current market. This is good news as the criteria for determining a sale are less onerous than current GAAP (FAS 98) and the profit recognition is upfront for most deals versus current GAAP that causes deferral and, in most cases, amortization of gains in sale leasebacks.

Lease Inception vs. Commencement

Lessees and lessors initially measure (calculate the amount capitalized) and recognize (book) the lease assets and liabilities at the date of lease commencement. Lessees use incremental borrowing rate at lease commencement to calculate the amount capitalized. This is good news as it simplifies the lessee accounting.

Pre-commencement Payment/Interim Rents

Interim rents are recognized as a rent prepayment, and at the date of the commencement the prepayments will be added to the right-of-use asset. Interim rents are now officially part of the capitalized lease amount and as a result, lessees will be more aware of the cost of the lease.

Lease Incentives

Cash payments received from the lessor reduce the lessee's ROU asset.

Bundled Lease Payments

Payments must be bifurcated by lessees and lessors. Bifurcate using observable stand-alone prices if known for all elements, consistent with the revenue recognition project; if only one element is observable, assume the cost of the other is the residual cost. Where no observable market prices are available, lessees capitalize the whole payment as a lease. This will mean that lessors will be forced to disclose the breakdown of elements in a full-service lease as lessees will not accept capitalizing the full bundled payments.

Initial Direct Costs

These are costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made.

Lessees and lessors should capitalize initial direct costs by adding them to the carrying amount of the right-of-use asset and the right to receive lease payments, respectively.

Rates for Lessee and Lessor Accounting

Lessees use their incremental borrowing rate, unless the implicit rate in the lease is known, to capitalize the lease and impute interest expense in the P&L. Lessors use the implicit rate in the lease to calculate the receivable and residual assets and to accrue revenue.

Conclusion

The industry has fared very well in the re-deliberations as the project has gotten simpler and closer to current GAAP on the lessee side. There still are major concerns with lessor issues. It has been proven that comment letters influence the FASB and IASB. I urge you all to stay current on the project process. You should all comment when the re-exposed ED comes out later this year. You may wish to provide unsolicited comments now on the potential lessor models, as the staff is in the process of writing papers for the Boards to make decisions on. Comment letters can influence their thinking and how they present the issues for the Boards to deliberate. Your influence counts. Use it!

Note: Bill Bosco is asking for golfers, hole sponsors and donors for his annual charity golf outing, which raises funds for scholarships in memory of his son Richard Bosco, who was killed in the World Trade Center Sept. 11, 2001 terrorist attack. The date of the outing is June 24, 2011. Details can be found at www.richboscomemorial.com/index. asp?info=history or by calling Bosco at 914-522-3233.

Bill Bosco, a member of this newsletter's Board of Editors, is the President of Leasing 101, a lease consulting company. He can be reached at 914-522-3233. His website is http://www.leasing-101.com/.