Lease Accounting Project Update

A new exposure draft will be issued early in March or April 2012 with a 120-day comment period. Consequently, early 2013 is the earliest a new standard is expected to be issued. This is good news as it allows the industry and its lessee customers another chance to comment. The main problem areas are lessee front-ended lease costs, the deferral of gross profit in sales-type leases, the loss of leveraged lease accounting and complexity/compliance costs.

The effective date of the new lease accounting standard is most likely 2015 or 2016. The transition date also depends on the progress of the Boards' Revenue Recognition project, as they would like both to have the same transition date. If there are any delays in either project, the transition date will slip to 2016. Preparers will have to show two years' comparative data in the year of transition for all leases on the books in the transition year. In other words, there will be a need for information under the new rules for 2013 or 2014, depending on the transition year.

Lessee Accounting

• Capitalize all leases at the present value (“PV”) of estimated payments;
• P&L pattern will be front ended ' rent expense replaced by amortization and imputed interest;
• Lease term is substantially the same as current GAAP definition.
• Variable rents based on a rate (i.e., Libor) or an index (i.e., CPI) are booked based on spot rates with adjustments booked when the rate change alters contractual lease payments. Variable rents based on usage or lessee performance (e.g., sales) are not booked unless they are considered a tool to avoid capitalization (disguised minimum lease payment). Estimated payments under residual guarantees are booked with review and adjustment at each reporting date.
• Short-term lease election available by asset class to use the operating lease method with additional disclosure.

Exiting capital leases are grandfathered in transition. Lessees may use either the full retrospective or modified retrospective transition methods explained below.

For lessees using the optional full retrospective transition method, this will smooth the lessee transition year P&L impact by moving the initial “hit” of front ending lease costs to the inception of each lease. This will result in a large hit to retained earnings and the creation of a large deferred tax balance in the year of transition. This will be a problem for a capital-strapped banking industry. It will also be burdensome for lessees to go back to the inception of each lease.

The proposed modified retrospective approach for lessees would start the new accounting method for the lease liability for each lease (as though it were a new lease for the remaining term) beginning in the earliest period presented when a lessee converts. The ROU asset is adjusted in a complicated way by using a ratio of remaining rents to total rents to reflect a partial retrospective result. This is an attempt to lessen the first-year P&L cost front ending. Instead the charge from this depreciation adjustment is to equity and deferred tax assets rather than to current P&L. This adds additional complexity for the lessee. It means that existing leases will have a front-ended pattern almost as though they were new leases, but with a term equal to the remaining term. The difference between this new method and treating the existing leases as though they were new ones is the charge to equity and deferred tax assets ' still not an outcome that reflects the economics of a lease to the lessee. This method will still create large increases in the reported lease costs until the lessee's lease portfolio reaches a “steady state” point where an equal amount of expiring leases are replaced by new leases. At that point, the front-ending phenomenon leaves all lessees with a permanent reduction in equity and a permanent deferred tax asset. For a lessee whose business is growing (leasing more assets each year) and considering inflation, that lessee company will never reach a point of steady state leases costs.

Lessor Accounting

Four methods were identified for lessors: 1) The “receivable & residual” (“R&R”) method (much like the current GAAP direct finance lease method) for leases of the entire asset to one lessee (covers virtually all equipment leases); 2) Short-term lease election (current GAAP operating lease method); 3) Investment properties measured at fair value for qualifying real estate lessors that are investment companies (operating lease method with fair valuing of the leased asset); and 4) An exception for lessors of investment property (commercial real estate) to elect to use existing operating lease accounting.

• Under the R&R method, assets are the PV of the receivable and a plugged residual.
• Sales-type gross profits are limited with the residual portion of gain being deferred until resolved.
• Leveraged lease accounting is eliminated with no grandfathering. This is a FASB only issue. New leveraged leases may be allowed offsetting of the rent and debt service. To be determined if they include it in the scope of the FASB's Balance Sheet ' Offsetting project. The Boards will not allow tax affected revenue recognition for any lease.
• Short-term lease election available to use the operating lease method.

Existing direct finance and sales-type leases are grandfathered in transition. For operating leases, lessors book the PV of the rents as an asset, derecognize the operating lease asset and the difference is the residual. No decision has been made on how to handle transition for operating leases with a gross profit element.

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 www.leasing-101.com.

The previously stated goal of the FASB/IASB Boards was to release a new exposure draft by year-end 2011 followed by a 120-day comment period. This date has been pushed back, however. The new exposure draft will be issued in March or early April 2012 with a 120-day comment period. In addition, it is believed that because the FASB/IASB Boards may only have one more meeting, these latest amendments contain what will likely be the final version of the new exposure draft.

Key recent Boards' decisions include:

• New transition methods for lessees and lessors;
• New guidance for lessor accounting, including allowing operating lease accounting for lessors of certain real estate and sublessors in real estate subleases;
• Disclosures for lessors; and
• Business combinations accounting.

Executive Summary of Key Elements of the Total Project

Timeline

A new exposure draft will be issued early in March or April 2012 with a 120-day comment period. Consequently, early 2013 is the earliest a new standard is expected to be issued. This is good news as it allows the industry and its lessee customers another chance to comment. The main problem areas are lessee front-ended lease costs, the deferral of gross profit in sales-type leases, the loss of leveraged lease accounting and complexity/compliance costs.

The effective date of the new lease accounting standard is most likely 2015 or 2016. The transition date also depends on the progress of the Boards' Revenue Recognition project, as they would like both to have the same transition date. If there are any delays in either project, the transition date will slip to 2016. Preparers will have to show two years' comparative data in the year of transition for all leases on the books in the transition year. In other words, there will be a need for information under the new rules for 2013 or 2014, depending on the transition year.

Lessee Accounting

• Capitalize all leases at the present value (“PV”) of estimated payments;
• P&L pattern will be front ended ' rent expense replaced by amortization and imputed interest;
• Lease term is substantially the same as current GAAP definition.
• Variable rents based on a rate (i.e., Libor) or an index (i.e., CPI) are booked based on spot rates with adjustments booked when the rate change alters contractual lease payments. Variable rents based on usage or lessee performance (e.g., sales) are not booked unless they are considered a tool to avoid capitalization (disguised minimum lease payment). Estimated payments under residual guarantees are booked with review and adjustment at each reporting date.
• Short-term lease election available by asset class to use the operating lease method with additional disclosure.

Exiting capital leases are grandfathered in transition. Lessees may use either the full retrospective or modified retrospective transition methods explained below.

For lessees using the optional full retrospective transition method, this will smooth the lessee transition year P&L impact by moving the initial “hit” of front ending lease costs to the inception of each lease. This will result in a large hit to retained earnings and the creation of a large deferred tax balance in the year of transition. This will be a problem for a capital-strapped banking industry. It will also be burdensome for lessees to go back to the inception of each lease.

The proposed modified retrospective approach for lessees would start the new accounting method for the lease liability for each lease (as though it were a new lease for the remaining term) beginning in the earliest period presented when a lessee converts. The ROU asset is adjusted in a complicated way by using a ratio of remaining rents to total rents to reflect a partial retrospective result. This is an attempt to lessen the first-year P&L cost front ending. Instead the charge from this depreciation adjustment is to equity and deferred tax assets rather than to current P&L. This adds additional complexity for the lessee. It means that existing leases will have a front-ended pattern almost as though they were new leases, but with a term equal to the remaining term. The difference between this new method and treating the existing leases as though they were new ones is the charge to equity and deferred tax assets ' still not an outcome that reflects the economics of a lease to the lessee. This method will still create large increases in the reported lease costs until the lessee's lease portfolio reaches a “steady state” point where an equal amount of expiring leases are replaced by new leases. At that point, the front-ending phenomenon leaves all lessees with a permanent reduction in equity and a permanent deferred tax asset. For a lessee whose business is growing (leasing more assets each year) and considering inflation, that lessee company will never reach a point of steady state leases costs.

Lessor Accounting

Four methods were identified for lessors: 1) The “receivable & residual” (“R&R”) method (much like the current GAAP direct finance lease method) for leases of the entire asset to one lessee (covers virtually all equipment leases); 2) Short-term lease election (current GAAP operating lease method); 3) Investment properties measured at fair value for qualifying real estate lessors that are investment companies (operating lease method with fair valuing of the leased asset); and 4) An exception for lessors of investment property (commercial real estate) to elect to use existing operating lease accounting.

• Under the R&R method, assets are the PV of the receivable and a plugged residual.
• Sales-type gross profits are limited with the residual portion of gain being deferred until resolved.
• Leveraged lease accounting is eliminated with no grandfathering. This is a FASB only issue. New leveraged leases may be allowed offsetting of the rent and debt service. To be determined if they include it in the scope of the FASB's Balance Sheet ' Offsetting project. The Boards will not allow tax affected revenue recognition for any lease.
• Short-term lease election available to use the operating lease method.

Existing direct finance and sales-type leases are grandfathered in transition. For operating leases, lessors book the PV of the rents as an asset, derecognize the operating lease asset and the difference is the residual. No decision has been made on how to handle transition for operating leases with a gross profit element.

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 www.leasing-101.com.