Lease Accounting Project Update

The latest FASB/IASB Lease Accounting Project meetings on Feb. 28 and 29 had as the main objective changing the lessee cost pattern to straight-line, similar to current GAAP. This is an urgent need as lessee cost pattern is the most significant unresolved issue holding up the issuance of a new exposure draft for the Lease Project. The Boards could not agree on any of the three lessee accounting approaches presented by the staff at the meetings, creating a potential impasse. To solve the problem, the Boards directed the staff to conduct outreach to get preparer and user feedback on the proposed approaches. The important news here is that after the meeting the Boards added a fourth approach that the ELFA has been recommending from the start of the Lease Project.

The next step is that the Boards plan to meet in June to decide on the lessee accounting approach to use in the new exposure draft.

The reason for the continued work on the lessee cost pattern is that most comment letters to the initial Lease Project Exposure Draft (“ED”) supported a straight-line cost pattern for what are classified as operating leases under current GAAP to better reflect a lease's economic effects in lessee financial statements.

Four Approaches

The four approaches that are being discussed at the outreach meetings are:

• Approach A ' The right of use (“ROU”) approach is the method presented in the initial Lease Project Exposure Draft whereby the ROU asset is amortized straight-line and interest is imputed versus the ROU liability using the “effective interest method.” This ROU approach has been highly criticized in the comment letters as it front loads lease costs.
• Approach B ' The interest based amortization (“IBA”) approach is a proposed method presented that amortizes the asset on a basis that factors in the timing and amount of rent payments as well as the estimated pattern of benefits realized from use of the leased asset. The resulting rate of amortization is similar to the debt amortization rate. The intent of this method is to produce a straight-line cost pattern, but this method only creates a straight-line pattern if the rents are level throughout the term and the estimated use benefit from the underlying asset is level. It is complex and involves estimates.
• Approach C ' The underlying asset approach (“UA”) is a proposed method that amortizes the ROU asset as the lessee estimates it consumes the value of the leased asset over the lease term (estimated decline in fair value of the underlying asset). Its intent is to produce a pattern of costs that reflects the pattern of the estimated decline in value of the underlying asset. This method only creates a straight-line cost pattern if the leased asset's residual value at expiry is the same as the fair value at inception (this may be the case in real estate leases but not equipment leases). This method is complex and involves estimates that may not be feasible for the lessee to make.
• Approach D ' The whole contract (“WC”) method is the new proposed method that accrues the average rent as the reported lease cost (much the same as current GAAP) and adjusts the ROU asset and lease liability on each balance sheet date to be the present value of the remaining lease payments. The outreach information provided by the FASB/IASB staff presents this new approach as follows: “The whole contract approach considers the ROU asset and the lease liability that arise from a lease contract to be one unit of account when initially and subsequently measuring those balances. This approach views the ROU asset as being different from other non-financial assets and different from the underlying asset itself. This is because the ROU asset is inextricably linked to the lease liability, not only at lease commencement, but also throughout the lease term. This approach also does not view a lease contract as a financing transaction.”

It should be noted that the Institute of Management Accountants (“IMA”) sent an unsolicited comment letter dated April 12, 2012 to the Boards recommending consideration of Approach D and praising it as the approach that is most responsive to the important issues that have been raised regarding lessee accounting.

The ELFA has supported Approach D from the outset of the Lease Project in 2006. In an unsolicited comment letter to the Boards dated May 8, 2008, the ELFA recommended it for their consideration, providing a detailed example. The ELFA believes it reflects the appropriate values of the ROU asset and lease liability (being equal except of impairment) on the balance sheet that arise from the lease contract. It also reflects the cost as a level rent expense, which is what lessees perceive to be their lease cost benefit from the use of the leased asset for each month. The lease payment would be reported as an operating cash outflow reflecting the true nature of the payment.

Conclusion

It is obvious that there is no one method that will receive unanimous support, but Approach D accomplishes the objective of capitalizing operating lease obligations, while retaining current GAAP treatment in the P&L and cash flow statements that were never cited as needing changes. It is hoped that the presentation of this new method will be favorably received at the outreach meetings and lead to successful resolution of a major issue impeding progress toward completion of the Lease Project.

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

The latest FASB/IASB Lease Accounting Project meetings on Feb. 28 and 29 had as the main objective changing the lessee cost pattern to straight-line, similar to current GAAP. This is an urgent need as lessee cost pattern is the most significant unresolved issue holding up the issuance of a new exposure draft for the Lease Project. The Boards could not agree on any of the three lessee accounting approaches presented by the staff at the meetings, creating a potential impasse. To solve the problem, the Boards directed the staff to conduct outreach to get preparer and user feedback on the proposed approaches. The important news here is that after the meeting the Boards added a fourth approach that the ELFA has been recommending from the start of the Lease Project.

The next step is that the Boards plan to meet in June to decide on the lessee accounting approach to use in the new exposure draft.

The reason for the continued work on the lessee cost pattern is that most comment letters to the initial Lease Project Exposure Draft (“ED”) supported a straight-line cost pattern for what are classified as operating leases under current GAAP to better reflect a lease's economic effects in lessee financial statements.

Four Approaches

The four approaches that are being discussed at the outreach meetings are:

• Approach A ' The right of use (“ROU”) approach is the method presented in the initial Lease Project Exposure Draft whereby the ROU asset is amortized straight-line and interest is imputed versus the ROU liability using the “effective interest method.” This ROU approach has been highly criticized in the comment letters as it front loads lease costs.
• Approach B ' The interest based amortization (“IBA”) approach is a proposed method presented that amortizes the asset on a basis that factors in the timing and amount of rent payments as well as the estimated pattern of benefits realized from use of the leased asset. The resulting rate of amortization is similar to the debt amortization rate. The intent of this method is to produce a straight-line cost pattern, but this method only creates a straight-line pattern if the rents are level throughout the term and the estimated use benefit from the underlying asset is level. It is complex and involves estimates.
• Approach C ' The underlying asset approach (“UA”) is a proposed method that amortizes the ROU asset as the lessee estimates it consumes the value of the leased asset over the lease term (estimated decline in fair value of the underlying asset). Its intent is to produce a pattern of costs that reflects the pattern of the estimated decline in value of the underlying asset. This method only creates a straight-line cost pattern if the leased asset's residual value at expiry is the same as the fair value at inception (this may be the case in real estate leases but not equipment leases). This method is complex and involves estimates that may not be feasible for the lessee to make.
• Approach D ' The whole contract (“WC”) method is the new proposed method that accrues the average rent as the reported lease cost (much the same as current GAAP) and adjusts the ROU asset and lease liability on each balance sheet date to be the present value of the remaining lease payments. The outreach information provided by the FASB/IASB staff presents this new approach as follows: “The whole contract approach considers the ROU asset and the lease liability that arise from a lease contract to be one unit of account when initially and subsequently measuring those balances. This approach views the ROU asset as being different from other non-financial assets and different from the underlying asset itself. This is because the ROU asset is inextricably linked to the lease liability, not only at lease commencement, but also throughout the lease term. This approach also does not view a lease contract as a financing transaction.”

It should be noted that the Institute of Management Accountants (“IMA”) sent an unsolicited comment letter dated April 12, 2012 to the Boards recommending consideration of Approach D and praising it as the approach that is most responsive to the important issues that have been raised regarding lessee accounting.

The ELFA has supported Approach D from the outset of the Lease Project in 2006. In an unsolicited comment letter to the Boards dated May 8, 2008, the ELFA recommended it for their consideration, providing a detailed example. The ELFA believes it reflects the appropriate values of the ROU asset and lease liability (being equal except of impairment) on the balance sheet that arise from the lease contract. It also reflects the cost as a level rent expense, which is what lessees perceive to be their lease cost benefit from the use of the leased asset for each month. The lease payment would be reported as an operating cash outflow reflecting the true nature of the payment.

Conclusion

It is obvious that there is no one method that will receive unanimous support, but Approach D accomplishes the objective of capitalizing operating lease obligations, while retaining current GAAP treatment in the P&L and cash flow statements that were never cited as needing changes. It is hoped that the presentation of this new method will be favorably received at the outreach meetings and lead to successful resolution of a major issue impeding progress toward completion of the Lease Project.

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