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New Accounting Standard Moves Closer to Conclusion
The Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) are jointly working on a replacement for the current lease accounting standards, FAS 13 and IAS 17, that will be followed by all companies worldwide. The impetus to this new standard was the Enron accounting scandal of 2001. Enron's demise was not caused by leases, but it was caused by other off-balance-sheet transactions. These transactions proved to be accounted for incorrectly, and readers of Enron's financials were not totally aware of the implications. The crisis prompted the U.S. Congress to enact the Sarbanes Oxley Act, which, among other things, directed the SEC to identify other off-balance-sheet transactions. Leases, specifically operating leases, were cited as a major class of off-balance-sheet obligations. In the opinion of the SEC, readers of financial statements would have better information if operating leases were capitalized as an asset and a liability on balance sheet. As a result, the FASB/IASB put a lease accounting project on their agenda in 2006 with the objective of creating a new lease accounting standard requiring lessees to capitalize an asset and liability for all operating leases. Unfortunately, the project has gone much further than merely capitalizing lessee operating lease obligations. The project also includes major changes to lessor accounting, which no one thought was a problem.
Timing of the Project
The Lease Project is progressing with a target completion date of mid-year 2011. The Exposure Draft (“ED”), published in mid-August, is a draft of the final proposed rules. The accounting boards will review public comments on the ED until mid-December 2010. I urge all readers to read the Exposure Draft and write comment letters. The ELFA and I will write comment letters to challenge some of the proposed elements, but we need a greater volume of comments to change their minds. The accounting boards will review all comments and adjust the draft if warranted. FASB and IASB plan on issuing the final standard in 2011. The effective date from which companies must comply with the new standard is expected to be January 2013. Although this date may seem distant, the transition requirements and the compliance requirements are complex, so companies should start to plan for the new standard immediately. The FASB will decide on the effective date after results of an outreach project that will consider the compliance burden of the major accounting projects expected to be completed in 2011.
Timeline
- Aug. 17, 2010 ' Issue Exposure Draft for public comment;
- Dec. 15, 2010 ' Deadline for comment letters;
- Q1 2011 ' Make changes, if any, based on comment letters;
- Mid 2011 ' Issue final rule;
- Effective date TBD but likely, 2013 ' Lessees and lessors implement new rules.
Summary of Key Elements (with Commentary in Italics)
Scope
Project scope includes lessor accounting and excludes leases that are financed purchases. Financed purchases are only those leases with bargain purchase options or automatic transfer of title.
Lessee Accounting
For lessee accounting right-of-use leases (“ROU”) as opposed to leases that are financed purchases, capitalize an asset and liability at the present value (“PV”) of the estimated lease payments (includes contingent rents, renewal options and residual guarantees) for the longest possible estimated lease term that is more likely than not to occur (considers lessee behavior in prior leases). Use the lessee's incremental borrowing rate to PV payments. The industry continues to challenge the requirement to capitalize contingent rents and non-bargain renewals on grounds they are not liabilities at lease inception.
If it is evident that there have been material changes in estimates, lessees will have to record adjustments on each financial reporting date using the original incremental borrowing rate to discount the remaining estimated payments. This is burdensome for lessees, and we continue to challenge it.
Lessee expense recognition is level depreciation/amortization of the capitalized asset and interest on the capitalized obligation for all leases, creating a front-ended lease expense pattern. Straight-line rent expense would be eliminated. The front ending of lease costs continues to build until leases reach their mid point when the costs become back ended. The cumulative impact can be viewed as permanent unless the lessee ceases all leasing activities. This front ending of lease costs in excess of the cash rent that the IRS allows as a deduction forces lessees to recognize large deferred taxes receivables. This is our major issue with lessee accounting.
For contracts that include the use of equipment and for full-service leases, both lessees and lessors have to bifurcate the lease and service elements and account for them separately using the relative fair value of the lease and service components. If lessees cannot bifurcate the payments, they have to account for the whole contract as a lease. This, of course, would mean that the service element would get capitalized, and that would be bad.
For short-term leases (one-year term or less), lessees will not have to PV the rents, but rather will report the full value of the rents as an asset and liability. The Boards believe that this will simplify short-term lease accounting, but we feel it is overkill.
For sale leasebacks if the sale is truly a sale, book the ROU asset and liability, remove the asset and book a gain. If the terms are not market terms, adjust the gain. If not a sale, book the lease as a loan and leave the asset on the books. This is decidedly better than current GAAP, as gains are not deferred and sale criteria are eased vs. FAS 98.
For subleases, the lessee leaves the head lease on the books and records the sublease using the performance obligation method (see below). The sublease receivable and the performance obligation liability are shown linked on the balance sheet net with the head lease asset. The lease cost and lease revenue are not netted.
Lease rent will no longer be considered an operating cash outflow in the cash flows statement. New leases will be treated as capital expenditures. Lease payments will be considered financing cash outflows. This means that leases will not be considered out of the CAPEX budgeting process. Strangely, EBITDA will improve as cash paid for rent will no longer be a deduction.
Lessor Accounting
There will be multiple accounting models for lessors. The determining factors for the choice of what method to use are still unclear. The four models (There will be no leveraged leases in the future) and likely determining factors for their use are:
Partial Derecognition Method ' This is the industry's favored method except for its treatment of residuals.
- For leases that transfer most of the risks and rewards (criteria will be similar to IAS 17 with no bright lines). We are challenging the idea that risks and rewards should be the classification criteria, as it would mean many of our leases may not qualify for derecognition. This also means the potential for a reduction in the number of leases qualifying for sales-type gross profit accounting.
- Lessor books PV of estimated rents at a rate like the implicit rate and plugs the residual asset ' lease revenue is finance revenue and sales-type gross profit, if any ' residual asset left unchanged except for impairment. We will challenge the residual accounting, as it is a step backward from DFL accounting.
- Revenue will be somewhat back ended.
Performance Obligation Method ' This method has flaws, and we will challenge it.
- For leases that do not transfer most of the risks and rewards.
- Lessor leaves leased asset on the books, books a receivable at the PV of the estimated payments and a performance obligation liability (not a real liability but a deferred income account). The three elements are netted on the asset side of the balance sheet. The residual is ignored, so it is accounted for on a cash basis by default.
- Lease revenue has a finance component and straight-line amortization of the deferred liability ' there is also depreciation on the leased asset ' the three components are netted as lease revenue. Revenue pattern depends on depreciation assumptions. No sales-type revenue recognized.
Short-Term Lease Method
- For leases with terms of less than one year use existing operating lease accounting.
Investment Property Method
- For actively managed real property leases use existing operating lease accounting but fair value the residual with gains or losses flowing through P&L. This is a current method under IFRS, and the FASB has started a project to add it to U.S. GAAP. This method allows write ups of residuals, but is restricted to IAS and only real estate assets. We will challenge the notion that only RE assets can have the right to write up residuals.
Transition
For transition, lessees will capitalize the remaining payments under all operating and some capital leases based on the new rules. Lessors would be required to rebook all leases based on the new rules going forward under the new rules. Leveraged leases will be rebooked with any net P&L hit charged to retained earnings. Going forward, leveraged leases will not get special treatment for netting of debt nor will the MOISF yield be used to amortize revenue. Transition will be a major undertaking for lessees and lessors, and we will push for grandfathering of DFLs, leveraged leases and lessee capital leases.
Conclusion
All affected companies must get involved and send comment letters, as this rule change may cause the largest “hit” to earnings of any change in the history of accounting. It will take the business world a while to adjust its covenants, analyses and measures. The credit ratings of lessees will not change, but their balance sheets and income statements will surely look different. Lease costs will go up as leveraged leases are not offered (alternative structure ideas in the works will never duplicate the effectiveness for both lessees and lessors of the existing leveraged lease structure) and sales-type leases will decline. Banks and captives may pull back so independents with higher pricing may take over more market share.
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