It has been more than two years since the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued their joint proposal on lease accounting. In fact, the proposal was issued on August 17, 2010, and the boards were seeking comments on their proposal by December 15 of that year.
Well, they received comments and most of them were negative. The FASB received 786 “comment letters” and the IASB received somewhat fewer. The boards have been struggling with their lease project, a topic discussed in my earlier blog article, “Lease Accounting—Will There Be a New Accounting Standard?” However, it now appears that the standard-setters have developed a new approach and are willing to send up another trial balloon to see if it might fly better with constituents.
The importance and breadth of this proposal on accounting for leases cannot and should not be underestimated. Some accounting rules such as those applicable to derivatives, business combinations, or operating as a public company can easily be avoided by a company if it adopts a policy of not engaging in any transactions that would be subject to the rules. However, when it comes to lease accounting, almost every business has leases for computers, copiers, cars, and real estate—to say nothing about the more specialized leasing needs of businesses such as major air carriers with fleets of leased aircraft.
Background—An Arduous Standard-Setting Process
Being a standard-setter is not an easy job in the United States or elsewhere around the world. Before a new accounting rule is finalized, the FASB has to publish an “exposure draft” of its proposal, seek comments from constituents, then redeliberate the rule in public—and, in the case of the controversial new rule on leasing, conduct “roundtables” and other forums to get input. This time around, the process also included working with the IASB, which has comparable due process requirements for getting input from companies that must apply its accounting rules, auditors, and other constituents.
Background—The Need for a New Rule
Over the years, businesses have structured transactions to avoid having liabilities on their balance sheets for leased items. The standard-setters believe, and most rational lay persons concur, that the existing rules for accounting for leases are arbitrary and make no sense—many liabilities are missing from company balance sheets. Credit agencies that issue ratings that facilitate borrowings by businesses typically have to make their own “adjustments” to the audited financial statements of the business to properly gauge risk to lenders, shareholders, and the like.
The Original Proposed Rule
While there was much controversy in the FASB’s original proposal to “improve” accounting for leases, probably the biggest concern from the lessee’s perspective was expense recognition. Borrowing the example from my prior blog article, a company has a 10-year noncancelable lease that requires payments of $100,000 per month, or $1,200,000 per year, or $12,000,000 over the entire lease term. Under existing U.S. generally accepted accounting principles (GAAP), which is similar in most respects to the IASB’s International Financial Reporting Standards (IFRS), the company would likely conclude that this lease meets the criteria for being an operating lease. Accordingly, the company would record lease expense of $1,200,000 for each year during the 10-year term and make various disclosures in its financial statement footnotes. Under the FASB’s originally proposed exposure draft, the company would be required to initially record the right-of-use asset and liability associated with the leased asset at its present value.
Under the originally proposed exposure draft, assuming a discount rate of 8% and ignoring any initial lease costs, the company would initially record this asset and related liability at $8,242,000. Thereafter, the company would charge two items to operations—amortization expense on the “right-of-use asset” and interest expense on the lease liability. Assuming the company has an accounting policy that follows the commonly used straight-line method of depreciating or amortizing its property assets, in this simple example, the related amortization expense would be $824,200 per year. In the first year of the lease, interest expense would be $640,000, and, together with the amortization expense, the company would charge its operations $1,464,200 or $264,200 more than under current accounting rules.
In short, many lessees were not happy with this “accelerated approach” to recording expense, and the FASB and IASB looked for creative (theoretically supportable) ways to make the difference “go away.”
The “New and Improved” Lease Proposal
Here is how the FASB and IASB have tentatively agreed to mitigate the controversy. A lessee would first have to determine whether its lease is an interest and amortization (I&A) lease or a single lease expense (SLE) lease. As originally proposed by the boards, the lessee would typically have all I&A leases and the accounting outlined above would apply. Now the boards have created the SLE concept. Under this approach, the lessee would not have amortization or interest expense to record; rather, it would have only “lease expense,” again using the above example, of $1,200,000 per year over the life of the lease. The amount initially shown on a lessee’s balance sheet for either an I&A lease or an SLE lease would be the same. Following this “new approach,” the boards are happy that the lease obligation is “on balance-sheet” and SLE lessees are happy because they effectively receive existing U.S. GAAP treatment—at least in their income statement.
The distinction between the two types of leases is as follows. A lease of real estate would be considered an SLE lease by the lessee unless the lease term is for the major part of the economic life of the underlying asset or the present value of the fixed lease payments represents substantially all of the fair value of the underlying asset. Leases of assets other than real estate (e.g., machinery), would be considered I&A leases unless either the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset being leased. This distinction would generally apply to lessors, too. The FASB and IASB apparently desire that lease arrangements be evaluated to determine whether the lessee is paying to finance the acquisition of the underlying asset or simply using the asset.
Of course, this leads to questions like, what is meant by “major part,” what is “substantially all,” and what is “insignificant”? Whether the boards will provide any guidance to answer these questions before issuing a new proposal is unknown, but sooner or later the questions will have to be addressed.
The FASB and IASB have agreed to other changes as well, including less onerous transition to the new rules, definition of the lease term, how contingent rent is reflected in the calculations, definition of short-term leases, etc. Whether the boards’ constituents agree that there has been enough “relief” is unknown, but certainly the most controversial part of the proposal has been addressed.
The boards have yet to deliberate effective dates of the proposal and of course they must re-expose their conclusions in another exposure draft. The timing of the revised exposure draft reflecting the new concepts and other agreed upon changes will probably be late in 2012 or possibly early 2013. Stay tuned.
About the Author
Ron Pippin is an experienced CPA based in Wheaton, IL. His 40 plus year career includes being an audit partner in Arthur Andersen, a member of Andersen’s Professional Standards Group (“national office”) in Chicago, the Director of Financial Reporting for a Fortune 50 company and most recently, the editorial director of CCH’s Accounting Research Manager. Currently, Ron does independent writing and analysis together with accounting consultation on a variety of topics.