As mentioned in my September 2012 blog article, “Possible New Lease Accounting Rule—An Update,” a new proposal for lease accounting was likely to “hit the streets” sometime in 2013. Sure enough, a new proposal was issued on May 16, 2013. This proposal was issued jointly by the U.S. accounting standard-setter, the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB), which issues accounting standards that are used by many companies in countries outside the United States. The two boards are striving to conform their accounting principles and this lease project is one example of that effort.
The concept of lease accounting has been around for years, but the existing lease accounting rules are complex, arbitrary and don’t achieve the desires of many investors—quantification of liabilities associated with leases by lessees. Currently, many large companies including United Continental Holdings, Inc., American Airlines, Inc., and Delta Air Lines, Inc.—just to name a few—lease many of their aircraft using what is termed an operating lease arrangement. If properly structured, the lessee only reports lease expense in its statement of income and the related obligation is buried in the footnotes to financial statements—resulting in an “off-balance sheet” presentation of the obligation, which many believe is misleading. In fact, a former FASB member stated at a conference a few years back that it was beyond comprehension that the profession would allow such “bad accounting.”
First Attempt to “Fix” Bad Accounting
The two standard-setters issued a proposal in August 2010 that would change the way in which lease accounting is handled—not only by lessees, but by lessors as well. In short, reaction to the proposal was “not good” and the boards decided to take another “bite at the apple” or find another solution.
Yes, the FASB and the IASB could have finalized the proposed rule without considering constituent feedback, but that is neither good due process nor politically smart. The major complaint by respondents to the first proposal was that it accelerated the timing of expense recognition by a lessee (notably real estate type leases), which was “unfair.” So, the boards set in motion an attempt to try to fix it. They directed their staffs to develop a less “unfair” approach to lease accounting.
The original proposal was discussed in my prior blog article “Lease Accounting—Will There Be a New Accounting Standard?” that was written when the fate of the first exposure draft appeared uncertain.
The Second Attempt to “Fix” Bad Accounting
After months of debate, deliberations, and drafting, the second FASB/IASB attempt at a fix for lease accounting has been made available in the form another exposure draft, for your reading pleasure. Be in the right frame of mind, however, as it is nearly 350 pages in length! The boards are seeking comments on their proposal until September 13, 2013.
The concept the two boards developed can be summarized as follows. An entity would recognize assets and liabilities arising from a lease and would recognize changes in the future based on whether the lease is considered to be, what the boards term a “Type A” lease or a “Type B” lease. The distinction is based on whether the “lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset.”
When measuring assets and liabilities arising from a lease, a lessee and a lessor would exclude most variable lease payments. In addition, a lessee and a lessor would include payments to be made in optional periods only if the lessee has a significant economic incentive to exercise an option to extend the lease or not to exercise an option to terminate the lease.
A lessee would recognize assets and liabilities for any lease that has a term 12 months or more. The resulting asset would be “right-of-use” asset and the entity would record a lease liability for future lease obligations. Consistent with the above-described overall concept, recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee would depend on whether the lessee is expected to consume “more than an insignificant portion of the economic benefits embedded in the underlying asset.” This assessment would often depend on the nature of the underlying asset. For most leases of assets other than property (e.g., cars, trucks, aircraft, equipment, etc.), a lessee would classify the lease as a Type A lease and would (a) recognize a right-of-use asset and a lease liability, initially measured at the present value of future lease payments; and (b) recognize the “unwinding” of the discount on the lease liability as interest expense separate from the amortization of the right-of-use asset.
For most leases of property (i.e., land and (or) building or part of a building), a lessee would classify the lease as a Type B lease and would account for the transaction by (a) recognizing a right-of-use asset and a lease liability, initially measured at the present value of future lease payments; and (b) recognize a single lease cost, combining the “unwinding” of the discount on the lease liability with the amortization of the right-of-use asset, on a straight-line basis.
Similarly, the accounting applied by a lessor would depend on whether the lessee is expected to consume more than an insignificant portion of the “economic benefits embedded in the underlying asset.” For practical purposes, this assessment often would depend on the nature of the underlying asset. For most leases of assets other than property, a lessor would classify the lease as a Type A lease and would (a) derecognize the underlying asset and recognize a right to receive lease payments (lease receivable) and a residual asset (representing the rights the lessor retains relating to the underlying asset); (b) recognize the unwinding of the discount on both the lease receivable and the residual asset as interest income over the lease term; and (c) recognize any profit relating to the lease at the commencement date.
For most leases of property, a lessor would classify the lease as a Type B lease and would apply an approach similar to existing operating lease accounting in which the lessor would (a) continue to recognize the underlying asset; and (b) recognize lease income over the lease term, typically on a straight-line basis.
The existing accounting model for leveraged leases would not be retained, and the proposals described above for lessors would be applied to all leases currently accounted for as leveraged leases.
Effective Date and Transition for the Second “Fix”
The two boards did not propose an effective date for companies to adopt a new lease standard as they first want stakeholder feedback. However, most believe a new standard won’t be effective until at least 2017. Look for further deliberations into 2013 and possibly 2014 before any final standard is issued.
The exposure draft proposes that companies would adopt the standard either retrospectively or using what the boards term, a “modified retrospective approach.” The latter approach would have a company recognize and measure its leases at the beginning of the earliest period presented. In the case of a company subject to Securities and Exchange Commission (SEC) oversight, and assuming the boards agree upon an effective date of January 1, 2017, the company would have to modify its financial statements for 2015 and 2016 for the new lease rule (the SEC requires companies subject to its oversight to present three years of comparative information). For companies that have numerous leases with unique terms, neither transition method will be easy.
Net Effect of the Second “Fix”
Companies that lease real estate get the most relief from the guidance proposed in the first “fix.” The second “fix” will likely closely match, at least from a bottom-line income statement perspective, the accounting used by companies today—the big change is moving a large “off balance sheet” obligation from the footnotes to the balance sheet. That said, there are numerous nuances in the second “fix” that companies and auditors should be reviewing now, as some of the changes could be significant and costly to implement. Any such concerns should be communicated to the FASB and IASB during the comment period.
The FASB approved issuing the second exposure draft by a vote of 4 to 3. Leslie Seidman, current chairman of the FASB and representing 1 of the 4 affirmative votes approving the lease exposure draft, is leaving the FASB on June 30, 2013. A replacement has not been identified. The replacement could have an interesting effect on the outcome as the 3 dissenters were fairly strong in their views and may be unlikely to change their minds. Separately, only 2 of the 16 IASB members dissented on the issuance of the latest exposure draft. Because leasing is such an important transaction type, a 4th dissenter on the FASB regarding issuance of a final lease standard would significantly affect the attempt to converge U.S. and international accounting standards!
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.