Later this week the next joint meeting of the global accounting standard setters – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) – is due to make major decisions on the proposed new lease accounting standard. On the main model for lessee capitalization of leased assets, as decided at their January meeting (see AFI Lease Accounting January) they will choose between three alternative models.
None of these three alternatives is exactly the same as the proposal in last year’s second exposure draft (ED 2). There is at least a chance that the Boards will agree to leave current finance/operating lease classification largely as it is (though with a different definition), for the new purpose of determining how lessees will expense leased assets in the profit and loss (P&L) account.
If that is decided, most current finance or capital leases would remain with the current front-loaded expensing model (presently termed “Type A” by the Boards); while most current operating leases, though coming on to the balance sheet, would retain their existing straight line expensing model (“Type B”) with a single rental expense rather than a mixture of interest and amortization charges.
The other alternatives are Type A for all leases; or a split based on equipment versus real estate, with nearly all equipment leases on Type A (a modified version of the ED 2 proposal).
The Boards will also be considering various possibilities – not all mutually exclusive – for simplifying capitalization for lessees. These would be in addition to the “materiality” condition applying to all leasing standards, which the staff suggest would in practice allow some small ticket leases not to be capitalized.
The “portfolio basis” (see AFI Lease Accounting January) for groups of leased assets with similar characteristics, is positively recommended in the staff report. It seems likely to be adopted, and the Boards will be considering associated disclosure rules for notes to accounts.
Another possibility, on which the Boards’ staff are divided and make no clear recommendation, is an exemption from capitalization for small non-specialized assets. This would be confined to assets that are both individually small in value and non-specialized, such that they would be used in unmodified form across a variety of industrial sectors. However, the “individually small” condition would ensure that neither business cars nor photocopiers would be exempted, and only such assets as personal computers, mobile phones and office furniture would qualify.
The staff report raises, but recommends against, possibilities for broader exemptions. These include value thresholds for all leased assets (relative to total assets or other measures of corporate size); or a wider small ticket exemption, without the “individually small” condition and with a “core/ non-core” criterion to distinguish between revenue-generating and administrative assets.
The Boards seem likely to agree to extend the “short term” lease exemption that was proposed in ED 2. It is recommended that this still be based on a 12-month lease term, rather than a longer period; but that it be extended to all leases that would run for no more than a year under the general rule for determining the lease term at inception, rather than only those contractually precluded from overrunning 12 months.
Mainstream equipment lease contracts still seem unlikely to be affected by the short term extension. However, as now proposed it could serve to exempt some (but not all) shipping charters and construction plant hire facilities.
The general lease term rule, affecting leases with options to extend or to terminate early, will itself be reviewed by the Boards this week. The staff report recommends that the initial determination should be based, as in ED 2, on the period up to which the lessee has a “significant economic incentive” to renew.
Suggested simplifications of the lease term rule are focused on the extent to which the term determined at inception may need to be reassessed at financial reporting dates while the lease is running. The staff recommend that these reassessment rules should be less onerous than the ED 2 proposal, but they are split as to how far this easing should go. Some staff favour removing the reassessment requirement altogether, while others recommend that it be confined to conditions of a significant change in circumstances.
For the main lessor accounting model, the Boards will also be choosing among three alternatives, all based on a split between Type A front-loaded income recognition as for current finance leases, and straight line (Type B) as with current operating leases.
Essentially there are two basic alternatives as detailed in the AFI Lease Accounting report of January 17 – either the current lease classification rule exactly as it stands (in the IAS 17 version rather than in US GAAP), or otherwise a “business model” basis. The third alternative is slightly different from that proposed in January; but as proposed before, its divergence from current rules would be potentially relevant only to captive lessors, and entailing a condition such that most of them would in fact be unaffected.
This alternative would apply different rules only to captives taking a residual value guarantee (RVG) from a third party. In practice, as the staff report acknowledges, it is rare for captive lessors to do this. The possible rule would be that in these cases, on a finance type lease where the captive lessor group currently recognizes a normal selling profit at lease inception, the captive lessor would continue to apply Type A accounting; but the equipment selling side of the group would no longer recognize an initial selling profit.
Another staff report now recommends that on Type A leases, lessors would apply the IAS 17 version of current finance lease accounting rules, where any RV is in effect embedded within the receivables, rather than the “receivable and residual” (R&R) model as proposed in ED 2. This means that (on any of the alternative models) the question of lessor groups recognizing initial selling profit would remain an “all or nothing” judgement as now, depending on lease classification, rather than having a rule for proportional recognition as under R&R.
The principle of symmetry between lessee and lessor accounting, which ED 2 aimed for in terms of lease classification, has now been abandoned following the Boards’ preliminary discussion in January. Of the alternative models on either side currently under consideration, one of the lessor models would contain lease classification close to the same line as in one of the lessee models. However, the two would not be identical. The lessor version would be as in IAS 17; while the corresponding lessee one would be based on a modified formulation, based on the question of whether the lessee obtains “control” of the asset, rather than focusing on the “risks and rewards of ownership” as in current rules.
Two of the simplification proposals for lessees (see above) would also have implications for lessor accounting. The staff report now recommends that lessors, as well as lessees, should be able to apply the portfolio basis.
As in all previous proposals on the subject, the rules for determining the lease term would be the same for lessors as for lessees – but in both cases based on a lessee-focused view of the incentive effects. The outcome of this appraisal need not always be symmetrical on either side, however, since the two parties could come to different views of the lessee’s incentive to renew at any stage, based on their differing levels of knowledge of the lessee’s business environment.
Written by Andy Thompson, legal & regulatory editor
© Asset Finance International 2014