Lease Accounting: More decisions – but big issues still on hold

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) held a further joint meeting last week to re-deliberate some aspects of their global draft accounting standard. However, the major lessee accounting issues on which they failed to reach agreement in March (see AFI report, March 26) remain outstanding.

As agreed in March, the Boards’ staff will be producing a further report on possible alternatives for exempting some small ticket leases from the proposed comprehensive capitalization rule. This is now likely to be considered by the Boards in either May or June; and in the light of the decisions on that, the Boards will then reconsider their non-converged March decisions on the profit and loss (P&L) account expensing methods for those operating leases that do have to be capitalized.

Following a suggestion made last week by an IASB member, the coming staff report on small ticket leases will look at another possibility for easing lessees’ compliance costs. This could involve not requiring present value (PV) discounts for rental obligations, as a further alternative to not requiring balance sheet recognition at all for some small leases (or perhaps as a separate concession for a different category of leases). For lessees, non-discounting would of course have the disadvantage of inflating the PVs of capitalized leases, although it would remove one feature of the compliance costs.

Discount rate (lessees)

The general issue of the discount rate was among the points re-deliberated by the Boards last week. On the lessee accounting side, the standard setters confirmed that the rules for the discount rate to be applied to future rental obligations in order to derive the value of the right of use (ROU) asset to be capitalized under the new standard will be very similar to those for valuing the underlying asset in the case of on-balance-sheet finance or capital leases under existing rules.

Lessees will be required to use the rate implicit in the lease, as required in lessor accounting (see below), only where that rates is “readily determinable”. Otherwise they will generally use their own incremental borrowing rate (IBR).

The Boards’ staff understand that with the great majority of current finance leases the IBR is in fact the rate used by lessees; and the Boards envisage that this will remain the case with wholesale capitalization under the new standard. Lease contracts do not generally disclose information on the implicit rate itself, nor the value of the asset from which such a rate could readily be derived – except in some jurisdictions in the case of conditional sale contracts or leases with bargain purchase options, which are already on-balance-sheet.

The IBR will be defined as “the rate of interest that the lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar cost to the ROU asset in a similar economic environment”. This is the same as in the second exposure draft (ED2) issued last year, except for a minor change substituting “cost” for “value”.

However, the Boards rejected a staff recommendation to provide guidance as to when a subsidiary company might use its parent company’s IBR for the discount rate. The use of a parent company IBR will not be specifically prohibited. However, the criteria which had been suggested by the staff for specific guidance, such as whether or not the subsidiary had its own treasury function, were not felt appropriate by Board members.

The Boards also rejected a staff recommendation to include one or more illustrative examples  of how to determine the IBR within the guidance notes to the new standard. The standard itself will, however, be drafted so as to require the use of “real” rather than nominal discount rates in the case of inflation-linked rentals (see below under “Variable rate leases”).

ED2 was not fully converged in respect of the discount rates to be used by entities other than public companies. For US GAAP only, FASB proposed to allow the optional use of a “risk-free” market interest rate in place of the IBR or the implicit rate, for non-public entity lessees. The staff report recommended that this elective option should be retained in the US GAAP version. This issue was not reached at last week’s joint meeting, and it will be decided by FASB at a separate later meeting.

As with the possibility of not discounting at all in the case of small ticket leases (see above), the use of a risk-free rate would to some extent overstate PV. It is not therefore certain that most US private company lessees will opt for it, should this be permitted.

The Boards agreed that the discount rate should not be reassessed by the lessee from one reporting period to another, except where there has been a reassessment of the lease term in the light of renewal or break options – which, as they agreed in March, should be necessary in only a limited range of circumstances – or a similar reassessment of whether a purchase option is reasonably certain to be exercised. This decision was in line with the staff recommendation.

Discount rate (lessors)

The Boards also agreed on the definition of the rate implicit in the lease. Since the IBR will effectively be the default option for lessee accounting, the implicit rate will be most relevant for lessor accounting on finance leases, where the lessor recognizes lease receivables on its balance sheet.

The implicit rate will be defined as the interest rate that causes the sum of the PVs of  the rental payments and the residual value to equal the sum of the fair value of the underlying asset  plus any capitalized initial direct costs (IDCs) incurred by the lessor.

This differs in two respects from the ED2 proposal. Firstly, the inclusion of IDCs was not proposed in ED2. It is a feature of the current IAS 17 rules in international financial reporting standards (IFRS), though not in the US GAAP standard Topic 840 (formerly coded as FAS 13).

The staff recommended this latest change as a simplification of lessor accounting. By defining the implicit rate such that IDCs are automatically included in the lease receivable, it avoids the need for lessors to calculate one discount rate for determining the initial receivable and another to determine the interest income on it. On the lessee accounting side, however, where the implicit rate definition will be the same, including the lessor’s IDCs will no doubt make it even more difficult to use this rate in place of the lessee’s IBR.

The other change from ED2 affects only real estate leases. ED2 referred to “the rate the lessor charges the lessee”, specifying that in the case of a real estate lease this could be the local commercial property yield for the relevant location rather than the implicit lease rate. However, this was in the context of the proposal to change current lease classification, so that “Type A” of finance lease type accounting (with lease receivables rather than the underlying asset on the lessor’s balance sheet) could have extended to many current operating leases, where leases are not priced on the basis of an implicit rate.

Following last month’s decision to make only limited changes to lessor accounting and to converge on current IAS 17 lease classification for lessors, allowing the use of a property yield was no longer felt appropriate. It was also felt that on the lessee accounting side, in a low interest rate environment where the property yield in some prime locations might be significantly higher than lessees’ IBRs, permitting use of the property yield could have allowed the lease assets and liabilities to be understated.

For lessors, it was agreed that there will be no requirement to reassess the discount rate at any accounting periods subsequent to initial recognition.

Variable rate leases: initial recognition

The Boards also re-deliberated the rules for lessee and lessor accounting for variable rate leases. The most controversial area within this was on the rules for reassessing such leases from one accounting period to the next (see below).

The question of the initial recognition of variable rate agreements was more straightforward. Except in respect of inflation-linked agreements the Boards agreed with their staffs’ recommendation to confirm the ED2 proposals, which had already been much simplified from the first exposure draft (ED1) issued in 2010. Where the variations depend on an index or rate, lessees and lessors will recognize them on their balance sheets on the basis of the index figure or rate as at lease commencement. Such variations will be recognized separately in P&L as they arise.

However, one IASB member Stephen Cooper noted an anomalous feature of ED2 in respect of contracts subject to rental escalations based on an inflation index. As the proposals stood, the recognized cash value of the rentals would be based on the index value at inception, i.e. excluding all prospective escalations, but these would then have been discounted to a PV at the same type of implicit rate or IBR as for non-indexed contracts (which, other things being equal, would normally start at a higher rate than indexed ones). There would thus in effect be a duplicated PV discount for indexed leases.

The Boards agreed that the new standard should make it clear that discount rates should where necessary reflect relevant features of the contract. The intention would be that a “real” rather than nominal discount rate (i.e. one excluding the effect of prospective price inflation in the reporting entity’s jurisdiction) should be applied where rentals are to escalate with inflation. The wording of this guidance remains to be drafted by the staff, and will be brought back to the Boards later.

Variations based on usage of the leased assets, such as mileage payments on motor vehicles, will not be recognized on balance sheets except in the case of “in-substance fixed payments” that are virtually certain to be incurred. In a separate report, the staffs reviewed the single proposed rule for all “in-substance fixed payments”, covering cases where ostensibly variable payments relate to rates or index figures, usage or any other factors.

It was agreed , as proposed in ED2, to retain the principle that in-substance fixed payments should be included in the definition of lease payments; and it was further agreed to stress in the Basis for Conclusions document that this would be consistent with current finance lease practice.

However, the Boards rejected a staff recommendation to retain and extend some illustrative examples which were provided with ED2 for determining the “in-substance fixed” criterion. It was felt that some of the major accountancy firms were likely to retain similar illustrations in their own handbooks on the leasing standard, and that the Boards should simply prescribe the principle without providing examples.

Reassessments of rate based leases

As for any reassessments of leases subject to index or rate variations, subsequent to initial recognition, the staff report had outlined three alternative solutions:

• Approach 1: to require reassessment at every reporting period, which was proposed in ED2 but attracted a great deal of criticism in response comments;

• Approach 2: to require reassessment only when there is a contractual change in the cash flows . This would be similar to Approach 1, except that a particular lease might not need to be reassessed for every quarterly or even annual reporting date if the lease payments changed only at longer intervals;

• Approach 3: to require no reassessment of index or rate based rentals except where the lease valuation is reassessed for other reasons (i.e. in the case of reassessment of either the lease term or the question of whether a purchase option is reasonably certain to be exercised). This was recommended by the staff, and represents a major concession compared with both the EDs.

In the case of lessors, Approach 3 would require no reassessments for index or rate changes at all. This is because of last month’s decision by the Boards that reassessments of lease term, or of purchase option exercise, should in any case not be required in lessor accounting. In addition, following last month’s tentative decision to leave the main lessor accounting models unchanged from current practice, it is only in the case of current finance or capital leases (i.e. those where lessors recognize receivables on the balance sheet) that reassessments under the other alternative approaches could mean major accounting adjustments for lessors.

For lessees, all the alternatives would still require at least some potential instances of reassessment of index or rate based variable leases. In the case of “Type A” leases, with accounting similar to current finance leases, reassessment would mean varying the periodic amortization and interest charges under the relevant lease. As the proposals for the main lessee accounting model currently stand, after the failure of the Boards in March to agree on that, all lessees subject to IFRS would account under Type A.

For lessees subject to “Type B” accounting (which is only in the case of operating leases under US GAAP as the project now stands) a reassessment would lead to changes in the single rental expense. On all types of lease where triggering of variations does not require reassessment, the relevant variation expenses would be presented in P&L  as a separate item from general lease rentals.

The outcome on this question was another non-convergent decision. Although there was no support for Approach 1, FASB voted for Approach 2 (i.e. the very limited concession to the ED2 critics); while the IASB voted for the major simplification of Approach 3. A later attempt at the same meeting to see whether a majority on either Board was prepared to change its first preference for the sake of convergence was unsuccessful: virtually no IASB members, and only a minority on FASB, were then prepared to change.

While the Boards’ deadlock on the main lessee accounting model should be revisited within the next two months, their latest disagreement on variable lease payment reassessments is not due to be reconsidered until near the end of the re-deliberation process. It is hoped that by then most currently outstanding issues from ED2 would have been agreed; and that it might be possible to review the remaining non-convergent votes in the light of later agreed decisions on some partially related areas of the standard.

Contract modifications

All of the above decisions on payment variations related to those arising under pre-existing contracts. The Boards also considered this time a separate report on lessee and lessor accounting for modifications to contracts. They concurred in adopting a set of staff recommendations which change – and considerably expand upon – what was proposed in ED2.

The ED2 proposal was that wherever a modification to the contractual terms results in a substantive change to the existing lease, the modified contract should be accounted for as a new lease starting from the effective date of the modification. Any differences between the carrying amounts of the assets and liabilities as between the original and the replacement lease should be recognized as a net gain or loss in P&L at that time.

Although comments on this proposal were not specifically canvassed in the ED, some respondents did comment, mostly calling for clarification of how to identify a contract modification or how to define a substantive change. In addition, on subsequent reconsideration the Boards’ staff came to the view that relatively minor changes to a contract, even if above a threshold of “substantive” change, should not trigger recognition of gains or losses.

What has now been agreed is firstly that a modification will be defined as any change to the contract terms from the original terms and conditions. However, a modification should be accounted for by both parties separately as a new lease – not affecting the accounting for the original lease – if the modification grants the lessee an additional right of use (ROU) and this extension is priced on a standalone basis.

In other circumstances rather more complex rules will apply, and they will not be symmetrical as between lessees and lessors. In these cases the lessee would adopt variable types of accounting depending on whether the modifications change the scope of the lease, one way or the other, or only the consideration to be paid for it.

Where a modification increases the scope of the ROU – by providing a term extension beyond any renewal option in the original contract (or, in the case of a real estate lease, increasing the floor space on lease) – the lessee would account for any change to the lease liability as an adjustment to the carrying amount of the ROU asset. The lease liability would be remeasured at the effective date of the modification. No gain or loss would be recognized from the modification, because the original lease would not be considered to have terminated.

On the other hand where a modification decreases the scope of the lease, as with early settlement, the lessee would account for an early termination (either full or partial), and adjust the ROU asset and lease liability accordingly. Any difference between the respective decreases in the carrying amounts of the asset and of the liability would be recognized in P&L.

Where the periodic scope of the lease remains the same but the consideration paid for it is subject to contractual modification – e.g. where a real estate lease rental may be subject to a downward renegotiation with a distressed lessee – the lessee would remeasure the lease liability at an updated discount rate to reflect the new contractual terms. The difference between the carrying amounts of the adjusted liability and the immediately preceding one would be recognized as an adjustment to the ROU asset.

The Boards preferred the above lessee accounting rules, partly based on “lease scope change” criteria, to a possible alternative (in the same case where a modification does not qualify to be recognized as a separate new lease) which had been identified, but not recommended, by the staff. Under the rejected alternative, differential treatment would have been based on a numerical test of whether the modification was “substantial”.

For lessors – again only in the case where a modification does not qualify to be recognized as a separate new lease – the Boards agreed an  approach designed for consistency with the draft of the new converged revenue recognition standard for transactions other than leases.

For contracts that are Type B (i.e. operating leases) prior to the modification, the modified lease would in effect be accounted for as a new lease from the date of the modification. Any prepaid or accrued rental for the original lease would be considered as part of the payment for the modified lease; and if the modified lease is still classified as Type B, no gain or loss would be recognized from the modification.

For Type A leases, where the lessor recognizes a financial asset, the Boards decided that lessors should apply relevant provisions of IFRS 9 on financial instruments, or in the case of US GAAP those of Topic 310 on receivables.

For those subject to IFRS this is not intended to represent a change from current practice. The staff report suggested that under existing IFRS finance lessors would account for this type of contract modification in one of two ways. The modified lease is accounted for as a new lease where the IFRS 9 criteria for de-recognizing a financial asset are met. Otherwise the lessor adjusts the carrying value of the asset using the original discount rate, with an offsetting amount recognized in P&L.

In the case of US GAAP the new Type A modification rules for lessors would represent a change from existing practice, where specific modification guidance is contained in the leasing standard Topic 840/ FAS 13. However, the FASB staff felt that the existing rules are complex to apply in practice and that realigning with Topic 310 would be a preferable outcome.

Contract combinations

Finally, the Boards agreed last week to adopt a rule not specified in the previous EDs, on “contract combinations”. The lessee and the lessor would be required to account for two or more lease contracts as a single transaction if they are entered into around the same time with the same party and either one of two other conditions is also met. These are that the contracts are negotiated as a package with a single objective, or that the consideration to be paid for one depends on the price or performance of the other.

Among other possible applications, this rule would put it beyond doubt that a series of pre-agreed leases of the same asset over successive periods cannot be used to take advantage of the short term lease exemption from the new lessee capitalization rule, through what is effectively a single lease for a period much longer than a year. However, because of the simultaneous agreement condition the contract combination rule would not require capitalization in the case where one or more repeat contracts for the continued short term leasing of the same asset might be freely negotiated close to the expiration of a previous contract, if the previous one made no provision for continuation.

The Boards had in fact always envisaged that contracts would have to be combined in the kind of circumstances provided for in the new agreed rule. In IFRS such a rule is specifically laid down in the current interpretation note SIC 27: “Evaluating the substance of transactions involving the legal form of a lease”. Although SIC 27 is planned to lapse and be superseded by the new converged leasing standard, the Boards have also assumed that the respective Conceptual Framework documents in both IFRS and US GAAP would also have the same effect. However, as an afterthought at this stage in the course of re-formulating the above rules on contract modifications, the staff suggested that the rule be made specific in the new standard.

Written by Andy Thompson, legal & regulatory editor of