On Wednesday last week the global accounting standard setter bodies – the International Accounting Standards Board (IASB – Hans Hoogervorst, Chairman, pictured) and the US Financial Accounting Standards Board (FASB) – held their first joint re-deliberation meeting following the recent consultation on their revised exposure draft (ED) of a new converged lease accounting standard.
No substantive decisions were due to be taken at last week’s meeting. It was to take stock of the responses to the ED and the Boards’ concurrent outreach programme with lessors, lessees and account users. However, the discussion gave some pointers to possible outcomes.
The Boards remain committed to the core principle of requiring lessees to capitalize the presently off-balance-sheet category of operating leases. At the same time, however, they have taken note of widespread criticism of the compliance costs for lessees from having to bring on to the balance sheet large volumes of small ticket operating leases for vehicles and machinery, and perhaps having to change their expensing in the profit and loss (P&L) account.
The re-deliberation process will therefore include consideration of possible moves to simplify the ED requirements for small ticket leases. Options for this could include scope-outs based on:
• lease values (either in absolute terms or perhaps relative to the lessee’s overall balance sheet);
• the concept of “non-core” assets (viewed in terms of the lessee’s business model);
• length of lease term (through extending the ED’s “short term” scope-out to maximum terms substantially longer than the initially proposed 12 months);
• or some combination of these factors.
Another possible simplification approach, mentioned by some Board members at this week’s meeting, could be in terms of a “portfolio basis” for balance sheet recognition, rather than lessees having to assess each contract individually for capitalization purposes. However, the practicality of that might depend on the final decisions on other aspects of the lessee accounting model.
Lessee’s income statement
It is clear that the most challenging issue to be resolved in further re-deliberation will be the P&L treatment of capitalized operating leases. The current ED proposes front loaded expensing (or “Type A”) treatment for nearly all equipment leases, and straight line “Type B” expensing – unchanged from current operating lease rules – for the bulk of real estate leases.
Responses to the current ED – and to the earlier ED in 2010 when front loaded expensing had been proposed for all leases – shows that no single solution could meet with general support among preparers and users of accounts and the audit profession.
It is clear that there would be strong opposition in all quarters to Type A treatment for real estate leases. At the same time, however, there is widespread opposition to the proposed Type B model among accountants on conceptual grounds. Having a single lease expense, presented as rental as proposed for Type B – rather than a mix of amortization and financing charges, as is normal in expensing an asset recognized on-balance-sheet – is seen as fundamentally inconsistent with capitalization of the lessee’s “right of use” (ROU) asset.
National standard setting bodies, within countries applying or currently moving towards the international financial reporting standards (IFRS) overseen by the IASB, are among the strongest critics of the ED Type B proposals. These bodies retain important roles, even in most countries which have fully adopted IFRS.
Critical respondents to the ED have proposed a variety of solutions, including:
• Type A accounting for all leases as in the previous ED;
• Type B for all current operating leases;
• adopting the new lease classification line proposed in the current ED, but leaving “low consumption” (i.e. mainly real estate) leases off-balance-sheet;
• retaining the current model, leaving all operating leases off-balance-sheet but strengthening the disclosure rules for those contracts.
The Boards agreed this week that the next step will be to receive a staff report reviewing all the options for a package of the most interconnected outstanding issues. This will include the basic models for both lessee and lessor accounting; the lease classification issue; and possible ways of simplifying the lessee requirements for small ticket leases (see above).
Costs and benefits
A number of ED responses called for the Boards to undertake a general cost/ benefit analysis of the proposals. However, the Boards decided this week that in relation to the current ED proposals, they had sufficient data on costs and benefits through the feedback from the response comments and the outreach consultations.
The Boards envisage that the compliance costs for lessees might be significantly reduced through possible moves to simplify the requirements during the re-deliberation process (see above). They plan to undertake further outreach with lessees, lessors and account users on the cost/ benefit implications of the proposals as they will stand at the end of the process.
Views of analysts
The perceived benefits of lease accounting changes are centred on the use made of lessees’ accounts by all account users, not least by corporate analysts and equity investors. Account user groups registered a low level of formal response to the ED, accounting for only around 20 of the total of 638 comment letters. Anticipating this, the Boards canvassed analysts intensively in their outreach process.
Referring to the outreach feedback, the Boards’ staff report for this week’s meeting stated that analysts were generally in favour of the core ED proposals on capitalization and P&L expensing, though not unanimously so. Credit analysts were reported to be overwhelmingly supportive of capitalization, but among equity analysts there were more divergent views.
On P&L expensing, the industry-specific equity analysts – whether focused on sectors more important in equipment leasing like transport, or on those bigger in real estate like retail trades – were reported to be all in favour of the dual Type A/ Type B model. However, others including many credit analysts were said to be critical of it.
The Boards’ meeting this week spent some time considering the lessor accounting side. It was noted that most ED respondents who had commented on the lessor side proposals, including lessors themselves and others, had suggested leaving the current lessor rules unchanged.
At the same time some lessors were supportive of the changes. For most current operating leases of equipment, the receivable and residual (R&R) model proposed in the ED for Type A leases would mean more accelerated income recognition than at present, but also a rather more complex accounting model.
Most, though not all, FASB members suggested that when the Boards come to make substantive decisions the lessor side issues should be resolved first. They argued that there was no particular merit in symmetry between the lessee and lessor sides; and that if it were first agreed to leave the the basic lessor model unchanged and thus unaffected by any decisions on the lessee side, the lessee accounting issues would be simplified as a result.
However, IASB members strongly disagreed. Many felt that lessor/ lessee accounting symmetry was highly desirable. IASB chairman Hans Hoogervorst said: “Lessor accounting is a secondary issue in this project. Let us tackle the core lessee issues head-on, and then see how the lessor side may fit with the decisions.”
This procedural issue is not yet fully resolved. It is likely that the next staff report, addressing both the lessee and lessor models and lease classification (see above), will set out the merits of resolving the lessor side issues first or otherwise, and perhaps make a recommendation on that point.
There was some potentially good news this week for large ticket US lessors involved in “leveraged lease” transactions. These deals, in which lessors can claim significant tax benefits but which are funded by third parties without recourse to the lessor, can currently be accounted for by the lessor under US GAAP on a “net cash investment basis”. That allows for the tax effects on such arrangements, in computing the constant rate of return applied in income recognition for capital (i.e. finance) leases.
The ED proposed to end leveraged lease accounting as part of the convergence process with IFRS. It did not specifically ask for comments on this subject, but a number of US respondents called for a continuation of current rules, while others called at least for a “grandfathering” exception for pre-existing contracts in this category. The staff report noted these comments; and the issue has now been slated for review by FASB during the re-deliberation process.
Time to adapt
The ED did not contain a specific proposal for the effective date. However, many respondents commented on this, and stressed the need for time for lessees in particular to adapt.
These concerns seem to have been noted by the Boards. Reporting on outreach meetings with lessees, IASB member Jan Engstrom said: “We were told that if the standard were to become effective within two to three years from being issued, the system costs could be extremely heavy. However, given a year longer than that, adjustments could be undertaken within the normal cycle for system renewals.”
The next steps
Some responses to the ED, including those from major global accountancy firms and national standard setters, suggested that the whole ROU model as proposed for lessee accounting needed further conceptual review before going forward. They called for this to await further progress on a separate IASB project to review the Conceptual Framework document that underpins all its accounting standards.
However, the Boards did not even consider that suggestion. Hoogervorst said at this week’s meeting: “We certainly have to proceed very carefully with this project, but let us not say ‘Go slow’. There is no excuse to procrastinate.”
The Boards have agreed to a sequential programme for re-deliberating all the outstanding issues within the proposed leasing standard. The conclusions at each stage, though intended to be final, will have the status of tentative decisions; and will be susceptible to subsequent review in the light of related decisions later.
The first step will be the comprehensive consideration of the basic lessee and lessor models, including lease classification and together with possible exceptions or simplifications to the lessee accounting rules. This seems likely to continue across at least two monthly meetings; and it is not yet clear whether it will start in December or January.
The planned sequence for reviewing other issues is as follows:
- “Measurement” issues, comprising the rules for lease renewal options and variable rental terms (both on initial measurement and on periodic reassessment within the lease term); residual value guarantees; and the discount rate.
- “Scope” issues, including the rules on identifying “embedded leases” (within what would otherwise be pure service contracts); accounting for leases that are clearly service-inclusive; and whether to exclude leases of intangible assets.
- Sale and leaseback transactions; and (for FASB only, and assuming that lessor accounting changes would still be contemplated at this stage) leveraged lease accounting.
- “Presentation” issues (including whether or not to define the tangible/ intangible status of the lessee’s ROU asset, and the extent to which lessees should report or disclose ROU assets separately from owned assets); and general lease disclosure rules for the notes to lessees’ and lessors’ accounts.
- The transition rules, for lease contracts running at the date when the new standard is first applied.
- All other substantive topics, including accounting for lease assets and liabilities in business mergers and acquisitions; and some FASB-only rules for unlisted companies.
- The effective date; and a final review of cost/ benefit issues.
It seems likely that even if the process goes entirely as now planned, it would take at least until around the end of next year to finalize and issue the new standard. The final effective date could slip to as late as January 2019, and could hardly be more than a year before that.
However, under varying national or European laws listed companies would have to start applying the new rules for comparative purposes to their financial statements for periods of either one or two years before the effective date. Depending on the final decisions on the transition rules, it is also likely that at certain stages the new standard could become applicable to some leases already running now.
Written by Andy Thompson