Within the past few days, the accounting standard setters have made a series of major concessions on their proposed new rules for leasing. Following the abandonment of the plan to force lessees and lessors to account for lease renewal options (see AFI report, 17 February), the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have proposed major changes affecting lessees' profit and loss (P&L) accounting. Further changes are proposed on accounting for variable rentals, and the rules for identifying a lease.
The most significant change from last year's exposure draft (ED) proposals is to retain some form of lease classification – not dissimilar to the current distinction between finance and operating leases – for both lessee and lessor accounting.
P&L for lessees
After initially setting out to remove the distinction between finance and operating leases, the Boards have now accepted that under the new rules there will still be essentially two types of lease.
They remain committed to forcing all leases on to the lessee's balance sheet. However, for a category of leases described in a staff report as “other-then-finance leases”, comparable with operating leases under current rules, they now propose to allow lessees to report rental expense on a straight-line basis over the lease period (under a typical contract with level rentals).
That will match the current P&L rules for operating leases. It contrasts with the front-loaded expense rules that were proposed in the ED for all leases, and are already required for finance leases.
The front loading of expense, where applicable, results from splitting the rental cost into interest and amortization. The interest is on a front loaded profile, declining in line with the outstanding balance sheet value of the liability. Amortization is normally on a straight line basis, consistent with depreciation of assets owned by the reporting entity, but the combined expense is still front loaded because of the interest profile. That kind of accounting will not now be required for most operating leases. This represents a success for lobbying by the global leasing industry, and by lessees who would have been directly affected by the change.
The Boards' staff report prior to their latest decision cited a typical comment by one lessee respondent to the ED, energy group TransCanada: “For lessors, the Boards have proposed different accounting approaches ... based on [the extent of] retention of significant risks and rewards [from use of the asset] ... [We] believe that different accounting approaches for other than financing leases should equally apply for lessees.”
In fact that respondent, like many others making a similar point, was arguing against the capitalization of operating leases. Some others, however, including a number of US equipment lessors, felt that the front loading of expense would be a more significant problem for lessees than capitalization in itself. Their concerns now appear to have been largely met.
The staff paper also reported support for straight line lessee expense profiles among account users such as corporate analysts. These did not respond to the ED in large numbers, but were consulted later by the Boards.
The report noted: “Some [accounts] users prefer for some leases the current straight line [P&L] recognition pattern ... Most [analysts] for today's operating leases ... do not adjust the straight line ... pattern presented in accordance with current [accounting rules]. Other users make adjustments only to reflect operating leases on the balance sheet but do not make any corresponding [P&L] adjustments.”
Drawing the line
Again in line with a staff recommendation, the Boards decided not to draw the lease-classification line entirely on residual value (RV) type considerations as under existing rules.
Instead they provisionally propose to base it on a range of criteria. In addition to RV, and closely related factors – i.e. the lease term in relation to the remaining asset life, and potential ownership transfer to the lessee - these will include:
- whether rentals are set by reference to a fixed return on the lessor's investment, or are benchmarked against market rents;
- whether the asset is specialized or customized for the lessee;
- whether the asset was available to be purchased instead of being leased;
- whether the contract contains significant embedded services not separable from the lease component;
- whether rentals are based on usage or performance of the asset.
It was agreed that these proposed criteria will be discussed in an “outreach” process with selected parties including respondents to the ED, and then brought back to the Boards for final decisions.
Lessor side implications
The implications of this decision for lessor accounting are to some extent still ambiguous. In accordance with a procedural decision last month, the Boards will not be focusing on the overall models for lessor accounting just yet. They will return to it when further progress has been made with issues affecting both lessees and lessors, and with other current convergence projects that have some interface with the leasing rules.
However, the staff report on “other-than-finance” leases assumed that the split model would apply to lessors as well as lessees. The proposed classification criteria are largely the same as those proposed in the ED for the hybrid lessor model.
The latest decisions reinforce the principle of a hybrid model for lessors, though without entirely resolving the details of the rules on either side of the finance “other-than-finance” line.
The Boards' discussion of lease classification at the latest meeting was almost entirely focused on the lessee side. However, one influential IASB member Warren McGregor indicated that his support for a continued principle of binary lease classification on the lessee side was conditional on eventual symmetry with the lessor side
It would seem likely that for contracts falling on the finance side of the new dividing line, lessors will be made subject to the partial de-recognition accounting method as proposed in the ED.
For those similar to current operating leases, however, it now seems likely that lessors would continue with current operating lease accounting rules, rather than the more complex “performance obligation” model in the ED. The staff paper envisaged that “an other-than-finance lease [would be] characterized by straight line ... income [recognition] consistent with today's ... operating lease accounting.”
Bargain purchase options
In spite of the decision to retain a binary model for lease accounting within the new standard, the Boards have not as yet changed their decision to scope out from that standard what the ED described as “in-substance purchases”. These are principally contracts with bargain purchase options (BPOs), such as hire purchase (HP) deals in the UK. The Boards are due to consider feedback from the ED on this and other scoping issues at a later date. BPOs are accounted for as finance leases under current rules. However, some Board members at the latest meeting said that they felt that BPO contracts should remain scoped out, to be covered instead by the separate current IASB/ FASB convergence standard on Revenue Recognition.
If that remains the decision, the intended substantive accounting for BPO contracts by lessees and lessors would remain similar to that for finance leases. However, these rules would be found in a separate standard, probably with no guidance specific to the contracts.
Contingent rentals
Again following a staff recommendation, and in response to critical reactions from respondents, the Boards have tentatively agreed to simplify the ED proposals on accounting for contingent rentals. This includes rental variations based on asset usage volume, such as mileage payments in vehicle leases.
The ED proposed that where leases have variable rentals, lessees should account for them on a probability-weighted expected outcome basis. Lessors would have been required to do the same for their lease receivables, though only where the variations could be reliably estimated.
However, the Boards now propose that the initial recognition of contingent rentals should take account of only indexed-based variations, such as those based on market interest rates or a price index, plus any other contingent rentals that are “reasonably certain” to be incurred. This is subject to further outreach consultations to ensure that the “reasonably certain” criteria will be workable in practice.
The Boards also agreed that the initial measurement of index-linked rentals should be based on prevailing rates at the inception of the lease. This replaces an ED proposal to use forward rates where readily available.
The rules for reassessing contingent rentals at subsequent reporting dates will be considered by the Boards later.
Identifying a lease
The Boards have now made some tentative decisions, subject to outreach consultations, on the question of how to identify the existence of a possible lease embedded within a service contract. This follows consideration of the issue at non-decision-taking meetings in the preceding weeks.
This aspect involves a variety of contract types, some more relevant to mainstream equipment leasing than others. The relevant guidance proposed in the ED was based largely on existing rules.
Following comments in response, however, the Boards now accepted that the guidance needs to go further now that operating leases are going on to lessees' balance sheets. The difference between lease and service accounting becomes more critical as a result.
One issue raised by the Boards' staff was whether a contract, in order to be identified as a lease, should have to involve the availability of a uniquely identifiable asset, or just an asset of a particular specification. A small majority of Board members preferred the potentially broader definition (i.e. an asset of a particular specification).
However, it was agreed that both alternatives should be “field tested” in outreach. The consultations will focus on whether the broader definition would be reasonably easy to apply, and whether the narrower one would create structuring opportunities to avoid lease accounting.
The Boards decided to add a new provision, so as to exclude identifying a lease where an asset is incidental to the provision of a service. This would apply where the asset is specified by the service supplier as a mechanism for providing a contractual service; or alternatively where the asset component of the contract is insignificant compared with the service component in terms of benefit to the customer.
Members considered whether both of those conditions should need to be satisfied in order to avoid having to recognize a lease. However, they decided that one or the other should alone be sufficient.
The Boards also decided that guidance should be given on the possible recognition of an embedded lease of part of a larger asset not solely used by the relevant customer. They decided to go for outreach consultation on two alternative formulations. Under one alternative, only a physically distinct portion of a larger asset would give rise to the identification of a lease (if made available for the customer's use within a service contract). The only example to be given in guidance would be a real estate asset (i.e. a floor within a building).
Under the other alternative, preferred at this stage by a majority of the Boards' members, lease recognition could extend to a physically non-distinct part of an asset, such as part of the capacity of a fibre optic data cable.
Finally, the Boards considered criteria related to control of an asset specified in a contract. The starting point for this (although it was accepted that changes were needed) was the draft ED guidance based on existing rules. Essentially that defines control as either:
- Having the ability to operate or control physical access to the asset as well as the right to obtain some of its output or utility; or
- Having the right to obtain “all but an insignificant amount” of the output or utility, if the pricing is such that the customer is paying for the right to use the asset, rather than for the actual extent of use or for the output.
Various alternative definitions of control were considered. The Boards decided to field-test two possible variations through further outreach.
Their preferred version would somewhat reduce the scope of contracts that would fall to be recognized as leases, by aligning the rules with a definition of control in the draft Revenue Recognition standard. This would specify that the customer would obtain control of the asset where it has the right to obtain “substantially all of the potential cash flows from that asset”.
In this variant the customer would not recognize a lease unless it had both the defined right to the benefits of the asset and the ability to direct its use. Some “take or pay” power supply contracts might be excluded.
As an alternative, another variation that would be intended to have broadly the same scope as existing rules, but with a simplified form of words compared with the ED version, will also be filed-tested.
Contracts that clearly include both lease and service elements, but where there may be issues in separating the two components for accounting purposes, have not yet been reconsidered by the Boards since the ED consultation. That aspect will be dealt with later.
