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Journal entry — FASB and IASB reach numerous decisions on lease project, decide to reexpose ED

Published on: Jul 21, 2011

At their joint meetings this week, the FASB and IASB (the “boards”) continued redeliberating their exposure draft (ED) on leases and confirmed that they plan to reexpose the ED. The boards also discussed a host of topics, including the lessor accounting model, reassessment of variable lease payments, embedded derivatives, and lessee presentation and disclosure.

Editor’s Note: The boards did not discuss when they expect to issue the revised ED; however, we believe it will most likely be before the end of 2011. Although the boards have not discussed a potential effective date for the final lease standard, they did discuss effective dates pertaining to the revenue project and noted that such dates would not be earlier than January 1, 2015. Although the lease project is a few months behind the revenue project, we would expect the lease project to follow a similar time line.

Lessor Accounting Model

The boards tentatively decided that a single lessor accounting model should apply to all leases. The only exceptions would be short-term leases and leases of investment property measured at fair value. The proposed model employs a receivable and residual approach. It is generally consistent with the partial derecognition approach, which was one of the models proposed in the ED. Under the model, the lessor will derecognize the underlying asset and recognize (1) a lease receivable measured as the present value of the lease payments and (2) a residual asset measured on an allocated-cost basis. Day-one profit would be recognized if the profit is reasonably assured.

Editor’s Note: For entities that favored current operating lease accounting, this is not a favorable decision. As a result of it, the scope of the investment property project that is being developed by the FASB will receive greater scrutiny since many lessors want to avoid this accounting by measuring the asset at fair value. The boards discussed an exception for lessors that enter into numerous lease contracts for physically-distinct portions of a single asset (e.g., real estate that does not qualify for fair value accounting). However, the boards ultimately rejected providing this exception.

Variable Lease Payments

The FASB and IASB had previously decided that variable lease payments that depend on an index or rate should be included in the initial measurement of a lessee’s liability and a lessor’s receivable. In addition, they had decided that this estimate should be based on the “spot rate” and that the availability of a forward rate should not be considered. The boards reaffirmed this decision. The boards also decided that the measurement of the variable lease payments should be reassessed when facts or circumstances indicate that the index or rate has changed. A lessee will recognize these changes in current income to the extent that they relate to current periods and as an adjustment to the right-of-use asset when the changes relate to a future period. Some board members expressed concerns about how a lessor would recognize changes and instructed the staff to consider the issue and present their findings to the boards at a future meeting.

Embedded Derivatives

The boards decided to retain current accounting guidance and require entities to assess whether lease contracts include embedded derivatives that should be bifurcated and accounted for in accordance with financial instrument guidance. The ED was silent on this issue, which some interpreted as a potential change to current practice.

Presentation — Lessee

The FASB and IASB tentatively decided that the lease assets and liabilities should be presented separately in the statement of financial position or disclosed in the notes. In addition, the right-of-use asset should be presented with owned assets that are similar to the underlying asset associated with the lease or the right-of-use asset.

The boards discussed the need to clarify whether the right-of-use asset is an intangible or tangible asset. This was a question from some respondents to the ED, specifically financial institutions and regulators. After some debate, the boards ultimately agreed that it was not necessary to clarify the nature of the asset for financial reporting purposes.

The boards also tentatively decided how cash paid relating to various lease components should be classified in the statement of cash flows:

  • Cash paid relating to principal should be classified as financing activity.
  • Cash paid relating to interest should be classified in accordance with applicable IFRSs or U.S. GAAP requirements.
  • Cash paid for variable lease payments that are not included in the measurement of the liability should be included within operating activities.
  • Cash paid for short-term leases that are excluded from the liability should be included in operating activities.

Editor’s Note: The determination of whether a right-of-use asset is a tangible or intangible asset could significantly affect some industries. For example, a financial institution’s regulatory capital may be affected depending on how the regulator views these assets.

The requirements to classify interest in the statement of cash flows are different under U.S. GAAP and IFRSs. IAS 7, Statement of Cash Flows, permits an option to classify interest as either operating or financing. ASC 230, Statement of Cash Flows, requires cash paid for interest to be classified within operating cash flows.

Disclosure — Lessee

The FASB and IASB voted to retain the ED’s disclosure requirements but made some editorial changes and added some disclosure requirements. The more significant required disclosures include:

  • Reconciliation of the beginning and ending balances of the right-of-use asset and the liability to make lease payments.
  • Maturity analysis of the liabilities to make lease payments.

The boards expressed some concern about the potential confusion they are creating by splitting the current concept of rent expense into several components. Therefore, they tentatively agreed to require a single disclosure detailing all various expense components (e.g., amortization expense, interest expense, short-term lease expense, and variable lease expense). However, they also agreed that this would not be combined and presented as lease expense.

Editor’s Note: The boards’ decision to not combine the amortization and interest expense and label it as lease expense could affect entities that have “cost-plus” contracts with government organizations or that have regulatory rate agreements. These contracts will often allow for reimbursement of rent expense but not interest expense. As a result of the boards’ decision, government organizations will need to provide guidance on how to treat these expenses under the new standard.

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