Leases — FASB and IASB Continue Project Deliberations

Published on: 24 Oct 2011

At their joint meetings last week, the FASB and IASB (the “boards”) continued redeliberating their exposure draft (ED) on leases. The boards reached tentative decisions on several topics related to lessor accounting as well as on transition requirements for both lessees and lessors.

Significantly, the boards decided that a lessor’s lease of investment property would no longer be included in the scope of the proposed lessor model. This scope exception would apply regardless of whether such lessor was within the scope of the FASB’s investment property entities (IPE) ED. The boards believed that this exception was necessary for lessors of multitenant real estate (e.g., a lessor that leases different floors in a building to multiple tenants); however, this scope exception could include more than just multitenant real estate.

At a previous meeting, the boards tentatively decided on a receivable and residual lessor model. Under this approach, a lessor would derecognize the underlying asset and replace it with a receivable for the lease payments and a residual asset. The measurement of the residual asset and the recognition of any day-one profit would depend on whether the profit was reasonably assured. However, since those decisions were made, the staffs received input from constituents. As a result, the boards reconsidered several aspects of the approach and ultimately reached several tentative decisions, including the following:

  • There should be just one approach for measuring the residual asset and day-one profit; that is, different approaches based on whether profit is reasonably assured are not needed.
  • The residual asset should be measured on an allocated cost basis.
  • Any manufacturing profit related to the residual asset is deferred until the asset is sold or re-leased.
  • The gross residual asset (not including any deferred manufacturing profit allocated to the residual asset) would be accreted by using the rate the lessor charges the lessee.

As discussed above, the boards also tentatively decided that a lessor’s lease of investment property would not be included in the scope of the proposed lessor accounting model. If the lessor meets the scope requirements of the FASB’s IPE ED, the lessor would account for its properties at fair value through earnings. Otherwise, such lessors would continue to recognize the underlying asset and recognize lease income over the lease term.

Editor’s Note: We expect this decision to be well received by lessors of investment property. Many of these entities viewed the proposed lessor model as inconsistent with the economics of leasing these assets and indicated that the proposed model would not be operational. The boards discussed the definition of an investment property and decided that the leases ED would use the definition in the IPE ED and IAS 40, Investment Property, acknowledging that both definitions may need to be revised. The definition of investment property in the IPE ED includes real estate property and any property improvements or integral equipment. Several board members noted that cell tower lessors would therefore be excluded from the scope of the lessor accounting model because they would typically meet the definition of an investment property.

The boards did not discuss how rental revenue from an investment property should be recognized other than noting that the lease income would be recognized over the lease term. The IPE ED proposes that entities recognize rental revenue when lease payments are received or as the lease payments become receivable under the contractual terms of the related lease. However, in supporting memos, the FASB staff discussed retaining existing operating lease accounting, but the boards did not make a decision on this topic. The topic is likely to be discussed at a future meeting.

In addition, some FASB members acknowledged that this decision may be inconsistent with the lessee model. Earlier in the year, the boards pursued a different income statement pattern for certain types of leases (e.g., a straight-line pattern rather than the front-end loaded model currently proposed) but ultimately rejected that model. It is uncertain whether the boards will revisit that decision, but a majority of FASB board members expressed an interest in at least discussing the concept again in light of their decision related to investment property lessors.

The boards also discussed how the receipt of variable lease payments by the lessor affects the measurement of the residual asset. They tentatively decided that if the lessor had an expectation that variable payments would be received (i.e., that the rate the lessor charged the lessee reflected the impact of variable lease payments), then the residual asset would need to be adjusted when those variable payments were received. Any payments that exceeded the expectation would not result in an adjustment to the residual asset. If the rate the lessor charged the lessee did not include an expectation of variable lease payments, then the residual asset would not be adjusted upon the receipt of variable lease payments.

In addition, regarding lessor presentation, the boards tentatively decided that:

  • The income associated with the accretion of the residual asset should be characterized as interest income.
  • Gross or net presentation of lease income and lease expense on the income statement would be based on a business model (e.g., a manufacturer would present revenue and cost of sales, while a financial institution would present a single line item).
  • Lease income (including interest income) and lease expense could either be presented separately from other nonlease income and expenses of the lessor on the face of the income statement or disclosed in the notes.
  • Amortization of initial direct costs should be presented as an offset to interest income.

The boards also revisited an earlier discussion about whether lease receivables should be held at fair value if the lessor intends to hold the receivables for sale. The boards tentatively decided that such receivables should not be measured at fair value. In addition, the boards decided that the derecognition requirements in IFRS 9, Financial Instruments, and ASC 860, Transfers and Servicing, should apply to lease receivables.

Transition — Lessor and Lessee

The boards made several tentative decisions about transition requirements related to implementation of the proposed leases standard. The most significant decision would give both lessors and lessees an option regarding how to apply the new standard to existing leases currently classified as an operating lease. Namely, entities could use a full retrospective approach to implementation (e.g., go back to the beginning of the lease arrangement and apply the revised guidance) or use a modified retrospective approach that would attempt to simulate a full retrospective approach. In addition, to ease the burden of adoption, the boards voted to allow some transition relief from the requirements, including:

  • Not requiring evaluation of initial direct costs for contracts that began before the effective date.
  • Allowing the use of hindsight in the preparation of comparative information, including the determination of whether a contract is or contains a lease.

In addition, the boards tentatively decided that lessees and lessors with existing capital/finance leases (other than leveraged leases) could either carry forward the amounts recorded as of the date of initial application or apply a full retrospective approach to those leases and then prospectively apply the proposed guidance to them and to new leases.

Editor’s Note: The decisions on implementation are intended to alleviate concerns about the simplified approach proposed in the leases ED. That approach essentially treated all leases as being entered into on the adoption date, which exacerbated the income statement effects of the new standard (i.e., for lessees it resulted in a front-end loading of expense). Under the modified approach, a liability would still be measured as the present value of the remaining lease payments. However, the right-of-use asset would be measured as a proportionate amount of the liability, with the difference recorded as a cumulative adjustment. This is intended to provide some relief from the front-end loading of lessee expense on adoption. Some staff members felt this approach would not be as costly to implement as a full retrospective approach. Others wanted the option of a full retrospective approach to eliminate altogether the punitive income statement impact of adoption for lessees.

The boards had received feedback on how a lessee should determine its incremental borrowing rate (IBR) upon adoption and whether a lessee should determine such rate on a lease-by-lease basis or by using a portfolio approach. Some constituents commented that a lease-by-lease approach would be too onerous but that a portfolio approach might be too broad and fail to take into account a portfolio with vastly different durations. The boards directed the staffs to develop wording on a principle that would settle somewhere between the two approaches (e.g., various IBR rates for groups of leases with similar durations).

The boards also tentatively decided that a lessor’s discount rate at transition would always be the rate the lessor charges the lessee, determined as of the date of commencement of the lease.

Editor’s Note: An entity employing the full retrospective approach would need to go back to the original lease commencement and use an IBR that was appropriate at that point.

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