FASB and IASB Revise Decisions on Leasing Project
At their meetings on April 12 and 13, the FASB and IASB (the “boards”) reached several tentative decisions related to their leases project. The decisions on variable lease payments represent a significant change from the guidance in the exposure draft (ED) on leases and align more with current GAAP. In addition, the boards reconfirmed that although all leases will be on the balance sheet for lessees, certain leases would receive straight-line expense recognition on the income statement. The boards also decided that the expense for those leases would be recorded as rent expense (rather than interest and amortization expense as was required by the ED). For information about other recent decisions on the leasing project, see Deloitte’s March 28, 2011, and February 21, 2011, Accounting Journal Entry. (Note that all tentative board decisions are subject to change before any standard becomes final.)
Variable Lease Payments
The boards had tentatively decided that variable lease payments that meet a high threshold — such as “probable” or “reasonably certain” — should be included in the initial measurement. However, after reviewing the feedback received from staff outreach, the boards rejected this approach because most constituents believed such a concept would be just as difficult to apply as the proposal in the ED. Accordingly, the boards tentatively concluded that the initial measurement would only include variable payments (1) based on an index or rate and (2) for which the variability lacks commercial substance (e.g., the lease contains disguised fixed lease payments).
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Editor’s Note: The boards directed the staffs to perform further work on the concept of disguised fixed lease payments. On the basis of our observations at the board meetings, we believe that the concept the boards are working toward consists of the identification of situations in which a lease provision is structured solely to enable the exclusion of rental payments from the right-of-use asset and lease liability (i.e., abusive situations in which there is no economic reason for the contingent rental provision other than the avoidance of booking the payments or the escalation of payments as a liability). An example of how this type of concept is applied under current GAAP is a situation in which a lease establishes a lessee's base rent in the first year and increases the rent in each subsequent year to an amount calculated as the lesser of (1) a stated fixed rental amount or (2) the original rental amount increased by a percentage equal to the consumer price index multiplied by five. In this situation, there does not seem to be any economic reason for the leverage factor, and it appears virtually certain that the future lease payments will be capped at the fixed amounts. Therefore, the stated fixed rental amounts would be included in minimum lease payments. This is different from a scenario in which rentals vary entirely on the basis of usage or sales (i.e., specified dollar amount of rent per copy in a copier lease or per mile in an automobile lease with no minimum usage requirements). However, it remains to be seen how the boards will decide to articulate this principle in the final standard because board members appear to have different views on its application. |
Definition of a Lease
The ED primarily retained the current guidance in Issue 01-81 and IFRIC 42 on distinguishing between a service contract and a lease contract. That guidance requires lease accounting if an arrangement conveys the right to control the use of a specific asset. In response to initial constituent feedback, the boards’ earlier tentative decisions supported a broader definition of “specified asset” than that in the ED as well as a concept of control that would be more consistent with the proposed approach in the revenue recognition project. However, additional outreach by the staffs ultimately revealed a lack of support for expanding the notion of a specified asset.
As a result, the boards tentatively decided at their April 12 meeting to retain the concept in the ED that a specified asset must be identifiable (e.g., by a specific serial number). This concept is consistent with current GAAP and would also require an analysis of a lessor’s right to substitute assets, which could result in a conclusion that an arrangement does not contain a lease if it is practical and economically feasible for the owner to substitute alternative assets and the owner can do so without the customer’s consent. Additional guidance on substitution of the asset by the lessor will be provided in the final standard. In addition, the boards tentatively decided that the underlying asset can be a physically distinct portion of a larger asset (e.g., a floor of a building) if that portion is explicitly or implicitly specified. A capacity portion of a larger asset that is not physically distinct (e.g., 50 percent of a pipeline) is not a specified asset.
The boards also decided on the basis of staff outreach that the concept of control will be similar to that in the proposed revenue recognition project — that is, a contract would convey the right to control the use of a specified asset if the customer has the ability to direct the use, and receive benefits from use, of that asset. Such benefits would include economic benefits that arise directly from the use of the asset, such as renewable energy credits and secondary physical output, but would exclude income tax benefits.
In addition, the boards tentatively decided that in situations in which a supplier directs the use of an asset used to perform services for a customer, the customer and supplier must assess whether the use of the asset is separable from the services provided to the customer. If the asset is separable, the arrangement would contain a lease. However, if the use of an asset is an inseparable part of the services requested by the customer, the arrangement would not be accounted for as a lease. The staff provided indicators for use in determining whether the asset is separable (e.g., whether the asset is sold or leased separately by the supplier and whether the customer can use the asset on its own or together with other resources available to the customer).
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Editor’s Note: We believe that the board’s revised definition of “the right to control the use of an asset” represents a significant change from the Issue 01-8 model, as illustrated by some of the application examples in the board memos. The change in definition could significantly reduce the number of take-or-pay and supply contracts subject to lease accounting since it appears to remove the notion that an arrangement contains a lease simply because the purchaser obtains all but an insignificant amount of the output of an asset. This is illustrated in the staffs’ examples concerning application of the tentative conclusion to a power purchase arrangement.3 In addition, the tentative decision would appear to change the conclusion for the gas supply contract in Example 1 of Issue 01-8 (which means that neither of the application examples in Issue 01-8 contains a lease). The requirement to evaluate whether the asset and service are separable could also result in a significant change related to which arrangements are accounted for as a lease. This is illustrated in the staffs’ examples concerning application of the tentative decision to an arrangement involving the use of a drilling rig.4 Entities affected by these decisions will want to closely monitor the final wording and any application guidance in the final standard. |
Two Types of Leases — Profit and Loss Recognition Pattern
At their February meetings, the boards reconfirmed that all leases should be on the balance sheet; however, they decided that there could be different types of leases and that they would pursue an alternative income statement treatment (such as straight-line expense recognition) for leases designated as “other than finance.” However, the boards directed the staffs to perform outreach on this tentative decision.
At their April 13 meeting, the boards decided that two types (classifications) of leases exist for both lessees and lessors (finance and other than finance) and that lease classification should be based on the current guidance in paragraphs 7–12 of IAS 17.5 This decision does not change the boards’ conclusion that all leases should be on the balance sheet for lessees.
Lessees
For finance leases, the boards’ decisions do not change the ED’s income statement recognition approach. However, for other-than-finance leases, entities would use the effective interest method to measure the liability to make lease payments; amortization of the right-of-use asset would be based on the difference between the straight-line expense amount of the undiscounted lease payments and the interest expense amount (in other words, the reduction of the right of use asset is simply the “plug” needed to produce a straight line expense pattern on the income statement). The total expense would be presented in a single line item by lessees as operating (rent) expense within profit or loss for all other-than-finance leases, and it would be recognized on a straight-line basis.
Lessors
The boards discussed lessor accounting in a non-decision-making session. The boards indicated this would be discussed further at a future meeting.
[1] EITF Issue No. 01-8, “Determining Whether an Arrangement Contains a Lease.”
[2] IFRIC 4, Determining Whether an Arrangement Contains a Lease.
[3] Examples 6 and 7 in the appendix to IASB Memo 1D and FASB Memo 158.
[4] Example 4 in the appendix to IASB Memo 1D and FASB Memo 158.
[5] IAS 17, Leases.
