Apr 13 2011

Proposed Lease Accounting Update

April 13, 2011 Update

The Boards have met a number of times over the last eight weeks to discuss some of the more controversial issues that are contained in the exposure draft on proposed changes to lease accounting. Here are the more important tentative conclusions that have been reached:

  • The definition of the lease term has now tentatively been revised to include only optional periods where there is a significant economic incentive for the lessee to extend the lease. This replaces the concept where the lease term would have been based upon “the longest possible term that is more likely than not to occur”. In many cases, this will result in shorter term leases for accounting purposes and is much more in line with current lease accounting guidance. However, “significant economic incentive” is highly subjective terminology and can be difficult to implement. In addition, this determination will have to be reassessed over the term of the lease based upon any changing facts or circumstances.
  • Variable lease payments included in lease related assets and liabilities have now tentatively been revised to include lease payments that depend upon a rate or index, those where the variability lacks commercial substance or those that meet a high recognition threshold, such as reasonably certain. The original proposal was to include variable payments based upon a probability-weighted expected outcome approach. Although the change should certainly result in a lower calculation for lease related assets and liabilities, there is still considerable subjectivity and complexity for users to consider in the guidance as tentatively revised.
  • The ability to separate lease and non-lease components has been revised so that it will be much easier to exclude executory costs, such as insurance, maintenance and taxes from the lease payment component. Previously, in order to exclude such costs, the costs would have had to have been considered as distinct costs, a determination which many respondents considered difficult to achieve. Although this revision does not remove all the subjectivity surrounding the accounting for executory costs, it is a very significant revision to the original proposal.
  • Short term leases (those with a maximum term of 12 months) would be allowed to be accounted for under current accounting guidance for operating leases.  These short term leases would be kept “off balance sheet” and lease income and expense would be recognized on a straight line basis. Although this revision is helpful, it should not have a significant impact on the typical real estate lease.
  • Amounts recognized for lease accounting and the related discount rate to be utilized in the calculations should be determined as of the commencement date of the lease. Previously there was some concern and confusion about the distinction between the lease inception date and the lease commencement date.

The Boards continue to deliberate a number of other issues related to the exposure draft and we will continue to keep you updated on the tentative conclusions that are being reached.