In their April meetings, the FASB and the IASB tentatively agreed upon a number of changes to their original proposed Exposure Draft for lease accounting. In this update, we highlight those issues that we believe are particularly important.
Lease Classification and Pattern of Expense Recognition
In a major change, the Boards have agreed to allow two classifications for leases, similar to what we now have under US GAAP. A lease would be classified as either a finance lease or other-than- finance lease at the initiation of the lease term. The guidance for determining those leases that have significant financing components would be based upon the principles currently contained in IAS 17.
IAS 17 does not contain the same sort of “bright line” tests that are currently contained in US GAAP with respect to evaluating the classification of a finance lease versus an operating lease. Whether a lease is a finance lease or an operating lease under IAS 17 depends on the substance of the transaction rather than the form of the contract.
Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
- the lease transfers ownership of the asset to the lessee by the end of the lease term;
- the lessee has the option to purchase the asset that, at the beginning of the lease, is reasonably certain to be exercised;
- the lease term is for the major part of the economic life of the asset;
- at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
- the leased asset is of such a specialized nature that only the lessee can use it unless major modifications are made.
Other instances that individually or in tandem might result in a lease being considered a finance lease under IAS 17 are:
- if the lessee can cancel the lease, any losses incurred by the lessor associated with the cancellation are borne by the lessee;
- gains or losses from the fluctuation in the fair value of the residual accrue to the lessee; and
- the lessee has the right to extend or continue the lease at the end of the initial term for a rent that is substantially below market rent.
The distinction between a finance lease and an other-than- finance lease is important with respect to the pattern of expense recognition. Both types of leases (other than short term leases) would still be required to be recognized on the balance sheet and the initial measurement of both the right to use asset and the rent liability would be the same (measured at the present value of lease payments over the lease term).
For finance leases, the expense recognition would be the consistent with the Exposure Draft and the current requirements for capital leases under US GAAP. Therefore, interest expense on the lessee liability would be recognized using the effective interest method and the right to use asset would be amortized over the shorter of the lease term or the useful life of the related asset. Interest expense and amortization would be presented separately in the income statement.
For other- than- finance leases, the expense recognition would be consistent with current US GAAP requirements for operating leases, generally straight-line. Amortization expense would be calculated as the difference between the straight-line amount and the interest expense on the lessee liability using the effective interest method. The total expense would be presented in a single line on the income statement (rent expense) as compared to separately presenting amortization and interest expense. The liability for lease payments would continue to be presented on the balance sheet at the present value of the lease payments. Therefore, the liability presentation would be consistent for both types of leases.
Our View on this Change
The Boards are clearly reacting to the feedback they received regarding the expense recognition pattern originally contained in the Exposure Draft. It appears to us that the vast majority of real estate leases will meet the requirements of other-than-finance leases and that the timing of expense recognition will not substantially change from the current US GAAP requirements. But the Boards are staying committed to the goal of getting all leases recognized on the balance sheets of the lessees at the present value of future lease payments. Therefore, there will continue to be the need to analyze the terms of the leases and perform the calculations that are necessary to derive the present value amounts.
Variable Lease Payments
In a major change, the Boards tentatively decided to exclude contingent rents based upon performance or usage from the measurement of the lessee’s lease liability. Instead, these rents would be recognized in the income statement as they are incurred, consistent with current expense recognition requirements. However, variable rent payments that depend upon an index or rate (such as rent increases that are indexed to CPI) would be included in the initial measurement of the lease liability, along with those payments for which there is only a remote possibility that the contingent event will not occur. The Boards agreed to develop guidance that will enable to users to assess what are truly variable payments that can be excluded from the initial calculations. There will also be additional footnote disclosure that will be required to describe the exact nature of the variable payments.
Our View on this Change
Once again, the Boards are reacting to the extensive feedback that was received regarding the subjectivity that was contained in the original Exposure Draft with respect to variable lease payments. This tentative decision would seem to bring the proposed new model much more in line with the current expense recognition requirements. However, we believe that there should be guidance provided in order to clarify what types of variable payments can be excluded from the balance sheet calculations. In any event, financial statement preparers must have complete lease information available to them so that they can analyze all aspects of variable rent payments and make a determination on the proper accounting treatment.