There has not been much mention over the last few months about the FASB and IASB Boards (“the Boards”) Joint Project which would result in significant changes in the manner in which leases are accounted for. The Boards have instructed the staff to revise the Exposure Draft to incorporate the tentative conclusions that have been reached by the Boards. The revised Exposure Draft is expected to be issued in the first quarter of 2013. Interested parties should review the revised Exposure Draft carefully to evaluate the changes to the original document, however, we believe  that most of the controversial issues have been discussed and agreed to by the Boards. All leases, except short term leases, will have to be reflected on the balance sheet of lessees and amortized in one of two ways, depending primarily upon the nature of the underlying asset being leased. The key consideration for the amortization method to be used would involve whether the lessee acquires or consumes more than an insignificant portion of the leased asset over the lease term. The presumption is that leases of property would be classified as straight-line leases unless there is evidence that a major portion of the property is consumed by the lease. Conversely, leases of equipment would be presumed to have accelerated amortization unless there is evidence that only an insignificant portion of the leased equipment is consumed.

Due to lack of visibility about these proposed changes over the last few months, it is easy to overlook the significance of the changes and the potential impact that they will have on lessees’ financial statements. The Boards have not provided any guidance on the proposed effective date for these changes; we hope that the revised Exposure Draft will provide additional insight on this issue. But going forward, lessees should keep in mind that any lease that commences in 2013 and has more than a five year term will probably have to be reflected on the lessees’ balance sheet at the time of the adoption of the new accounting standard.

The FASB and the IASB Boards (“the Boards”) met at the end of last month to discuss the status of the 2010 Exposure Draft (“the Exposure Draft”) on changes to lease accounting. The majority of the discussion centered on the lessee accounting issue. As has been the case in past meetings, the Boards again reaffirmed their commitment to institute an accounting model requiring that the vast majority of lease liabilities be recognized on the balance sheet. The focus of the discussion in this meeting was on the manner in which lease related expense is recognized and the concerns raised by a number of constituents regarding the accelerated expense recognition pattern which is contained in the Exposure Draft.  Unfortunately the Boards did reach any final conclusions and requested that staff engage in further industry outreach. However, there was some consensus that constituent concerns should be addressed and certain alternatives were discussed.

One approach discussed would reintroduce the concept of operating versus finance type leases into the analysis. For those leases that have operating lease attributes, a new type of amortization model would be utilized that would result in a smoother expense recognition pattern and might approximate a straight-line amortization, depending upon variables such as free rent periods and step rents. For those leases that have finance type lease attributes, the amortization method contained in the Exposure Draft would be utilized.

A second approach discussed would introduce another new amortization model which would consider the consumption of the underlying asset during the term of the lease. This method would depend heavily on the fair value of the underlying asset and the estimated decrease in value of the asset during the term of the lease.  In those situations where the fair value of the leased asset did not decrease or deceased slightly, the amortization expense would be higher in later periods and therefore the total lease expense would be smoother. This could be the case for many real estate leases. In those situations where the fair value of the leased asset decreased significantly, the amortization expense would be more straight-line resulting in an accelerated expense pattern. This could be the case for many equipment leases.

Our View

In attempting to address constituent concerns regarding expense recognition, the Boards have suggested approaches which, in essence, would add complexity, subjectivity and additional cost to the amortization calculations. In some instances, such as fair value estimates, lessees simply would not have the information available to them to make the required calculations. We believe that the feedback that the staff will receive to these approaches will not be positive. The Boards are scheduled to address the issues again in their April meetings and we strongly suggest that interested parties monitor future developments. It seems clear that a revised exposure draft will not be issued until the third quarter of this year.

In a related development, a survey was recently issued by CFO Publishing LLC which gathered responses from 179 senior executives on their plans for dealing with the proposed changes in lease accounting.  The responses are consistent with previous posts that we have entered on our Blog. Concerns were expressed regarding the impact on key financial ratios, costs associated with complying with the new accounting standard and business issues related to lease terms and lease versus buy decisions. Two additional key points were made. First, up to 65% of the respondents expect that moderate or substantial changes will have to be made to financial and operating IT systems. And second, only 10% of the respondents believe that they are adequately prepared for the changes at this point. Although there are still issues to be addressed before finalization of the new standard as indicated above, it is critical that companies begin now to prepare for the new standard by making a comprehensive inventory of all leases and capturing critical lease data in a manner that will facilitate review of this information and completion of the required calculations. For the vast majority of companies, this is not the type of analysis that can be completed and maintained on a spreadsheet.  Begin now to assess your particular situation and the system enhancements that will be necessary to address the business and financial issues that will inevitably arise.

The revised Exposure Draft on Lease Accounting should be issued in the near future. All interested parties should be prepared to review it and react to the revisions as quickly as possible. The FASB and the IASB have continued to discuss some major changes from the original proposal. Balance sheet recognition of other than short term leases should remain in place but we will want to review changes to issues such as the pattern of expense recognition. Other especially important issues will involve the proposed implementation date and how existing leases will be transitioned into the new accounting model. This revised document should provide a reasonably final  roadmap to the new accounting model.

In their July 2011 meetings, The FASB and the IASB (the Boards) decided to formally re-expose the proposed lease accounting standard for public comment. The timetable for final issuance will be pushed out even further into the future. The Boards’ goal is to finish final deliberations in the third quarter of 2011 with the issuance of a revised exposure draft shortly thereafter.  It is likely that the final standard would not be issued until the second half of 2012.

The Boards continue to reaffirm previous tentative decisions related to accounting for short-term leases, variable lease payments and subleases. The Boards also expanded the scope of disclosure requirements in the area of maturity analysis and expense component disclosures.

With respect to lessor accounting requirements, the Boards developed an approach for lessor accounting that is different from the approaches put forth in the original exposure draft. This new approach, called the “receivable and residual approach”, would require balance sheet presentation of the lessor’s right to receive lease payments and would allocate the carrying value of the leased asset between the portion related to the right of use asset and the portion retained by the lessor.

Our View

Although the time table for final issuance of a new accounting standard has been extended even further, the basic principles related to proposed lessee accounting continue to be reaffirmed, namely, a balance sheet approach with the need for significant upfront calculations, reassessment of original conclusions under certain circumstances and an acceleration of expense recognition as compared to current GAAP accounting. The delay in issuance is mainly due to the Boards’ position that the new standard deal with both lessee and lessor accounting and the reconsideration of lessor accounting as compared to the proposals in the original Exposure Draft. The model now proposed for lessor accounting will be significantly more complex than the current GAAP requirements.

Lessees should continue to follow the approach that we have outlined in the past by making certain that critical lease information has been collected and organized in a manner that will facilitate the analysis required not only to meet the new accounting standards but also to satisfy business needs of the enterprise. For even a relatively small portfolio of leases, an easy to use technology solution is essential.

The issuance of the final standard for lease accounting will likely be delayed until the first half of 2012. At the least, there will be another draft version of the new standard made available for review and comments. There still has not been any decision made regarding the effective date of the new standard.

The Boards continue to reaffirm balance sheet recognition for most leases.

Current operating lease accounting can continue to be used for short-term leases. Short-term leases are defined as those which have a maximum possible lease term, including any options to renew, of 12 months.

Except in limited circumstances, non-lease components, including payments for services and executory costs (insurance, taxes and maintenance), would be separated from the lease payments and would be accounted for similarly to the way that they are currently.  The allocation between lease and non-lease components would be a new process for many lessees and may require significant judgment.

The determination of the lease term is critical. Currently, the lease term is defined as the non-cancelable period, plus any options periods where there is a significant economic incentive for the lessee to extend or not terminate the lease.

Changes in certain circumstances would require reassessment of the original accounting judgments. Reassessment would be required if the conclusions reached on lease term and purchase options, among other things, changed based upon changes in the original conclusions regarding significant economic incentives.

The Boards reaffirmed their position that contingent rent based upon performance or usage would be charged to expense as incurred.

Our View

This project continues to progress, albeit at a much slower pace than originally projected.  Although some of the complexities contained in the original Exposure Draft have been eliminated, the basic principle of balance sheet recognition for all leases (except short-term leases) has been maintained. There are still a number of areas that will be complex and subjective to apply, including determination of lease term, non-lease components and the requirements to reassess due to certain changing conditions. Companies will have to develop processes and procedures that will allow them to review lease terms, identify critical dates and reassess original conclusions. Having comprehensive lease information readily available is crucial. We continue to believe that the technology tool that we are developing will provide the user with the critical data that is necessary not only to meet the needs of this new accounting requirements but just as importantly to manage the lease portfolio in an efficient and effective manner.