Client Advisor – Update to the Proposed Changes to Lease Accounting
March 1, 2011
On December 14, 2010 we advised that the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) were considering dramatic changes to the accounting rules for leases. Their joint proposal would have eliminated the basic concept of an operating lease for all but extremely short-term or month-to-month leases. However, after reviewing comments from a wide variety of sources, they appear to be moderating their position.
They now seem to be returning to a closer view as currently used under U.S. GAAP. At their meeting on February 17 they drew some preliminary conclusions (which ultimately will need to go through due process exposure drafts before becoming final). The following information was extracted from FASB’s release which we thought you would find helpful.
- Lease Term: The FASB and the IASB tentatively decided that the lease term should be defined, for both lessees and lessors, as follows: The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.
The Boards tentatively decided that a lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.
- Types of Leases: The Boards tentatively decided on a principle for identifying two types of leases for both lessees and lessors, with different profit and loss effects, as follows:
1. A finance lease with a profit or loss recognition pattern consistent with the proposals in the exposure draft (similar to the currently existing capital lease)
2. An other-than-finance lease with a profit or loss recognition pattern consistent with an operating lease under existing IFRS/U.S. GAAP.
The Boards tentatively decided to establish indicators to distinguish a finance lease from an other-than-finance lease.
The Boards also looked carefully at variable lease payments (such as contingent rents, residual value guarantees, early termination payments, etc.) and have tentatively decided that some of these amounts may be includable in the amount capitalized in a finance lease. They believe that, ultimately, such amounts should be includable if the lease payments are dependent on an index or rate (which would be measured using spot or prevailing rates), payments for which the variability in payments “lacks commercial substance” or payments that meet a high recognition threshold (reasonably certain). It is expected that the high recognition threshold would eliminate certain types of contingency payments (based on property usage or performance) from being included.
So what does this mean for you? At BMF, we will continue to watch developments on this matter very closely, and we will continue to keep our clients and friends up to speed with respect to proposed changes in accounting rules that may impact your daily business decisions. Changes in lease accounting will impact how you look at your financial statements and how you measure your performance, so staying in touch with the potential for these changes in accounting rules is important.
The change in direction on the lease term could significantly reduce the amounts that would be required to be capitalized (as leased-assets and capital lease liabilities) unless the economic substance of the lease options demonstrates a significant incentive for the lessee to continue the lease. Further, the Boards' current direction appears more favorably inclined to reduce the potential for reassessments of leases on an ongoing basis unless there is a significant change in factors – this addresses a big concern that respondents had to the exposure draft, which is that it would be costly to have to reassess lease terms annually.
There are a number of other twists and turns in how the Boards are now viewing leases, and there is a long way to go in the Boards’ deliberations, and we would encourage you to contact us and we can help you better evaluate the potential implications.