BRIEFING PAPER
Lease Accounting Proposals: Analysis of Respondents’ Comments Written by Andy Thompson, Legal and Regulatory Editor, Asset Finance International The table summarizes the responses to date on the most contentious points in the exposure draft (ED). At present relatively few corporate analysts or other account user interests have commented. There is currently a high level of criticism of the Boards' proposals among respondents. Exposure draft on lease accounting 2013: responses up to September 4, 2013 Lessee accounting models, and transition rules Lessee capitalization Support Support Opposed for ED after to ED changes 00 03 10 Lessors Lessees 04 04 06 00 07 Accountants 06 Account users 01 02 01 03 00 01 Others Total 14 09 25
Lessee expensing models Support Type A Type B for Other Total for ED for all operating critical against leases leases leases 1 0 08 2 10 2 1 02 1 04 3 0 02 1 03 0 0 02 0 02 0 1 01 0 02 6 2 15 4 21
Transition rules Support Opposed for ED to ED 1 1 3 0 0 5
2 2 1 0 0 5
How to identify a lease, which rentals to include, and lessor side models Renewal options and variable rentals Lessor accounting models Identifying a lease Support Support Major Calls for Support Calls for Other Support Support Other for ED (minor criticism fewer for ED more critical for ED for critical variation) inclusions inclusions current rules comments Lessors 4 2 1 1 2 0 1 0 9 4 Lessees 1 1 1 1 2 1 1 1 0 0 Accountants 3 2 1 1 2 1 1 2 0 2 Account users 0 0 1 0 0 0 0 0 0 1 Others 0 1 0 0 2 1 0 1 0 1 Total 8 6 4 3 8 3 3 4 9 8
NOTES The table includes response from 59 respondents. Not all respondents have answered every question. Consultants to leasing companies are included within lessors. Some respondents comment in more than one capacity, e.g. some are lessors of certain asset types and lessees of others. Their responses to each specific question are attributed to the respondent category apparently relevant to that question.
Sponsored by
Account users comprise corporate analysts and general corporate investor interests. “Others” comprise respondents who have not disclosed specific interests. A few comments on some questions were considered too ambivalent to be classified with any of the above categories of answers.
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Background
Lessee capitalization
The exposure draft (ED) for the latest proposed lease accounting standard was issued in May this year by the joint standard setting bodies International Accounting Standards Board (IASB) which oversees international financial reporting standards (IFRS), and the Financial Accounting Standards Board which oversees US generally accepted accounting principles (GAAP).
The core proposal of the ED is to require full capitalization on the lessee's balance sheet of all leases which can run for more than 12 months. This would replace current rules where “operating leases” - i.e. those where a substantial residual value (RV) interest in the underlying asset is either retained by the lessor, or taken by a third party such as an equipment supplier – are off-balance-sheet.
The lease accounting project is part of a wider programme to converge IFRS and US GAAP progressively across more areas. An increasing number of jurisdictions outside the USA are adopting IFRS. Lessees and lessors in most major countries will be affected by these proposals.
Currently only “finance leases” (in IFRS terminology) or “capital leases” (as defined in US GAAP) are on-balancesheet for the lessee. In these leases, which have zero or minimal RV risk not guaranteed by the lessee, the underlying asset is recognized by the lessee as if it owned the asset, with a corresponding financial liability for the future lease payments.
The respective current standards for leasing – IAS 17 within IFRS and Topic 840 (formerly coded as FAS 13) in US GAAP – are not particularly divergent. However, both Boards have favored changing them so as to require full balance sheet recognition of leasing commitments by lessees. The project has been subject to much delay, and the current ED follows an extended period of re-deliberation by the Boards after widespread critical reaction to an earlier draft issued in 2010. The notified deadline date for comments in response to the ED is September 16, although comments received reasonably soon after that date are likely to be considered by the Boards as part of the response. This edition of the AFI report analyses key features of the 59 responses received by the Boards up to September 4.
Under the ED proposals a newly defined type of asset, the “right of use” (ROU) asset, would be recognized by the lessee, with a corresponding financial liability, for all leases running longer than 12 months. The pattern of response among the parties in lease transactions is as follows.
Lessors, among whom there is of course a relatively higher level of awareness of the proposals at this stage, are more overwhelmingly opposed than lessees themselves.
Among lessees there is a balancing middle group who would be prepared to accept capitalization in principle, but only subject to some substantial exceptions or other conditions not proposed in the ED.
Accountants and account users are almost evenly divided between supporters and opponents.
Overall response pattern The table on the first page summarizes the responses to September 4th on the most contentious points of the ED. As shown there, relatively few corporate analysts or other account user interests - who are intended to be the main beneficiaries of any improvement to accounting standards – have commented as yet. It seems fair to comment that there is a high level of criticism of the Boards' proposals among respondents. The patterns of response to specific questions are referred to in the text below, together with extracts from the comment statements of individual respondents
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Opponents - Not artificial financial re-structuring Some respondents suggest that the Boards' proposals reflect a misplaced belief that leases are widely entered into for artificial balance sheet structuring purposes. A joint response from the US Chamber of Commerce (USCC) and other US trade associations representing a number of lessor and lessee sectors makes this point, alluding to the concession which the standard setters have made at a late stage of the project for real estate leases (see below under “The lessee's income statement”). This comment states: “[The Boards] have acknowledged that an entire category of leases – real estate leases – are generally not disguised financings but genuine economic and business choices, and thus not pretextual attempts to dress up a balance sheet. We believe that this is also the case for many lease transactions that do not involve real estate.” - Disclosure notes are sufficient Several respondents suggest that disclosures in notes to lessees' accounts, as required by the existing lease accounting standards, are either sufficient already for account users to obtain necessary information about lease commitments, or could be made so through stronger disclosure rules without capitalization. US based financial analyst David Roszak argues: “I use the financial statements from companies that use leasing extensively and … I do not need any changes made. For years I have been adjusting the financial statements using techniques taught in … all the major universities. These calculations make adjustments using the notes [to accounts] on leases to build the long term liability as if the lease were a loan instead.” “Analysts around the world use this same type of calculation that grosses up the balance sheet to compare a [lessee] … to a company that owns the … asset … It is better to make no change at all [to the rules], than to make a change just because a lot of time and effort has been spent, if it costs the industry millions but provides little in value.” UK based lease consultancy Invigors, part of the global Alta Group, makes the same point: “The indications from [account] users are that they will have no better understanding of the numbers produced by these proposals than they do of those currently available [from disclosures] and that some users would continue to make adjustments to published figures to fit their own templates.” Kathryn McBride, vice-president for finance at US financial advisory firm Marvin F Poer, comments: “The footnotes in financial statements about future commitments have sufficed in my experience. Investors can do cash flow analysis. For [our] financial statements [as a lessee], the new proposals will lead to less transparency, not greater transparency.” ©Asset Finance International, 2013. All rights reserved
Among critics of capitalization in the audit practice sector, US accountancy firm Cover Rossiter says: “It is generally understood.. that GAAP financial statements, as a practical matter, will never be a pure description of the true financial condition of an entity. There will always be a trade-off between accounting purity and the practical cost of gathering the required information … The changes proposed in the ED … are reaching for a level of accounting purity that is not practically achievable and … the significant costs of compliance will not prove to be worthwhile.” - Costs outweigh benefits Obi Gadzikwa, a chartered accountant practising in South Africa and Zimbabwe, comments: “The costs of implementing the ED [would] far exceed the benefits … In addition the ED goes against [some] sections of the IFRS Framework [i.e. the document adopted by the IASB governing all its accounting standards]... “ “Entities that enter into [operating] lease agreements … do so more for the purposes of convenience and flexibility rather than for accounting purposes … Capitalizing operating leases would not result in [their] substance … being accounted for faithfully.” “As a result of the overall complexity of IFRS the majority of users of financial statements … place more reliance and relevance on the statement of cash flows instead of the [P&L]. The ED will not have any significant effect on the cash flow statement and will have minimal impact on net profit/ earnings and equity...” “The implementation of the ED will be of minimal benefit to key users of financial statements... The costs of implementing the ED will far exceed its intended benefits...” The USCC and jointly responding bodies comment: “We believe that the proposed leasing standard will increase complexity, drive economic activity rather than reflect it and will create adverse unintended consequences and pressures upon financial reporting systems … It will not result in more decision-useful information [for investors] compared to what is currently available.” - The twelve month exception The proposed exception for short term leases (see below) will clearly include sectors like vehicle daily rental and construction plant hire. It will also clearly exclude most mainstream equipment leasing sectors. However, there are business sectors where typical lease terms overlap the 12-month maximum term proposed for the exception, and here there are suggestions that capitalization could affect commercial behavior. As well as property leases, this applies to ship charters. 3
The UK Chamber of Shipping says: “Given that the effect of a charter being [capitalized] would be so punitive for the charterer [i.e. lessee], we would see a risk that [the proposal] could actually determine market behavior, and cause charterers to avoid writing in options that could extend the term of a charter beyond 12 months. Plainly this would be unsatisfactory: an accounting standard ought not to drive business decisions.” Supporters Although a substantial number of the respondents to date have indicated support for lessee capitalization, relatively few of these have added comments. Louis W Sanford, CFO of a US hotels group but commenting in a personal capacity, argues: “Overall the general concept of [capitalization] … is appropriate. The disclosures in the notes … [have] not proven to reflect to users the future financial implications.” “By way of example, [in the case of] American West Airlines … the notes showed that the impact on operations was such that the increase in lease cost was going to be greater than operating income. Yet many were surprised when the airline went bankrupt.... I am convinced that users of financial statements … do not really look at the notes … The inclusion of the commitments [on-balance-sheet] is a far better communication medium.” Other viewpoints Bill Bosco, principal of the US leasing consultancy Leasing 101, suggests an alternative basis for capitalizing operating leases that would for all other purposes preserve the distinction between finance/capital and operating leases and leave the present lease classification line in place. He suggests: “[First] the Boards … need to.. develop Conceptual Framework … type analysis regarding the capitalization of [executory] contracts.” “[Then they should] re-examine and change the definitions of debt and assets to include issues like the treatment of assets and liabilities in bankruptcy and tangible versus intangible assets. Debt should … include items that are debt in a bankruptcy but exclude liabilities that do not survive bankruptcy. This would solve the unintended consequence of causing defaults in debt covenants caused merely by a change in GAAP [see below] … In an ongoing concern an operating lease obligation is a liability but it is not debt.” In the US regulatory context in particular, Bosco argues that the ED would put the accounting treatment of leases at odds with other regulations which follow existing GAAP principles. He says: “The legal (US Commercial Code), tax (Federal income tax, state income tax, local property tax and [other] state and local … taxes) and the current US accounting regime are fairly ©Asset Finance International, 2013. All rights reserved
well aligned in the view that some leases are executory contracts (operating leases) and some leases are financed purchases (finance/ capital leases). Having only GAAP accounting as the outlier should beg the question 'Why have a different approach?' “ Some respondents have called for more cost/ benefit analysis before the proposals are finalized. The American Bankers Association (ABA) says: “ … The breadth of change proposed is extensive and the complexity staggering to all but the most sophisticated of financial statement preparers. Considering that all lessees - from the largest corporations … to the local nonprofit organization that leases its store space – must comply with these requirements, [a] cost/ benefit study must address the issues that apply to entities of all sizes. Impact on loan covenants Some respondents have drawn attention to the fact that crystallizing new liabilities on the balance sheet through a change in the accounting rules will place some lessees in breach of loan covenants with bank lenders. These include the joint comment from the USCC and other bodies. The ABA comments: “... Most existing covenants will need to be changed as a result of the new standard. This is a timeconsuming process: banks will need to contact customers [and] explain the reason for the change.” “In some cases, renegotiations can result in other costs to banks or their customers who may want to renegotiate other [aspects] … Banks will need to involve legal counsel … Significant time will be needed to determine the appropriate metrics to be included going forward.”.
Leasing versus executory contracts Some respondents question whether operating leases should go on-balance-sheet, when analogous “executory contracts” such as long term service contracts will not. The ABA says: “It is understood that lease agreements are different from service and other executory contracts. However, significant value is normally placed on … those other contracts [by third parties] when making an investment or lending decision – just as much as the value of a lease.” “Considering that the purpose of … financial reporting is to provide information related to the amount, timing and uncertainty [of] … future net cash inflows to the entity, are the similarities between service contracts and leases sufficient … that the Boards may be viewed as undermining their overall Conceptual Framework by including lease agreements on the balance sheet and excluding other contracts?”. 4
Suggested exceptions The ED proposes no exceptions to the capitalization rule, except for contracts that are contractually precluded from continuing for more than 12 months. - Non-core assets Several lessees and lessors argue for broader exceptions in order to limit the compliance costs for lessees. Some argue for exemption of assets that are “non-core” to the lessee's business model, such as office equipment or business cars for typical types of lessee; others for ”de minimis” exceptions beyond the materiality qualification that applies to all accounting standards.
The Institute of Chartered Accountants in England and Wales (ICAEW) comments: “While we appreciate that this is primarily a [bank] regulatory matter, it would be useful if the standard clearly stated that the [ROU] is a tangible asset rather than an intangible one. Removing the … ambiguity would also reduce scope for confusion when assessing debt covenants.” Invigors comments: “The [Boards] should liaise with banking regulators to ensure that the final requirements do not result in banks as lessees having a greater capital requirement from property in which they have a leasehold interest than they do from equivalent property ownership interests.” The discount rate
- Low value assets Flowserve Corporation, a US based engineering manufacturer with worldwide operations, comments: “We feel strongly that certain high volume, low value assets (e.g. copiers, printers, ordinary vehicles etc) that [lessees] use for administrative rather than operational purposes, should be excluded from this standard … To account for [these] under the proposed requirements would require a level of effort that significantly outweighs the usefulness of the information.” - Lengthen short-term contracts exception Invigors argues for a three-year contract term exception: “ … There are many leases for relatively low value equipment for periods of up to three years, [which] … is the typical term of a car contract hire agreement. Consequently … extending the period for exemption from one to three years would not have a significant effect on the values shown … on lessees' balance sheets, but it would have a very significant effect on the numbers of leases for which these complex calculations are required and hence the compliance costs for lessees.” - value based exclusions The Credit Finance Association of Korea suggests an exception for assets worth less than 10 per cent of the lessee's equity, to a maximum of $100,000 in value.
The ED proposes that public company lessees should (as with current finance leases) discount the minimum lease payments to a present value (PV) using the implicit interest rate in the lease, where this is ascertainable. Otherwise they should use their own incremental borrowing rates. Other lessees, however, would be able to use a risk-free discount rate such as a government borrowing rate which would be simpler to ascertain but would result in higher PVs. One lessee representative, Dennis Moore, senior vicepresident and CFO of US group J&J Snack Foods Corporation, is critical of the discounting proposals, commenting: “The distortions [within] reporting by public companies resulting from the wide disparity in discount rates used to compute PV will be enormous …” “Public companies will go to outlandish lengths to mitigate the impact of this proposal … [Private companies] and notfor-profits would be allowed to use risk-free rates of return. Why a distinction from public companies? ” Sanford suggests that for relatively short term leases, up to three or five years, there should be no PV discount at all.
Tangible or intangible? The ED proposes not to clarify whether the ROU should be regarded as a tangible ot intangible fixed asset. The principal implication of this question is for many banks, as lessees of both real estate and equipment, under the global regulatory capital rules for banking. The Basel III accord includes a new rule, to be phased in over the coming years, which provides very unfavorable treatment for intangible assets. While this is clearly targeted at existing types of intangible asset, such as goodwill arising on corporate acquisitions, there is a potential risk of it being applied to ROU assets. ©Asset Finance International, 2013. All rights reserved
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The lessee's income statement The ED proposes a split accounting model for reflecting lease expense in the lessee's income statement or profit and loss (P&L) account. Nearly all equipment leases would be expensed as under current finance leases, with a front loaded profile of overall expense comprising a mixture of straight line amortization of the ROU asset with heavily front loaded finance charges. In the ED these are termed Type A leases. However, most real estate leases would be expensed like current operating leases, although they would no longer be off-balance-sheet. The cost would be presented in P&L as a single rental expense and would be on a level profile for the various accounting periods within the lease term. This would be achieved by back-ending the amortization of the asset, keeping the values of the asset and liability equal through the lease period. The ED terms these as Type B. For this purpose there would be a new lease classification line, in place of the current line between finance and operating leases which, though it has some differences as between IFRS and US GAAP, is based in both on the question of whether substantially all of the risks and rewards of ownership of the underlying asset are passed to the lessee. The proposed new line would be based instead on the question of whether a “more than insignificant part” of the value of the underlying asset is consumed by the lessee within the minimum lease term. Many leases which are currently classed as operating leases would move to the Type A side of the new line, being treated as financing type transactions. The test would start with a “rebuttable presumption” that equipment leases are Type A and property leases Type B. It would specify that equipment leases are Type A unless either the lease term is insignificant in relation to the asset's useful life or the PV of the lease payments is insignificant in relation to its value. The opposite presumption, with broadly converse exceptions, would steer real estate leases to the Type B classification. Most respondents favor Type B accounting for operating leases More than half of the respondents to the ED to date favor Type B accounting for current operating leases, i.e. retaining existing P&L expense profiles if these leases were to be capitalized. Less than a quarter support the ED proposals, and an even smaller number favor Type A accounting for all leases, as was proposed in the first ED in 2010. The ICAEW is among those favoring Type B accounting for all current operating leases, with the lease classification line remaining as it is in the IAS 17 version. It says: “We – like the Boards – have in the past advocated the introduction of a single accounting model [with front loaded expense] for all ©Asset Finance International, 2013. All rights reserved
leases. However, having considered the arguments on both sides of the debate, we now accept that not all leases are the same. “It therefore follows that different types of lease should be accounted for differently. However, the proposed dual approach … is not something to which we can offer our unqualified support....” Problems with the consumption principle “The logic behind the consumption principle is not without its merits. Indeed it reflects how many leases are priced. But it is a difficult concept to apply in practice as it is hard to draw a clear dividing line between those leases that do and do not involve consumption of a more than insignificant part of the underlying asset.” “While it is true that most leases of equipment or vehicles involve a more than insignificant degree of consumption of the underlying asset, while most property leases do not, this is not always the case. There are many other assets subject to leases where location is a key determinant of price, but which may not meet a strict definition of property, such as telecommunications towers … and pipelines … “Many 'big ticket' equipment leases are priced in a similar way to property leases, such as [for] ships and aircraft. It [is] therefore not easy to demarcate between the two types of leases. In truth, the economic characteristics of leases lie along a continuum.” “However, we accept that a [single] model accommodating different degrees of consumption would be difficult to define and highly complex in practice. Some sort of dividing line would seem to be necessary. We therefore appreciate what the Boards are trying to achieve but feel that their proposals introduce too much complexity.” “While we accept that the current dividing line between finance … and operating leases is not perfect, it does at least have the benefit of being well established and well understood. Accordingly, we recommend that the Boards simply carry forward the criteria from IAS 17, with leases that qualified as finance leases under the old standard being classified as Type A and those that qualified as operating leases … as Type B.” Invigors takes the same view, commenting: “... There is no clear conceptual reason for the introduction of the dual accounting model. The effects of the Type B model … are a better reflection of the way most lessees view the economics of leasing [compared with Type A] and the [Boards] should consider adopting this as the single accounting model for lessees.”
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A preliminary comment from Financial Executives International (FEI), a professional body for US corporate analysts, also appears to support the Type B accounting method for all current operating leases. It says:: “To have economic relevance, the initial and subsequent accounting for the newly created [ROU] asset … and [corresponding] liability must recognize that they are directly related and inextricably linked from an economic standpoint.” Bosco takes the same view, stating: “All account preparers, [almost] all users and the Securities and Exchange Commission [as US financial regulator] would have been satisfied by a decision to merely put the PV of operating lease payments on-balance-sheet … while keeping the P&L cost and the cash flow presentation unchanged.” The US Aerospace Industries Association (AIA) takes a somewhat similar line. Although its first preference would be to keep operating leases off-balance-sheet with stronger disclosure rules, if they are to be capitalized AIA argues for “straight line expense recognition consistent with current operating lease accounting with a separate 'pre-paid rent' asset or 'deferred rent' liability recognized to achieve straight line expense recognition.” Conceptual criticism One US based corporate analyst Dane Moss sees a fundamental problem with the “asset consumption” based approach of the ED, and with the equipment versuss real estate distinction. He comments: “The [Type A/ Type B] distinction is completely arbitrary … The lease asset in an operating lease is not the underlying tangible [asset] …. It is very misguided to define Type A and Type B leases based on the nature of the underlying property.” Some respondents favor Type A treatment with front loaded expense for all leases. CPA Australia, a national professional accountancy body, argues: “We do not consider the single lease cost [i.e. Type B method] to be consistent with the ROU asset approach. [That] approach treats a lease as a financing arrangement, however the [Type B] model does not reflect this (as it does not reflect financing costs) and neither will the presentation of cash flows...”
As it says in its comments: “We are concerned that the proposed accounting model for Type B leases is not underpinned by sound principles. … There is a clear mismatch between what is recognized on the balance sheet and what is recognized in [P&L] … It makes little sense to recognize a debtlike liability while not recognizing any interest cost or financing cash flows elsewhere in the financial statements … Nonetheless it offers a pragmatic solution and for this reason we are willing to accept it.” CPA Australia is specifically critical of the equipment versus real estate split within the proposed rules. It says: “We do not agree that the distinction in classification should be based on the nature of the underlying asset … We suggest [possibly] keeping the classification principle … but abandoning the presumption that property is a Type B asset.” Tax implications The US is the prime example of a country where lessees would experience mismatches between the financial reporting and taxation positions, in the case of current operating leases made subject to Type A accounting (i.e. mainly equipment rather than real estate leases) under the ED proposals. This arises because the US lease taxation rules are more closely aligned with current accounting rules than in other countries, but are unlikely to change in response to a change of accounting rules. Lessees in these leases would face a more front loaded accounting expense profile, while the profile of tax deductions would remain level throughout the lease period and therefore lag behind. Bosco comments: “Front loading lease costs … causes a mismatch versus the tax treatment where rent is the deductible expense. This will create the need for complex deferred tax accounting for all [operating] leases with front loaded costs. It also means large and permanent deferred tax asset balances for any entity that continues to lease. [Account] users will be confused by the large deferred tax assets as they highlight the inconsistency of the ED cost methodology versus the legal and tax view of [operating] leases.”
“We would consider that the [Boards] need to do more work in order to make a compelling case to proceed with the current proposal. Until the outcomes of further work are reviewed, we would consider [Type A expensing for all leases] … to remain a viable alternative for a new leasing model.” The ICAEW agrees with the conceptual criticism of Type B accounting. It is nevertheless prepared to accept this solution as a workable compromise, and indeed to see it extended compared with the ED proposals by leaving the current lease classification line in place. ©Asset Finance International, 2013. All rights reserved
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Renewals and contingent rentals
Lessor accounting models
For both lessee and lessor accounting, the Boards propose that there should be only limited initial recognition of contingent rentals. Renewal options would not be accounted for at lease inception except where the lessee has a “significant economic incentive” to renew. This is unlikely to be the case with typical operating lease renewal terms.
The ED proposes a split accounting model by lessors, mirroring the proposal for lessees. Type A leases (defined by the same new “consumption based” lease classification test as for lessees) would be accounted for rather like current finance leases, with a front loaded income recognition profile. However, this would be effected through a new dualasset “receivable and residual” (R&R) model. The RV (if any) would be accounted for as a residual asset (RA) separate from the receivable.
Similarly, variable rentals based on the extent of usage of an asset, such as excess mileage payments in typical vehicle leases, would not be recognized at inception except where they are “in-substance fixed payments” which the lessee has little practical option to avoid. Although only about a third of respondents have commented on these issues, within that group there is a reasonably high level of support for the ED proposals. However, there is some disagreement about the required level of recognition, and also some calls for further clarification of the criteria. “Significant economic incentive” principle needs more guidance Though broadly supportive, the Heads of Treasuries Accounting and Reporting Advisory Committee (HoTARAC), representing senior public sector accountants at Federal and State levels in Australia, is critical of the detailed formulation of these rules. On renewals it comments: “... The meaning of 'significant economic incentive' [is] open to interpretation and [we request] further guidance [on] the meaning of 'significant' in this context.” Not all respondents take the same kind of view of different types of contingent rental. The US accountancy training group Mind the GAAP, though supportive of the ED proposals on renewals (and critical of the capitalization proposal itself), calls for lessees to be required to estimate all types of variable rentals within the committed lease term. While the initial recognition proposals for renewal options and other contingent rentals do not appear onerous, the ED calls for these matters to be reassessed at each reporting date within the lease where there is a change in relevant factors. The ICAEW is among respondents calling for a higher threshold for reassessment, such as specifying a “significant” change in the relevant factors. Mind the GAAP suggests limiting the reassessment requirement to once per year, for those companies required to produce quarterly or half-yearly reports.
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Rental income under Type B leases would continue to be recognized by lessors on the same straight line profile as for current operating leases. Among ED respondents to date generally, and even more so among lessors themselves, there is criticism of the proposals and more support for keeping the current rules. Some support the R&R model for many equipment leases, but take issue with the proposed lease classification line as applied to lessors. No need for symmetry between lessor and lessee accounting Bosco supports the principle of a split model for lessors, including the new R&R method for financing type transactions; but he argues that the split between the two models should be determined by reference to the lessor's business model rather than through symmetry with any split model to be applied on the lessee side. He says: “Lessor lease classification and accounting need not be symmetrical with lessee accounting … The reason for not having symmetry is that the lessee and the lessor often have two completely different perspectives given the same transaction...” “There are financial lessors who view leases as a discrete investment ([in that] they only buy assets to be leased when the lessee is committed to that asset) and intend to sell the asset … if the lessee returns it at lease expiry. In contrast there are operating lessors who view leased asset as their stock-in-trade ([buying] assets on spec) and they intend to lease the equipment several more times beyond the first lease. In both cases the lessors [may] offer very similar terms to the lessee. … The lessor classification test should be based on the business model of the lessor.” Invigors concurs with the business model approach: “Many lessors currently offering operating leases of equipment are primarily financial businesses and the R&R approach … is a better reflection of their business model than [current standards].”
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In the USA particularly, however, some equipment lessors are opposed to moving to the R&R model for operating leases. Textainer, a US lessor of inter-modal shipping containers, says: “Most [of our] leases are five years or less in duration for containers with an economic life of 18 or more years … Recognizing revenue on the interest method … will only confuse readers of our financial statements... “While the container is off-lease [the R&R model] would return [as underlying asset] to our balance sheet, and then when re-leased it would be removed from the balance sheet. With thousands of containers going on and off lease each month this will only add further confusion to readers of our financial statements.” HoTARAC supports the ED proposals for lessors, as for lessees, but nevertheless suggests that the combination of the two has one conceptually unfortunate effect. It says: “[We note] that in a Type B lease the lessor continues to recognize the leased asset while the lessee recognizes a ROU asset in relation to the same asset. The recognition of an asset by both parties, conceptually, is not ideal.” HoTARAC suggests that the Boards' evident objective of symmetry between the lessee and lessor sides is not in fact achieved with the respective proposals for Type B leases. “The lessee [would recognize] a lease liability but the lessor [would] not appear to recognize a lease receivable. This appears to be inconsistent with the core principle of the [ED]: that an entity shall recognize assets and liabilities arising from a lease.” CPA Australia makes a similar point: “If the lessee in a Type B lease is recognizing a ROU asset, it is illogical for the lessor not to de-recognize an asset or part of an asset.”
“Although the RV asset is not a financial instrument, it seems more practical and operationally simpler to assess both assets together against the expected cash flows from the underlying asset in calculating impairment...” Invigors takes the same view within a strong critique of the R&R impairment rules. It says: “Equipment lessors will typically take a … holistic approach to the total lease asset, taking into account the value of both components. In particular, while a lessor will be concerned at any indication that the lessee will not pay the rentals due in full, that concern will be mitigated [since] … repossession and sale of the underlying asset would result in realizing proceeds in excess of the RA.” “It is not uncommon for lessors to generate a higher profit from a lease which terminates early [on] default … than would have been generated if the lease had continued for the full contractual term … This position is not properly reflected in the proposals.” “... The R&R methodology set out in the ED requires an impairment to be recognized if the expected realizable value falls below the RA initially reflected in the accounting but does not allow for any increase in the expected realizable value to be [recognized] until disposal takes place.” US leveraged leases Currently US GAAP, but not IFRS, has special lessor accounting rules for “leveraged leases”. These are leases funded by a third party lender on a “non-recourse” basis – i.e. with recourse to the lessee and the asset but not to the lessor who holds legal title to the assets. Tax benefits to the lessor, reflecting fiscal depreciation of the leased asset, are a significant aspect of these leases.
Impairment rules Since it involves recognizing two separate assets, the R&R model proposed for Type A leases requires special rules for assessing potential impairments of their values at intermediate reporting dates during the lease period. The ED proposal is for each asset to be assessed separately for impairment. The ICAEW is critical of the proposal, commenting: “The separation of the RA and the receivable adds complexity to impairment testing and would not be consistent with the way that lessors consider impairment in practice. Lessors will need to determine which expected cash flows relate to the receivable and which relate to the RV asset, which is likely to be a fairly arbitrary split … This will be different from other secured loans where all the cash flows arising from the security are taken into account in determining the impairment for the financial instrument.” ©Asset Finance International, 2013. All rights reserved
Topic 840 currently allows for these to be accounted for by lessors on the basis of a constant post-tax rate of return, in contrast with the constant pre-tax return factored into other types of capital or finance lease accounting. However, for the sake of achieving fuller convergence with IFRS, FASB proposes to end leverage lease accounting under the current project. It also decided against a grandfathering concession for running contracts of this kind. The ABA comments: “The [proposals] … ignore the threeparty arrangement and the critical aspect of how leveraged lease decisions are made, including the after-tax advantages. As a result, lessor leverage [would be] overstated, as the rent receivable will no longer be reported net of the portion to be paid for principal and interest [on] the underlying nonrecourse debt. Further, operating revenue will be misstated, with a portion of the economic benefit now reflected within … tax expense.” 9
“... If the Boards insist on ending leveraged lease accounting, various operational challenges exist, related mainly to previous business combination accounting, and we strongly recommend that existing leveraged lease arrangements be grandfathered to continue the current lease accounting until the expiration of these leases.”
Transition rules The ED proposes that lessees and lessors should apply the new rules to leases that are already running at the date when the new standard first has to be applied. The most challenging transition issue is on the lessee accounting side, in the case of current operating leases which would be classed as Type A under the proposed rules (i.e. largely equipment leases). For these, the ED proposes to allow a “modified retrospective approach” (MRA). Though relatively complex to apply, this is designed to avoid the recognition of concentrated losses in P&L in the first accounting period under the new rules (as a result of these leases moving to a front loaded expense profile), without applying a fully retrospective approach, restating all running leases for each year from inception.. Many respondents are supportive of this proposal, but some suggest changes. Peggy T Ray, vice-president for finance and accounting at US lessor CCA Financial, comments: “Although it is better to have [MRA] as an option rather than not, … the Boards [should] be even more flexible regarding transition...”
The timetable The ED itself does not contain a proposed effective date for the new standard. The earliest feasible effective date would seem to be for reporting periods commencing on or after January 1 2017, though this is assuming that the Boards could complete all their re-deliberation following the ED response well before the end of 2014 and issue the standard by around the end of that year. Listed company lessees and lessors in many jurisdictions will have “dates of initial application” either one or two years before the effective date, for the purposes of producing comparative information on the new basis for preceding accounting periods. A number of respondents have stressed the need for ample lead-in times in view of the scale o adjustments required, especially for lessees. The ICAEW also calls for the Boards to defer their redeliberation of the leasing standard until the IASB has completed a concurrent project to review its Conceptual Framework document, which is also subject to an ED currently out for public comment. It says: “The IASB's work on its Conceptual Framework is clearly relevant to a number of aspects of the leasing project, not least the definitions of assets and liabilities. The Boards may therefore wish to return to the subject of leasing [only] after the Conceptual Framework has been finalized.”
“The cost of transition [to lessees] may be huge … As a minimum I would suggest that the Boards should strongly consider allowing existing leases with less than a certain remaining term … to be grandfathered with their existing treatment.”
©Asset Finance International, 2013. All rights reserved
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