“Lease accounting – the pendulum continues to swing (1st of 2 parts)” by John T. Villa (August 1, 2011)

Business World (08/01/2011)

(First of two parts)

In August 2010, the International Accounting Standards Board, through a joint project with the Financial Accounting Standards Board (collectively referred to in this article as the Boards), released an exposure draft (ED) to improve accounting for leases.

The deadline to comment on the ED ended on Dec. 15, 2010.

Since then, the Boards have been working to enhance the ED which was originally drafted to address the criticisms on the current lease accounting standards.

However, various comments were received relating to issues that the ED had failed to address, not to mention the complexities involved in its implementation.

Among the key issues, applicable to both lessors and lessees, are the definition of a lease, short-term leases as well as separation of lease and non-lease components.

The Boards deliberated again on issues including lessee accounting models, definition of lease terms, variable lease payments, purchase options, discount rate, and lease re-assessment.

Definition of a lease

One issue that was raised was the ED’s seemingly unclear definition of a lease.

Thus, the Boards clarified two key concepts underlying its definition, namely: “specified asset” and the “right to control the use” of that asset.

The Boards agreed that, consistent with current standards, a specified asset should be a unique, identifiable asset.

Although a physically distinct portion of a larger asset could be a specified asset, the Boards confirmed that a non-physically distinguishable portion of an asset (e.g., 50% of the capacity of a pipeline) would not qualify as a specified asset and would not represent a lease.

Contracts that provide the supplier with substantive substitution rights for an asset would also not be considered leases and would be accounted for as executory arrangements.

The Boards agreed that the right to control the use of a specified asset is conveyed if the customer has the ability to both direct the use of the asset and receive the benefit from its use.

This would be a change from the current standards under which contracts meet the “right-to-control-the-use” criterion if the customer obtains substantially all of the benefits, and the contractual price is neither fixed per unit of output nor equal to the market price per unit of output. Under the current standards, the control criterion may be met even if the customer does not have any right to direct the use of the asset.

The revised guidance is expected to result in certain contracts which under the current standards are treated as leases (e.g., certain take-or-pay contracts) to no longer be considered leases.

The Boards agreed to make these revisions to address constituents’ concerns that the original proposal would have resulted in on-balance sheet accounting for many service arrangements having embedded leases. These revisions would also align the ED with the control concepts used in the revenue recognition project.

Short-term leases

In March 2011, the Boards tentatively decided that both lessees and lessors may elect, as a matter of accounting policy for a class of underlying asset/s, to account for all short-term leases (i.e., with terms of 12 months maximum) by not recognizing lease assets or lease liabilities.

Both are allowed to recognize lease payments in income on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset.

In view of the proposal, companies should carefully evaluate whether short-term lease accounting applies to their arrangements.

Evergreen arrangements or continuous leases with no termination dates, for example, would not qualify as short-term leases.

Separation of lease and non-lease components

For contracts that contain both lease and non-lease components, the non-lease components, including service and executory costs, would be separated from lease components, except in limited circumstances.

Executory costs have not been defined but will likely include insurance, maintenance and taxes.

Lessees would allocate payments on a relative purchase price basis (if the purchase price of each component can be observed) or allocated using a residual method approach (if the purchase of one or more but not all components can be observed).

If there are no observable purchase prices, lessees would account for all payments as a lease.

It is not yet clear, though, what constitutes an observable price and whether a lessee can use estimation techniques.

Separating lease from non-lease components may require a change in practice for some companies.

Currently, these payments are excluded from minimum lease payments, but many entities may not have focused on separating them because the accounting treatment is often the same as for operating lease payments.

Entities would need to develop processes to identify observable prices for lease and non-lease components, which may involve the use of significant judgment.

Lessee accounting — a single model

In May 2011, the Boards tentatively decided to use a single accounting approach for lessees — the right-of-use model.

Under this model, a lessee recognizes a right-of-use asset (a fixed asset in the balance sheet) and lease liability is recognized at amortized cost based on the present value of payments over the lease term.

This model results in an accelerated expense recognition vis-à-vis the current straight-line accounting for operating leases because the interest on the lease liability is greater in earlier years, in addition to the additional expense arising from the amortization of right-of-use asset.

Lessee accounting — definition of lease term

In February 2011, the Boards tentatively defined a lease term as the non-cancellable period, plus any option where there is a significant economic incentive to extend or to not terminate the lease.

Factors that may create an economic incentive for the lessee include renewal rates priced at a bargain, penalty payments for cancellation or non-renewal, and economic penalties such as significant customization or installment costs.

In many cases, the new definition would result in lease terms that are shorter than the initial proposal.

The Boards seem to have considered the comments regarding the difficulties involved in determining the lease term.

The revised definition more closely aligns the measurement of lease-related assets and liabilities with concepts used in International Accounting Standard (IAS) 17, Leases, and would make the new model arguably less burdensome.

However, many of the challenges that exist under IAS 17 around these judgments would persist.

In particular, assessing “whether an economic incentive is significant” can be highly subjective.

Furthermore, including renewal periods in the lease term for accounting purposes could be more impactful under the proposed model than it is today, as generally all leases would be recognized on the balance sheet.

In the second part of this article, we will continue the discussion of some of the issues that were raised in reaction to the ED on accounting for leases.

(John T. Villa is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.