“Lease accounting – the pendulum continues to swing (2nd of 2 parts)” by John T. Villa (August 8, 2011)

Business World (08/08/2011)

(Second of two parts)

This article continues the discussion from last week, where we highlighted the main issues that respondents identified in the proposed exposure draft (ED) on accounting for leases.


In April 2011, the International Accounting Standards Board and the Financial Accounting Standards Board (collectively, the Boards) tentatively decided that contingent rents based on performance or usage would be recognized only when incurred.

For example, contingent rent based on the revenue of a lessee leasing a space in a mall food court would not be included in the right-of-use asset and lease liability.

Instead, these payments would be recognized as the sales occur.

Payments must be truly variable to be excluded from the amounts recognized; payments that are contractually described as variable, but are in substance fixed, should be treated as fixed.

The decision to exclude performance or usage-based contingent rents from the amounts recognized on balance sheet reduces the complexity of the proposed accounting for leases.

The Boards received feedback from many users that the proposed approach was complicated and would have been costly to implement.

Under the revised proposal, many variable payment features commonly found in leases (e.g., percentage rent, and mileage based fees) would be accounted for in much the same way as under IAS 17.


In March 2011, consistent with its decisions on lease term, the Boards tentatively decided to include the exercise price of a purchase option in the measurement of the lessee’s lease liability and the lessor’s right to receive lease payments, only if the lessee has a significant economic incentive to exercise such purchase option.

Although not very clear yet, it appears that the revised decision has some similarity to the current IAS 17.

IAS 17 provides that the minimum lease payments up to the exercise date of the option should include the payment required to exercise it (if such exercise price is expected to be sufficiently lower than the fair value at the date the option becomes exercisable) so that at the inception of the lease, it is reasonably certain that the lessee will exercise it.

While the Boards may need to further clarify if the concept of “significant economic incentive” is similar to “sufficiently lower,” the revised decisions seemingly indicate a broader set of factors to be considered apart from the fair value of the underlying asset.


The Boards tentatively affirmed the proposals in the ED on discount rates, but clarified that the lessee would use the rate charged by the lessor when that rate is available; otherwise, the lessee would use its incremental borrowing rate.

On the other hand, the lessor would use the rate charged to the lessee. In the ED, it was not clear if lessees have a choice between two discount rates. Practically speaking, lessees will rarely know the rates that are being charged by lessors.


Lessees are required to reassess certain key considerations throughout the life of the lease. Among the variables that need reassessment are lease term and purchase options, discount rate, and residual value guarantees.

Once a fact pattern requires a reassessment, the lessee would need to determine the revised inputs and re-measure the lease liability as of the reassessment date.

The lessee would then have to adjust the lease liability to reflect the change in the calculation with the offset to either the related asset or net income.

Reassessment is a key change from the current lease standards.

Under IAS 17, lessees do not have to actively monitor many of these considerations, and adjustments are only taken up when leases are modified.

Some believe that the cost of reassessment could exceed the corresponding benefit.

As part of the re-deliberations, the Boards indicated that the changes made to the concept of lease term and accounting for contingent rents should reduce the cost of reassessment.

Accordingly, the Boards tentatively agreed that companies would be required to reassess the lease term only when there is a significant change in factors relevant in determining if a significant economic incentive exists to exercise an option to extend or terminate a lease.

For example, a significant increase in market rates that make fixed lease renewal rates a bargain, when the renewal rates were not initially priced at a bargain, may trigger a reassessment of the lease term.

It is noted that while this reassessment criterion is not present under IAS 17, the new reassessment rule is less onerous than the one proposed in the ED.

Companies would need to develop reassessment processes and related controls, including how changes in facts and circumstances affect their assessment of the economic incentives. This can involve a subjective process.

There are other matters that are still being considered by the Boards. Given these changes, it appears that the ED may still have a long way to go before it finally becomes a standard.

Very recently, the Boards issued their tentative decision on the use of a single “receivable and residual” model which bears some similarity to the derecognition approach introduced in the original ED. This reduced the lessor models from two to one.

Lessor presentation, disclosure and transition issues are also on the table.

With these significant changes from the ED issued in August 2010, the Boards plan to re-expose the ED for a second time.

The new standard is targeted to be released during the first half of 2012.

Although the Boards still have to decide on the effective date of the standard, we anticipate its implementation in 2015.

Where the current deliberations will lead remains to be seen.

However, the Boards have expressed commitment to proceed with a new standard that would, in general, require the on-book treatment of all leases.

While the Boards’ recent decisions may have eliminated some of the difficulties posed by the original ED, a new standard would still require significant accounting and related process changes.

Entities should carefully follow the developments on the ED, review the standard when issued, and begin preparations ahead to be ready when the new standard takes effect.

For the moment, the pendulum continues to swing. What users thought would be a simple accounting standard is taking longer than planned to become final.

(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.