Easing lease accounting

SUITS THE C-SUITE By John T. Villa

Business World (01/12/2015 – p.S1/5)

(First of two parts)

THE INTERNATIONAL Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), which we will collectively refer to as “the Boards,” are currently working on a new standard on leases (the “Leases Project”). The project aims to improve lease accounting under both International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US GAAP), and at the same time is intended as a convergence effort to align lease accounting under the two accounting standards. A first Exposure Draft (ED) was issued in August 2010 which was followed by second version in May 2013 (the 2013 ED).

The Boards invited users to submit comments on the 2013 ED and are now addressing those comments. Their efforts are mainly geared towards reducing the cost of implementation while preserving the conceptual soundness of their proposals. As some IASB and FASB decisions are different, this article focuses mainly on the IASB’s tentative decisions in 2014 in its attempt to simplify the lease accounting proposals, and our comments on such tentative decisions.

DEFINITION OF A LEASE

The 2013 ED defines a lease as “a contract that conveys the right to use an asset for a period of time in exchange for consideration.” An entity would therefore determine whether a contract contains a lease by assessing whether: a) fulfillment of the contact depends on the use of an identified asset, and b) the contract conveys the right to control the use of the asset (i.e., if the customer has the ability to direct the use and receive the benefits from its use) for a period of time, in exchange for consideration.

During its 2014 re-deliberations, it appeared for a time that the Boards were seriously considering the idea that, for an arrangement to be regarded as a lease, the customer (or lessee) should have the ability to obtain benefits from using the leased asset/s on its own or together with certain other resources (e.g., goods or services) that are either sold separately (by the supplier or any other supplier) or can be sourced in a reasonable period of time. However, at their December 2014 meeting, the Boards decided against adding this requirement as the Boards believed this would add complexity to the application of the definition of a lease. Instead, the Boards reaffirmed their earlier decision on the definition of a lease, mainly as contained in the 2013 ED.

While the Boards have concluded their deliberations on the definition of a lease, there are still issues on how such definition would be applied to certain arrangements. For example, arrangements that include significant services may require judgment to determine whether the contract conveys the right to control the use of an identified asset.

LESSEE ACCOUNTING MODEL

The Boards discussed two approaches whereby lessees would measure the lease asset and obligation: Type A leases (i.e., financing type) and Type B leases (i.e., leases with a generally straight-line lease expense pattern). The IASB overwhelmingly supported a single-model approach allowing only Type A leases in contrast to the FASB’s two-model proposal. Under the IASB’s proposal, lessees would reflect the acquisition of a right-of-use asset and a corresponding liability on the balance sheet, and recognize interest expense and amortization separately in the income statement. The IASB believes this is the most conceptually sound approach because all leases contain a financing element. The IASB also believes that this model would be beneficial for users of financial statements because it will necessitate separate recognition of interest expense and amortization.

We believe that this IASB proposal could make lease accounting by lessees simpler in the long run, considering that there is only one model to apply. This, however, could create an initial disruption to preparers and users as this will create a difference compared to the current lease accounting where a dual-model approach (i.e., operating lease and finance lease) is required. Under the FASB’s proposal for a dual-model approach, users would benefit from more useful balance sheet information about leases based on classification principles that they are familiar with. Regardless, however, of the difference in the proposed accounting treatments, in both the IASB and the FASB proposals on lessee accounting, it is clear that the on-book treatment of generally all leases would address the main criticism to current lease accounting, i.e., the off-book treatment of operating leases.

SMALL-TICKET LEASES FOR LESSEES

In March 2014, the Boards discussed a scope exception for leases of “small-ticket” assets (e.g., leases of office furniture), which the IASB tentatively decided to adopt. However, the FASB generally opposed it. The Boards will revisit this topic in a future meeting after further research on the matter. We believe that the small-ticket exception is a more important issue to those supporting a single on-balance sheet model (i.e., those applying IFRS), as the FASB decided that the leases guidance should not include specific requirements on materiality. We also foresee that, in the event that the IASB allows this exception, the difficulty in accounting for many leases will be eased out considering that quite a number of leases may qualify under small-ticket items.

PORTFOLIO APPROACH

Many constituents have expressed concerns regarding the difficulty in implementing the 2013 proposals, particularly for leases that are high in volume but small in value and with the same characteristics. An example is the lease of a fleet of cars. The Boards decided that lessors and lessees would be allowed to apply the final standard using a portfolio approach rather than on a lease-by-lease basis. However, the Boards decided that this option is permissible only if the entities that taking this option would reasonably expect that doing so will not result in a material difference compared to accounting for those leases on an individual basis.

Currently, it is unclear how the Boards define “reasonably expect” and “material.” We believe, however, that based on the tentative decisions, before an entity can take this option, there should be an underlying detailed calculation on an asset-by-asset basis to ensure that the results under a portfolio approach will not be materially different.

In next week’s article, we will continue the discussion on the tentative IASB decisions on how to simplify lease accounting proposals, specifically looking at short-term leases, index and rate-based lease payments, and sale and leaseback arrangements.

John T. Villa is a Partner at SGV & Co.