Easing lease accounting

SUITS THE C-SUITE By John T. Villa

Business World (01/19/2015 – p.S1/4)

(Second of two parts)

Last week, we talked about how the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (collectively referred to as “the Boards”) have been working on improving and standardizing lease accounting standards under both International Financial Reporting Standards and United States Generally Accepted Accounting Principles (US GAAP). Given the comments from users, the IASB has issued some tentative decisions on how to address various lease arrangements. We shared our comments on the lessee accounting model, small-ticket leases, portfolio leases and short-term leases. We will now continue the discussion on other types of leases.

SHORT-TERM LEASES

The Boards also sustained their proposal contained in the 2013 ED, that lessees are given a choice of accounting policy (by class of asset) to exclude leases with a maximum lease term (including all optional periods where lease renewal or termination by the lessee is reasonably certain to happen) of 12 months or less. The Boards’ recent decision to consider only renewal options that are reasonably certain to happen is expected to result in fewer renewal option periods that will be included in the lease term, and will therefore broaden the population of leases that might qualify for the exception. Entities can, as a policy choice, also opt not to disclose certain quantitative and qualitative information covering short-term leases.

We also note that the Boards have put bias on the lessee’s perspective in assessing whether renewal is reasonably certain. Most renewal options we have seen in the Philippines are subject to approval by both the lessor and lessee. So while the lessee may judge that renewal is reasonably certain, that may not be true for the lessor. We believe that this is an area that the Boards need to consider.

INDEX AND RATE-BASED LEASE PAYMENTS

Consistent with their 2013 proposal, the Boards decided in April 2014 that the initial measurement of lease assets and lease liabilities would include index and rate-based variable lease payments, using the index or rate existing at the lease commencement.

In the case of lessors, the Boards decided that lessors would not be required to reassess variable lease payments that depend on an index or rate.

In the case of lessees, in an attempt to simplify the proposed accounting for index and rate-based variable lease payments, the Boards revisited in 2014 their 2013 decision. In the 2013 ED, the Boards decided that a lessee should reassess the lease payments if there is a change in either: a) the lease term, b) the relevant factors that result in the lessee having or no longer having a significant incentive to purchase the asset under a purchase option, c) the amounts expected to be payable under residual value guarantees, and d) an index or rate used to determine lease payments during the reporting period.

In 2014, the IASB decided that lessees would reassess index and rate-based variable lease payments whenever there is a change in the lease cash flows (e.g., when a lessee’s payments escalate based on the terms of the original lease). Compared to its 2013 decision, the IASB’s decision in 2014 indicates fewer situations or instances that will require reassessment of lease payments, and, as such, is expected to reduce the effort of lessees in accounting for leases under IFRS.

SALE AND LEASEBACK

The Boards jointly decided in July 2014 that a seller-lessee would apply the new revenue recognition standard (which was released in May 2014) to determine whether a sale has occurred in a sale and leaseback transaction. That is, a seller-lessee would assess whether the buyer-lessor has gained control of the underlying asset. This is intended to align the various standards that have been and will be issued by the Boards. Thus, users and preparers will be required to familiarize themselves with standards that are consistent and aligned.

The Boards also discussed the implications of repurchase options in lease contracts and concluded that a sale under a sale and leaseback would not occur if the seller-lessee has a substantive repurchase option. The Boards, however, have not reached a consensus on the specific instances or criteria when a repurchase option can be deemed non-substantive. Determining whether an option is substantive or not can involve significant judgment, and can pose structuring opportunities.

CONCLUSION

There are still other issues related to the leases project that the Boards have yet to address. It will be exciting to find out what other “simplifications” the Boards will decide on and carry forward to a final standard.

Since the first ED in 2010, the Leases Project has come a long way. The decisions as of today indicate a much simpler version compared to the 2010 ED, yet still conceptually sound as it preserves the key essence of the Leases Project, which is an on-balance sheet approach to lease accounting. As a final lease standard is nearing its anticipated issuance in the second half of 2015, many are still hoping that further simplifications will be considered. Many standard setters believe, however, that things can only go so far. As they say, “When you want to do the right thing, there is probably no easy way.”

John T. Villa is a partner of SGV & Co.