Accounting & Auditing

Note:  Since this article was published, the timeline for this project has been extended; a revised exposure is now expected in the first half of 2012.

As the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) continue to work toward a final lease accounting standard, the expected rules are evolving as further input influences the two boards. The life cycle of these efforts goes back many years, but formally made headlines with:

• The March 2009 release of a discussion paper
• The August 2010 release of a proposed standard as an exposure draft
• The December 2010 deadline for comments, resulting in more than 780 comment letters from interested parties
• Outreach efforts from November 2010 through January 2011
• Continuing deliberation by FASB and IASB in anticipation of a final standard to be released no later than June 30, 2011

During joint board meetings held in February and March 2011, FASB and IASB members came to tentative conclusions in their redeliberations of the exposure draft that will likely lead to substantial changes. This article contains those tentative conclusions through the most recent meeting, on March 2, but future meetings are scheduled throughout March where additional issues are likely to be addressed. Policy indicates that decisions reached are final only after a formal written ballot, but these continuing discussions provide great insight into the project's direction.

What follows is a recap of the exposure draft, with highlights on the boards' tentative decisions and the impact those decisions could have on the implementation of the standard. Continuing deliberations should eventually result in a final standard (tentatively scheduled to be released by June 2011), so stay tuned to both BKD Insights and updates from FASB, which can be accessed in the Projects section of the FASB website.

Lease Accounting Basics Under the Exposure Draft

Lessees

• Off-balance-sheet accounting for most leases is eliminated. All assets and obligations for operating leases would be brought onto the balance sheet.

• The resulting assets and liabilities would initially be recorded at the discounted present value of the required payments.
• Rent expense for operating leases would be replaced by amortization and interest expense. Asset amortization will generally be on a straight-line method, while interest will be recognized on the effective yield method, which will “front-load” the cost.
• Lease terms would include renewal periods that are judged “more likely than not” to be exercised. Currently, only those reasonably assured by bargain renewal options or economic penalties are included.

• Lease payments would include contingent amounts based on a probability-weighted approach. Currently, contingent rents are recognized in the period they occur.

• Renewal periods and contingent rents would be continually reassessed and changes recognized as changes in estimates. Currently, changes in these estimates are not recognized unless the lease is modified.

Lessors

The proposed standard includes two models for lessors. They apply the performance obligation approach if they retain significant risks or benefits related to the underlying asset; otherwise, they apply the derecognition approach.

• Under the performance obligation approach, the lessor recognizes a lease receivable, the right to receive future rental payments, and a performance obligation, the obligation to allow the lessee to use the asset. Essentially, the performance obligation represents deferred revenue. In this case, the carrying amount of the leased asset remains on the lessor’s balance sheet.
• Under the derecognition approach, the lessor recognizes a receivable and revenue for the right to receive future lease payments. The carrying amount of the leased asset considered to be transferred is derecognized from the lessor’s balance sheet.

Overall Impressions from the Continuing Deliberations

While the boards continue to move toward a final standard issuance by June 2011, significant questions remain unanswered. 

Regardless, the shift in attitude toward the inclusion of renewal periods only when there is a significant economic incentive is welcome relief for many, as the exposure draft’s original conclusions would have certainly led to longer assumed terms and more significant assets and liabilities to be recorded. The shift to a reasonably certain threshold for contingent rentals should also reduce the complexity of assessing certain future rents in the discounted cash flow model.

Our recommendation stands that the best course of action for companies prior to issuance of a final standard includes:

• Identifying all lease arrangements to confirm the population of agreements that could be affected by a new standard
• Identifying agreements that could be affected by changes in financial statement metrics resulting from changes to lease accounting—debt (covenants), management performance agreements and others often tied to measurements such as earnings before interest, taxes, depreciation and amortization (EBITDA) or debt ratios that might be inclusive of liabilities recorded under lease accounting
• Considering any contracts or agreements entered into between now and the issuance of the final standard that might have clauses or covenants driven by financial ratios that could be affected; while language specifically recognizing a change in standards may not be practical, acknowledging that changes could occur and potentially including clauses specifying how modifications to those agreements would be handled (and priced) based on a final standard may be appropriate

Meetings on the leasing topic scheduled as of March 3 include a meeting of the Financial Accounting Standards Advisory Council on March 8 and a FASB Education Session on March 9. Joint FASB/IASB meetings that likely could include a discussion on leasing are tentatively scheduled for March 14–16 and March 21–23, 2011.

For more information on the proposed standard and how it could affect your business, contact your BKD advisor.