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Lease accounting update: “more likely than not” is no more February 17, 2011

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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FASB/IASB have dropped one of the most controversial parts of their proposed lease accounting.   The Exposure Draft, released in August 2010, had called for lessees with options-to-renew to capitalize lease obligations for renewal periods that were “more likely than not” to occur.   This part of the accounting was attacked on many grounds.  First, it was going to require lessees to undertake a lot of work in making the assumptions as to whether renewals were more likely than not to occur, and many thought the benefits to users of financial statements were not great enough to justify the expense of compliance.  Second, in many cases the assumptions would end up being arbitrary, bringing into question whether capitalizing renewal periods had any value.  Third and perhaps ultimately most important, it seemed to fly in the face of other accounting doctrine.  Until a lessee signs up for a renewal period, regardless as to whether an option-to-renew exists, the renewal period is not an obligation.  It just didn’t seem right to put it on the balance sheet.

I think FASB/IASB made the right choice in eliminating this part of their proposal and had recommended that writers of comment letters to FASB/IASB point out the flaws and problems associated with capitalizing renewal periods.  Many others made similar recommendations, and many of the 700-some comment letters received by FASB/IASB recommended that this aspect of the accounting be eliminated.

The people have been heard!

Before “the people” start celebrating, though, they should understand that there will still be a need to evaluate each and every lease, with an option to renew, to determine whether there is an economic incentive in that option such that renewal of the lease is “reasonably assured” … in which case the renewal period would have to be capitalized … just as is the case under present accounting for capital (or financing) leases. 

This test will be much less onerous, though.  FASB/IASB are going to work on the exact wording, but this “reasonably assured” test has a much higher bar than would have the “more likely than not test” … akin to the difference between 99% and 51%.  Few leases will go over the bar and most won’t even come near it so assumption-making will be much easier, and easier to justify to auditors, than it would have been with “more likely than not”. 

Still, though, lessees will have more to do than they do today.  Under today’s accounting, most companies only need to apply the “reasonably assured” test to a very small group of leases that, due usually to their long length, are classified as capital leases.  Many companies have no such capital leases.  Now, though, companies will have to apply the test to all leases.  The process burden will be much, much less than it would have been with “more likely than not” … but it’s going to be measurably more than it is at present.

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Comments»

1. LB - February 18, 2011

Agree that this is a much better approach. However, there may well be an “economic incentive” to include option periods, particularly in the initial year of transition to avoid the year to year jumps in expense that will occur as renewals are exercised. Also agree with your last comment that there might be premature relief, since this will still be much more effort than currently, given shorter term leases.

Have you heard anything about the possibility of straight lining the Lessee Liability rather than using the finace model approach? That would significantly reduce the concerns over P&L impact and negative equity effect.

2. Bob Cook - February 18, 2011

I believe addressing the “straight-lining” of the interest on the liability (as opposed to the proposal to use the interest-method of amortization) has not yet been discussed. I don’t think, though, a change to the proposal in that area is likely; I could be wrong, tho.

3. BOB - February 18, 2011

Hi Bob,
Im not an accountant but have worked in FPA for retailers with large lease portfolios. The post confuses me since I’ve been under the impression that straightlining the lease expense was GAAP. At one point I worked for a retailer that had gone through a sale and as a result had re-written all leases. Since all of our leases were “new” and thus our actual rent expense was much higher than our cash rent we enjoyed the tax shield provided by lower earnings. Was this kosher or am I missing the point here? Thanks for your insight.

4. Bob Cook - February 18, 2011

What you did was kosher under current GAAP. Currently “straightlining”, as many call the process of accrual accounting for rent expense is GAAP. The new accounting will change that though. There no longer will be a rent expense. Instead, companies will have an depreciation expense related to the right-of-use asset that goes on the “left-side” of the balance sheet and imputed interest related to the lease liablity that goes on the “right-side”. As for tax accounting, presently it matches GAAP in most cases. This will not continue, though. When the new lease accounting for GAAP is established, most likely tax accounting will not change. GAAP and tax accounting for leases will, therefore, vary quite a bit. This is the case in other areas of accounting. Corporate real estate folks might not have encountered it before, but it is not unusual for GAAP and tax accounting to vary.

5. Richard L. Podos - February 18, 2011

Regarding straight-lining:

What we’ve been pushing for since Spring 2010 is an “annuity” or “mortgage” approach to amortization of both the asset and liability.

See this memo from the Boards:

http://www.ifrs.org/NR/rdonlyres/4B880847-CC20-422F-BDDE-0B183695DFB1/0/AP7LesseeSubsqtMeas.pdf

This would have the effect of replicating current GAAP at the net income level (although not for EBITDA).

I personally believe that this concept is *VERY* much on the table*, so anybody that has an opportunity to influence feedback to and discussion with the Boards should push HARD, i.e., please communicate with your accounting policy team.

RLP

* In fact, I expected this to be more easily accomplished than what has just happened re general removal of options periods.

6. Matthew Fahy - February 18, 2011

The “more likely than not” provision is just one provision to FASB 13 and not the entire deal and certainly not the most important part of FASB 13. Basically, this provision would expand the current accounting of lease obligations that will be required to be booked on the balance sheet of companies to include “potential” renewals of leases that were “more likely than not” to renew. So, FASB 13 will still require lease obligations to be recorded on the balance sheet and it is due to be release in a final accounting pronouncement in mid 2011, with a likely effective date in 2012.

I agree with FASB if they drop the “more likely than not” provision from the final rules because it would not be applied consistently across reporting companies and it would not be consistent with other accounting pronouncements. However,
FASB 13 will be one of the more significant accounting changes due to the broad implications:

* Companies will have to book tens or hundreds of millions of lease obligations on their balance sheets that were previously buried in footnotes to financial statements.
* Asset and other financial ratios will be impacted significantly for each company and industry.
* Those companies that run efficient workplace operations will be rewarded in stock price premiums over those with excess facilities in terms of revenue and people.
* Financial lenders and CFO’s will need to renegotiate debt terms that have asset ratio covenants.
* These assets will have greater visibility and exposure to FASB 121 Impairment of Long-Lived Assets by being recorded on the balance sheet. “Shadow space” will become a significant audit area for quarterly and annual reporting and overtime audit procedures will be expanded in this area.

7. Bob Cook - February 18, 2011

Richard,

Thanks for your view on the “straight-lining” vs “interest-method of amoritization” and thanks for providing the link to the discussion paper in your reply.

Bob

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9. Richard L. Podos - February 22, 2011

Not finalized, but it looks like:

(i) operating leases are back on the table, to be known as “other-than-finance” leases, with modifications to the tests, and

(ii) rents under “other-than-finance” leases will be “characterized by straight-line recognition consistent with today’s US GAAP/IFRS operating lease accounting.”

The Boards have indicated, however, that ALL lease assets and lease liabilities are still going be represented on balance sheet… I am not completely sure how that will interplay with the P&L treatment (i.e., presumably both asset and liability will match, but I don’t have any feedback on the mechanisms for rent versus interest versus amortization, and thus EPS versus EBITDA). I also don;t know how this will interplay with Impairment of Long-Lived Assets, or if it will even be deemed applicable.

RLP

10. Clay - February 23, 2011

The other big question now is how will the board define “other-than-finance” lease type? Is this merely just a way to provide a scope exclusion for leases under 3 years or so … or are the Boards back tracking to the point of putting the operating lease option back on board for long-term leases?

What are your thoughts? How are they going to define “other-than-finance” leases?

11. Lou Battagliese - February 23, 2011

Just recieved a write up from KPMG that has a pretty good section on the Lease Classification discussion. Since I don’t have e-mail addresses, I’ll try to get a copy to Bob and Richard and they might be able to distribute.

12. Clay - February 24, 2011

I saw that yesterday too … but their wording seems too general: “Other-than-finance lease – A lease that is similar to a rental transaction. Financing would not be considered a significant component of the arrangement”

What lease is not similar to a rental transaction? How can financing not be considered a significant component of any lease?

The answers to these two questions is the key to what makes this new standard different than SFAS 13 … if that line is no different than today’s standard then why pass a new standard?

13. Lou Battagliese - February 24, 2011

From what I have read, I still think the Other Than Finance Leases would still go on the balance sheet. I think the distinction is two fold: 1) different line items on the balance sheet and 2) pure straightline amortization of the asset and liability, rather than the financed model for both asset and liability that is now in play. I did not get the impression that they were taking a class of lease and keeping the current accounting.

Would be interested to hear other takes.

14. Clay - February 24, 2011

Interesting thought … So they both get a lease asset/liability but the other-than-finance leases are straight-lined to an amortization expense instead of rent expense or interest expense. I suppose the reading of “pattern of profit and loss recognition” would be consistent if it is straight lined too.

But still, what would be the line of demarcation line between the two? Do you foresee the same 90% FMV or 75% life tests of today? I am mainly concerned about real estate impact on landlords of multi-unit facilities where FMV is not distinguishable.

My initial take was that the P&L impact would be the same as today’s operating lease in line item too but they would in essence shift the exclusion of ST leases to all leases under a specific time frames (3 yrs or so) …

15. Lou Battagliese - February 24, 2011

I don’t think there will be any FMV demarcation under the new standard. All leases go on the balance sheet. Rent Expense goes away. FAS 13 no longer applies.

16. Clay - February 24, 2011

I too don’t think it will be a FMV … but rather comparison of the PV of future lease payments verses the raw sum of future lease payments, if that delta is not material, then I can see in essence a treatment similar to short-term lease or the operating lease accounting used today.

17. Clay - February 24, 2011

I was thinking about your take and have a question about recording a pure straightline amortization of the asset and liability. Would the original balance of the asset and liability be the PV of future lease payments? If it is then you think they will straightline interest expense? That doesn’t seem right.

If not, I don’t see how they could ignore the time-value of money on the balance sheet for long-term leases so they couldn’t just have the value be the sum of the raw payments either. In this scenario, how would you calculate and then amortize the balance sheet amounts as a straightline interest expense or rent expense?

18. Lou Battagliese - February 24, 2011

Haven’t seen anything published yet, but in the model we built, it is a 2 step process. You have to calculate the straightline cash rent, and also calculate the NPV of the payment stream using the incremental cost of funds rate. You multiply the NPV balance by the rate to get the period effective interest, and the difference between that amount and the straightline rent becomes the amortized amount for that period. So the combined annual interest expense and amortization would equal the sraightline rent expense, thereby eliminating the front end loading that was the big issue in the ED. In the model, the asset and liability zero out at the end of term, so it looks correct.

Clear as mud, right?

Clay - February 24, 2011

I would love to see the model … I need to T-Account this sucker to understand it. If you are on linkedin, I’ll find you and send you a note.

19. Richard L. Podos - February 28, 2011

Why not just use mortgage calculations? PMT, IPMT, and PPMT in Excel.

20. Clay - February 28, 2011

I agree, but I think the important question is which leases would even fall into the “other-than-financing” category? That clearly depends upon how they word their definition of “significant portion”. What would make the financing of lease payments not a significant portion? I think that would depend on the interest/discount rate used, but that for any lease over a year or two, how would financing not be a significant portion?


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