Lease accounting update: “more likely than not” is no more February 17, 2011Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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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