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Will lease accounting be re-exposed? Should the tail wag the dog? July 18, 2011

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.


The second quarter of 2011 has come and gone … and FASB and IASB are still re-deliberating their proposal for a new standard for accounting for leases.  They had targeted the end of June for issuing the new standard but announced in May that they would take more time to make sure they got it right.  They say they now plan to issue by the end of this calendar year.

Some people are questioning whether the Boards can issue by year end.   People wonder if there will be a need to re-expose the standard, something  the Boards are doing for the new Revenue Recognition standard which has been on a similar parallel course.   If the re-deliberations for the lease accounting standard take the standard too far afield from that proposed in the Exposure Draft of August 2010 (the “ED”), the Boards will probably feel compelled to re-expose by releasing a new draft and giving the public time to comment on this new draft before finalizing.   In that case, the standard probably won’t be issued until sometime in 2012.  If, however, the re-deliberations don’t result in a standard too different from the ED, then no re-exposure would be necessary, and issuance by the end of 2011 should be possible.

So where are deliberations and how far from the original ED have tentative decisions moved the proposal as it now sits?  Will re-exposure be necessary?   Can this get done by the end of this year?

How has accounting proposal changed?

Earlier this month, FASB released a presentation that gives an update of how the ED proposal has changed through deliberations.  The take-away:  not very much.   They have made no change to the basic concept of putting leases on the balance sheet as right-of-use assets and lease liabilities.  More importantly, the Boards have made no or little change to the five elements of the proposal that were arguably the most controversial for lessees.  Specifically:

Definition of lease.  Many contracts that are not conventionally thought to be leases, may be brought under the umbrella of lease accounting.  The result:  some of the future payment obligations for these contracts will have to go on-balance sheet.  While the Boards have provided some clarification to the definition, they are largely sticking with the standard outlined in the ED.  A lease exists if the client controls the use of a specified asset,  with “control” being interpreted very broadly to include situations where a client receives all but an insignificant part of the benefit of an asset.

Pattern of expense recognition.  The new accounting results in the P&L expenses related to a lease being higher in the early years than in the later years.  For long leases, this pattern is very pronounced, and many comment letters received by the Boards criticized the pattern as not portraying the economics of the lease well.  The Boards investigated the possibility of defining two types of leases … finance leases and other-than-finance leases  … with the latter being accounted for using the “straight-line expensing” presently used for operating leases.  When the boards began this investigations, many observers jumped to the conclusion that the Boards had “reversed course”.  In fact, after considering the possibility of two types of leases, the Boards decided it wasn’t a workable solution … leading observers to claim, again, that the board had “reversed course”.  As of now, the Boards are contemplating no change to the pattern of expense recognition outlined in the ED.  Note: 180 degrees + 180 degrees = 360 degrees.

Capitalization of optional renewal periods.   The ED called for lease liabilities during optional renewal periods to be capitalized if it was more likely than not that the lease would be renewed.  This evoked an outcry from the public.  People questioned both the accounting validity of capitalizing renewal periods that were not yet contractually obligated and the cost/benefit of collecting this data given the complex processes that would have to be run to determine whether an optional renewal periods needed to be capitalized.  The Boards responded by abandoning the “more likely than not” test and replacing it with an “economic incentive” test.  Now, an optional renewal period will only be capitalized if there is a significant economic incentive to renew.  Initially, many interpreted this as applying only to situations where the economic incentive was embedded within the lease, for example, in the form of a renewal rate at a significant discount to market.  The Boards have clarified, though, that the test needs to go beyond contractual language and needs to look at the facts related to the specific asset and the lessee’s situation.  Presumably, for example, one would look at how much had been invested in the asset and how important the asset was to the lessee given its current business.  It looks to me like this test is not significantly different from “more likely than not”, and modifying the test is probably not going to force a re-exposure.

Re-assessments.   The ED required that a company reassess all the assumptions for its leases, e.g. those affecting whether an optional renewal period needs to be capitalized, each time it issues financial reports.  Many were worried that the need to revisit each and every assumption for each and every lease, each and every quarter, would be overly burdensome.  The Boards have now stated that these re-assessments would only be necessary if there was a significant change to a company’s business.   While many saw this as a major change,  I always felt that this is how companies would have implemented the standard anyway, and so I see this as more of a clarification of the ED’s intent.

Short-term leases.   The Boards received many comment letters opining that short-term leases should be excluded from the standard.   The Board has responded by saying that a company could opt out of capitalizing short term leases.  The catch, though, is that short-term leases will be deemed to be only those leases that have a maximum possible lease length of 12 months, taking into account options to renew.  This really limits the number of leases that would not have to be capitalized and is therefore just a minor change to the ED.  I doubt it would require re-exposure.

What clarifications have been made?

The boards have made a number of other statements that should be considered clarifications.  These regard elements of the standard addressing situations like sale/leasebacks, contracts with both service and lease components, purchase options, residual-value guarantees, variable lease payments, and foreign-exchange changes.  None of these clarifications seem important enough to re-expose the ED.

What is left to deliberate?

So, what is left to deliberate and might these remaining deliberations result in changes requiring re-exposure?   Possibly.

FASB outlines five areas still being re-deliberated:  Lessor Accounting, Presentation, Disclosures, Transition, Effective Date.  Only the first of these seems to have the potential to require re-exposure.  As for the others:

“Presentation” … the issue of how right-of-use assets, lease liabilities, and their related expenses and cash flow effects are presented on financial statements … is largely a technical matter that the Boards will determine, taking into account input it has already received from accounting firms.

“Disclosures” … which will define what details on a lease portfolio needs to be provided in a company’s footnotes … could be somewhat controversial because it will guide how much work companies have to do to assemble that information.  It is likely, though, that this section of the standard will not be too specific in detailing what information must be presented, leaving that decision to a company and its auditors.

“Transition” … which will outline how companies will begin to use the new standard and abandon the old standard … and the “Effective Date” … which sets the timetable for the transition … will be of interest to everyone, but does not seem to be something that would warrant re-exposure.

Lessor Accounting

The only remaining re-deliberation with the potential to force a re-exposure of the lease accounting standard might be lessor accounting, which has been a problem in terms of getting the standard out ever since the beginning of deliberations.  A couple years ago, the Boards were going to not address lessor accounting in the context of the new standard, which they intended to be just about lessee accounting.   A few months prior to issuing the ED, though, they decided that lessor accounting did need to be included.

Lessor accounting has turned out to be more difficult to develop than anticipated.  It was the primary reason the Boards missed their target of issuing the Exposure Draft by June of 2010 (and not issuing it until August 2010).  It could become the reason the Boards miss their target of issuing a standard by the end of this year.

The Boards have proposed two approaches to be applied in lessor accounting:  ”de-recognition” and “performance obligation”.  These represent major changes to lessor accounting and probably have a lot of issues yet to be ironed out.  If new elements are added to lessor accounting as a result of ironing out these issues, it may become necessary to re-expose the whole lease accounting standard.  The irony, though, is that lessor accounting is not that important to anyone.  Landlords, to the extent they are concerned about GAAP, are more concerned about accounting for cash flow, which would not be significantly affected by the new standard; they are not that concerned about accounting  for balance sheets or income statements.

That is why the Boards haven’t spent a lot of time discovering and resolving issues related to their proposal.  They seem to leave re-deliberations on lessor accounting to the tail-end of meetings; in fact, they’ve left it to the tail-end of the entire re-deliberation process.   This tail could, though, delay the whole issuance process if the Boards aren’t careful.

Will the Boards issue standard without lessor accounting?

The Boards have identified lease accounting as a high-priority project because today’s lessee accounting is severely broken.  It seems a shame if the Boards need to delay issuance because of lessor accounting which not many people care about, anyway.

I wonder if the Boards will find a way to issue the new standard this year by not including lessor accounting, except perhaps as it relates to a lessee’s subleasing.  The re-deliberations regarding lessee accounting are largely complete.   In fact, the Boards could possibly issue as early as the third quarter if they ignore lessor accounting.   They could then issue the lessor accounting later.

The Boards need to find a way to issue the standard without re-deliberations on lessor accounting getting in the way.  They can’t let lessor accounting delay lessee accounting.  They can’t let the “tail wag the dog”.


1. Barry Toner - July 19, 2011


Thanks for the article. As someone who has not been following each step in the process – I found this a helpful catch-up and commentary.

Stretching your metaphor a little – “is the dog’s bark worse than it’s bite?”. In other words – do the provisions you expect to see in the final standard really matter to decision makers in the business – or is this just a lot of “busy work” for accounting professionals?

My question is a little tongue-in-cheek to prompt responses.



2. Bob Cook - July 19, 2011


Thanks for your comment which gives me the opportunity to remind people why this new accounting is good for society.

Most people focus on the administrative burden caused by the new accounting, but the focus should be on how the accounting will “true up” balance sheets so they better reflect the financial positions of companies. The societal benefit is that better disclosure of company financial positions will allow investors to better evaluate equity and debt investments which, in turn, will allow society as a whole to better allocate capital resources … ultimately helping GDP.

It is often pointed out that the “rule of law” is one of the reasons the U.S. has a dominant economy. The same concept applies to the “rule of accounting”.

The new lease accounting standards will definitely provide more information to investors than they now have and will elevate the visibility of leases. Company balance sheets will be significantly affected, many will be transformed … particularly in industries like retail and restaurants, which is not surprising, but also in industries like technology and business services which are not generally viewed by the public as being so dependent on leasing as a way to finance company operations. Stock investors will now view the riskiness of these companies differently. And based on research I’ve done, all companies will not be affected the same. While they all will have to apply the new standard, their past decisions related to own-vs-lease and lease length will affect how they fare relative to their peers. There will be winners and losers.

While this new accounting will increase administrative and accounting work and while the effort will be large, it is not that large relative to the size of the balance sheet items being accounted for. Companies presently spend a lot more time accounting for much smaller things. The fact that lease accounting has not been on the balance sheet has been major defect in accounting standards which will now be corrected. Unless one argues against having accounting standards at all … and doubt that many knowledgeable persons would .. it is difficult to argue against these new lease accounting standards.

3. FASB will re-expose lease accounting draft, but looks to still issue by year end « Corporate Real Estate Strategy - July 22, 2011

[…] The faster track probably reflects two things.  First, the Boards’ feel a sense of urgency to get the lease standard out, and second, the proposed standard as it applies to lessees has not changed that much from the August 2010 Exposure Draft.  See my previous post.  […]

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