FASB, IASB Revised Proposals Would Cause Significant Lease Accounting Changes

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U.S. and international accounting standards setters May 16 issued a revised proposal that would significantly change current lease accounting practices for some industries by requiring companies to capitalize operating leases and include them as assets and liabilities on their balance sheets.

Financial Accounting Standards Board Chairman Leslie Seidman and International Accounting Standards Board Chairman Hans Hoogervorst told reporters after the issuance that retaining the principle of the earlier proposal that leases convey valuable rights and obligations that belong on the balance sheet would increase transparency in financial reporting for investors.

The joint proposal is expected to have a strong impact in the U.S. on industries such as airline, retail, and some health care-to the degree that they own properties-because it requires companies to capitalize operating leases and include them as assets and liabilities on their balance sheets.

The exposure document, Leases, was issued with a comment period ending Sept. 13, 2013. The boards are expected to issue a final standard in 2014.

Ultimate Outcome Uncertain

However, the proposal drew initial criticism from some industries and organizations on which the proposal is expected to have major impacts. Also, upcoming changes to the FASB board and differences within it cloud the proposal's fate.

Under existing accounting standards-FAS 13 and IAS 17-operating leases are not reported on a lessee's balance sheet, yet the amounts involved can be substantial. For entities that perform accounting for capital leases today, the accounting will not be that different.

"We have retained the same basic principle in this exposure draft and that is that leases convey valuable rights and obligations that belong on the balance sheet," said Seidman. "[W]e did though make numerous changes in response to the feedback we both received on the first proposal, and I would say the two key categories of changes that we made had to do with feedback we received that not all leases are the same and so this proposal does introduce two categories of leases to reflect those different types of economic arrangements," she said.

The second category of changes that were made, said Seidman, "was in response to some request for simplification of various aspects of the proposal and evaluation of the costs and the benefits of the proposal."

Leasing, a very important source of financing around the world with about $800 billion in new contracts yearly, are booked mostly as operating leases, which means that they go unrecorded on the balance sheet.

Investors have said that leases represent valuable rights and obligations that belong on the balance sheet, but do not agree how best to represent that in the income statement and the cash flow statement.

Hoogervorst stated that there was a lot of hidden leverage "outside the books," which the boards found to be unacceptable. "It's misleading to investors and so it's very important to get the bulk of leases on the balance sheet."

Hoogervorst said that is why the development of an improved leasing standard is vital. Citing the needs of users of financial statements, he said it was not in their interests to "expect analysts and others to guess the liabilities associated with leases."

Hoogervorst added, "The proposals outlined in this revised Exposure Draft will go a great distance towards improving the quality and comparability of financial reporting in this area."


For U.S. lessees, the proposed guidance-if finalized-would change the reporting guidance under FAS 13, where operating leases are off-balance sheet and disclosed in the footnotes and in the management discussion and analysis. The lease expense is recorded on a straight-line basis of the profit and loss statement under current practice.

The boards' proposal also would expand the definition of a lease payment to include certain variable rents as well as contractual payments and bargain or compelling renewal rents.

Cost Pattern Must Be Front-Ended

Moreover, they propose that the lease cost pattern for capitalized operating leases be front-ended, which would primarily affect equipment leases, as opposed to straight-lined as is currently required. Other capitalized operating leases-mostly real estate leases and short term leases of long lived equipment-would have straight-line expense.

This latest round of proposals to shake up lease accounting will scrap today's cut between operating and finance leases and instead force entities to account for the assets and liabilities that result from leasing arrangements.

Building on proposals first aired in an August 2010 exposure draft (6 APPR 590, 8/20/10), FASB and IASB in their second attempt have proposed that a lessee must recognize a right-of-use asset and a corresponding lease liability for all leases with a term of more than 12 months.

Lessees will also have the option to apply the same accounting to short-term leases of 12 months or less. Both the lease asset and the lease liability are measured at the present value of the lease payments.

Away from the balance sheet, the boards have put forward a dual approach to the recognition of the lease expense. The move is in response to feedback from constituents on the 2010 exposure draft.

This dual model treats leases of equipment differently from most leases of property, affects the recognition, measurement and presentation of expenses and cash flows arising under a lease contract.

Fewer Changes for Lessors

As for lessors, IASB noted in a summary document accompanying the exposure draft that, "For all practical purposes, there are few changes proposed to the accounting applied by lessors of finance leases."

In the case of operating leases, however, echoing the changes for lessees, "the extent of change would depend on whether the underlying asset is property or equipment."

Accordingly, while the boards expect the changes for operating leases of property to turn out to be insignificant, the changes for operating leases of vehicles or equipment could be significant.

Under the new model, the two boards anticipate that a vehicle or equipment lessor will:

  • recognize a lease receivable and a retained interest in the underlying asset on the balance sheet;
  • derecognize the underlying asset; and
  • recognize interest income on both the lease receivable and the residual asset over the lease term in the income statement.

In addition, a manufacturer or dealer lessor might recognize profit on the lease when the underlying asset is handed over for the lessee to use.

For both lessees and lessors, the boards have proposed they exclude "most" variable lease payments. Further, both a lessee and a lessor would account for option periods "only if the lessee has a significant economic incentive" to extend or terminate the lease.

Convergence Could Unravel

The future of the proposed standard, including keeping the current converged accounting solution, remains ambiguous and has the potential to unravel.

Three of FASB's seven board members have dissented on the proposal and given alternative views. With the departure of Seidman at the end of June, it is unclear if the FASB's vote will shift to a majority dissenting with the arrival of a new board member.

Asked by BNA to opine on that future potential for convergence to unravel-on this subject-with her departure, Seidman said the boards' process was designed to solicit views from stakeholders.

"So it's hard to predict at this point in time how the existing board members will respond to that feedback let alone a new board member," said Seidman. "So this is designed to help educate us and help inform us and so at the end of the day the board members who are seated at the point in time where we decide what the final standards will represent will have to take all of that input into consideration," she said.

Hoogervorst, who expressed hope that the boards would remain converged during an earlier question said that the standard was not a popular one and was least popular among preparers because it would put an end to a major part of off balance sheet financing.

"Given that resistance and also given the fact that it is not really easy to define what a lease precisely is-it is not clearly a service; it is not 100 percent financing; its somewhere in between-so it was also conceptually a very difficult standard and given the fact that the two boards have managed to stay together is quite an extraordinary achievement," he said.

Reaction Less Than Enthusiastic

The potential precariousness of the proposal was underscored by the initially cool reaction by some industry groups and practitioners.

The Equipment Leasing and Finance Association-long a critic of the direction the boards were taking-said in a press release that the lease accounting model as proposed would not result in a significant improvement in the quality or reliability of financial information.

"[It] will not faithfully depict the economics of equipment leases, is unduly complex and will impose a compliance burden on lessees," ELFA said.

ELFA's stated that its overriding concern is that any standard that replaces FAS 13 should improve the clarity in financial reporting of these transactions without undue burden on businesses from an accounting or financial standpoint.

The group said it would ask the boards to address a number of concerns about the proposal, including issues related to the new classification criteria for lessees and lessors, lease cost allocation for lessees and revenue recognition for lessors that will not reflect the legal and economic nature of lease transactions in the financial statements of lessees and lessors.

Still that organization, as do other practitioners, said they support the boards' effort to develop an accounting standard that applies to the assets and liabilities arising from lease transactions.

European Opposition

A representative of Europe's leasing industry also has attacked the joint proposals. Speaking May 16 during an in-depth interview with BNA following publication of the proposals, Lease Europe's director responsible for asset and finance research, Jacqueline Mills, said the boards have failed to address the fundamental issue of executory contract accounting.

Mills, whose organization is an umbrella body for Europe's leasing and automotive rental sectors, added that the boards have also failed to articulate a satisfactory conceptual basis for their decision to have a different income-statement treatment for leases of equipment and leases of real estate.

"The fundamental problem is that we still do not believe that the boards have explained why you should capitalize contracts that convey a right to use an asset but not other contracts that are executory in nature," said Mills.

No Conceptual Basis, A Fudge

Mills added, "Again, we do not think that there is a conceptual basis to distinguish the profit or loss treatment of equipment leases and real estate leases.

"This is a fudge that the boards have developed because the real-estate industry did not agree with the profit or loss result they got if you treat their leases as financing."

Dual Model Proves Controversial

The decision to adopt a twin-track approach to the lessee income statement has also proved controversial. Brian Donovan, a partner in KPMG's international standards group told BNA that he questions the conceptual basis for the move.

"The dual model for leases is inconsistent with the Boards' initial objective of introducing a single lease accounting model," Donovan said. "This is a major compromise by the boards, designed to make the proposals more palatable when applied to leases of property."

Lease Europe spokeswoman Mills added, "Again, we do not think that there is a conceptual basis to distinguish the profit or loss treatment of equipment leases and real estate leases.

"This is a fudge that the boards have developed because the real-estate industry did not agree with the profit or loss result they got if you treat their leases as financing."

And although Mills said she could "sympathize" with the view that not all leases are financing contracts, a distinction based on the underlying leased asset, was, she added, artificial.

"Also, this differentiation clearly contradicts the boards' argument that all leases are financing. The end result is very messy-who knows what leases are now? Certainly not the standard setters!" Mills said.

The end result is very messy-who knows what leases are now? Certainly not the standard setters!"

Jacqueline Mills, Lease Europe

Michael Keeler, CEO of LeaseAcceleartor, LCC told BNA that for companies that currently have capital leases, the proposed accounting requirements are not that different. From a dollar value standpoint, those industries with many physical locations, like retail, or large assets, like airlines, will be hit hard.

"Most leases will soon be capitalized, and applying the new FASB standard to equipment leases will be administratively more complex and nuanced than real-estate leases," said Keeler. "As a result, lessees must be able to perform accounting at the asset level," he said.

Keeler, whose company provides on demand lease accounting and portfolio management software for equipment lessees, said, as an example, if there is a clear economic inventive to renew assets, the renewal term must be included as part of the accounting amortization term, which means that the accounting term may differ from the contractual lease term on an asset-by-asset basis within the same lease.

"This will require an asset-based lease accounting system wrapped with the appropriate processes and practices to ensure the completeness, accuracy, and timeliness of data, given that the equipment and the stakeholders inside a company are widely geographically distributed," he said.

Next Steps

In terms of next steps, the boards will hold a webcast May 20 to discuss the proposal and plan to conduct joint field work during the 120-day comment period, said Seidman.

Included in that outreach, Seidman said, would be various kinds of field visits, roundtables and other meetings with stakeholders which will supplement the traditional way of feedback to the boards, in the form of comment letters.

Moreover, the FASB's Private Company Council is expected to give feedback on the topic at its July meeting.

For a copy of the main accounting provisions, including how to submit comments, go to http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176162613656.


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