Written by Andy Thompson
This month the accounting standard setting bodies completed what should be the final stage of public re-deliberation of the draft new global lease accounting standard before the re-exposure draft (RED) is to be issued, probably in April this year.
These bodies are conscious that their main proposals will be contentious, and have been taking some advice through an external review process to ensure so far as possible that the issues are not complicated by any avoidable technical weaknesses.
The main round of public re-deliberation, bringing major changes to the first exposure draft (ED1) issued in 2010, was completed by the standard settershe International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) - in the middle of last year. Since then, however, the Boards have held further public "sweep-up" sessions on technical issues identified either by their staffs in the re-drafting process or by their external review advisers.
Transition for finance leases
From the standpoint of equipment leasing the main decision of the Boards this month concerns the transition rules, for both lessees and lessors, for those leases currently classified as finance or capital leases and which are running at the date when the reporting entity first has to make the transition to the new standard.
Since the Boards' first detailed proposals for transition in ED1, they have proposed a relatively simple "grandfathering" type solution for transitioning finance leases, which are of course already on-balance-sheet for the lessee. This involves carrying forward the same depreciated balance sheet amounts for the lessee's assets and liabilities under the lease, or for the lessor's receivables, as derived under the current accounting rules.
Under the controversial proposals adopted by the Boards in June 2012 for an "equipment v real estate" split (subject to some exceptions) in lessees' annual profit and loss (P&L) account expenses and lessors' income recognition profiles, all current finance leases (as well as many operating leases) will be within what the Board are now calling the Type 1 category. The accounting rules for these will broadly match current finance lease accounting, which of course strengthens the case for a simplified transition solution.
However, during the pre-RED review process it became apparent to the Boards that they had not fully clarified, and indeed perhaps not fully considered, how the grandfathering of finance leases should work after Day 1 of the transition.
For there will be some differences between current finance lease and new Type 1 lease accounting, mainly in the area of residual values (RVs) and more particularly RV guarantees (RVGs). For lessees, RVGs must currently be included in the measurement of minimum lease payments up to the maximum RVG amounts payable, whereas in the new rules they will be included only up to the expected amounts.
On the lessor accounting side, under the new Receivable and Residual (R&R) accounting model RVGs will be accounted for separately from the lease receivables, whereas at present they are included within them. The same is true of unguaranteed RVs, although by definition any of these will be relatively small in finance leases.
On the other hand the Boards feel that the more far reaching changes in lease measurement between the current and new rules, in such areas as contingent and variable rentals, will not arise to a significant extent on finance leases but only on operating leases.
The Boards wanted to avoid keeping the current leasing standards in operation alongside the new ones, just so that reporting entities could be referred to the rules for grandfathered transactions.
They have now confirmed that for both lessees and lessors, the carrying amounts for finance leases on transition will be the same as those immediately before under existing rules. For presentation and disclosure purposes, RVGs and RVs will remain quantified and characterized as under existing rules (i.e. reflecting existing measurement rules for lessees, and embedded within receivables for lessors) unless the lease is modified, for example through an upgrade, in which case it will be re-measured under the new rules.
This solution represented a compromise between two alternatives which had been identified in the staff report. The precise wording of the relevant part of the draft RED will therefore require some further re-drafting. As previously agreed by the Boards, lessees and lessors will have the option of a fully retrospective application of the new rules to running finance leases, though it seems perhaps unlikely that many will opt for it.
Other transition issues
The more challenging transition issue, particularly on the lessee side, is that for operating leases. In October 2011 the Boards agreed a significant simplification of what had been proposed there in ED1. That decision was not revisited this week, although it was made before the decision for the "equipment v real estate" (or Type 1/ Type 2) split for P&L accounting purposes, and current operating leases will be split between the two types.
The principles of the earlier decision on operating lease transition are considered equally applicable to Type 1 and Type 2 leases under the proposed new rules. Indeed the draft of this part of the RED was included in this week’s staff report on finance lease transition, in case the Boards might have wished to make a radical change in the earlier decision on finance lease transition by applying the same transition rules for both existing types of lease. As noted above, however, this was not their decision.
In conjunction with the joint Boards’ review of finance lease transition, FASB alone also this month reviewed the transition rules for US lessors under "leveraged leases". These represent a special class of capital or finance lease on which tax benefits are generally available to the lessor and the lease is largely funded by a third party investor who has recourse to the lease receivables rather than to the lessor as a debtor.
Current rules in US GAAP allow for linked accounting for the leveraged lease and the funding debt. They also allow for the deferred tax position to be taken into account in measuring the lessor’s net investment in the lease from one period to the next, for the purpose of deriving a constant periodic rate of return on the lease. There is no comparable rule within international reporting standards (IFRS); and lessee accounting in US GAAP is of course the same for these leases as for other capital leases.
FASB had already agreed that leveraged lease accounting will not be retained in the new converged standard, and there will be no grandfathering for such leases running at the time of transition. This week FASB decided that leveraged leases will be subject to fully retrospective transition. They decided not to adopt a staff recommendation to apply the same transition rules for these as for other capital leases.
The other decision this month affects only accounting for real estate sub-leases by entities subject to IFRS. It arose as an indirect consequence of the Boards' decision last June on the lessee's P&L profile.
This concerns the case where a sub-leased property falls within the definition of "investment property", viewed from the sub-lessor's standpoint. This will usually be the case where the sub-leased premises are held primarily for generating rental income, rather than to reserve them for future occupational use in the sub-lessor's own business subsequent to the sub-lease period.
Under the IAS 40 standard, lessors of investment property can account for it on a "fair value" basis, with gains or losses from regular revaluations taken to P&L, as an alternative to accounting for it at cost. However, the IAS 17 general lease accounting rules apply to all lessees of investment property (including sub-lessors in respect of their head leases), and also to property lessors where the lease is either outside the investment property definition or opted out of fair value accounting (FVA) and accounted for at cost..
FVA is always an elective option under IAS 40. However, where an investment property lease is a sub-lease, under current rules the finance/ operating lease classification of the head lease makes a material difference to the degree of flexibility in the FVA election.
Where the head lease is an operating lease, an investment property sub-lease can be opted into FVA individually. By contrast, the election can only be exercised en bloc for all of any investment properties that an entity either owns outright or holds on finance leases.
Following the Boards’ decision last June, there will in effect be a new form of polarized lease classification in the new converged general leasing standard. Among cases where a sub-lease is classed as an investment property lease, it seems likely that there will be head leases on either side of the new line. For example, to take real estate lease periods that are customary in the UK, 99-year leases are likely to be classed as Type 1 (in line with nearly all equipment leases); while 25-year commercial property leases would generally be in Type 2, with straight line P&L expensing for lessees.
The IASB therefore considered this month whether the difference of treatment within IAS 40 by reference to head leases should be carried forward to the new lease classification. That would have meant allowing investment property sub-lessors to exercise the FVA option on a lease-by-lease basis where the head lease is classified as Type 2, as they can now where the head lease is an operating lease.
However, the Board decided against this. They agreed that for the purpose of the FVA election on sub-leases, once the new general leasing standard is in place all head leases should have the same effect as those now classed as finance leases. The election will thus have to be exercised en bloc for all of an entity's investment property leases, whether the real estate is owned outright by the lessor or held on any kind of head lease.
This issue does not currently arise in US GAAP, which has no FVA rules for investment property. FASB is working on the adoption of an investment property standard, but as presently conceived it will not be fully converged with IAS 40 since it will apply FVA on a non-elective basis and possibly to a narrower range of entities.
Depending on its final form, FASB's future investment property standard may or may not need to incorporate specific rules related to sub-lessors' head leases. In IFRS, however, the new agreed rule for this will be within the general leasing standard. As with the first ED, the RED and final form of the standard will have separate IASB and FASB versions to cover limited points of divergence, mostly resulting from areas of interface with related non-converged standards like IAS 40.
The timetable now
It appears that the RED will not specify the proposed effective date of the new standard, nor even a possible "not before" date as was done in ED1. Instead the effective date will be decided when the final new standard is close to release.
The proposed Type 1/ Type 2 split for P&L accounting purposes seems certain to generate critical comment, and prior to the RED it will not have been field tested in any outreach process with account preparers and users. That could yet be a cause of even further delay.
However, if the Boards feel able to finalize the standard in accordance with the RED it may be possible to issue it towards the end of this year. In that case it now seems likely that the effective date would be for accounting periods beginning on or after January 1, 2017. For listed companies, the dates of initial application, from which comparative accounts will have to be prepared on the new basis alongside main accounts under the existing rules, could then be January 2015 for those subject to US GAAP and January 2016 under IFRS.
Significantly, the Boards this month decided on an effective date of January 2017 for a separate new converged accounting standard on the general subject of revenue recognition (Rev Rec). The Rev Rec standard has many areas of interface with the lessor side (though not the lessee side) of the leasing standard, and the two projects were originally intended to be contemporary.
Although both had to be re-exposed, the further long delays in the leasing standard between its two ED versions has led to its falling behind the Rev Rec one, which is now about to be issued in its final form following an RED issued 15 months ago. However, the Boards will probably be aiming for a common effective date for both