The accounting rules for sale and leaseback (S&LB) transactions were the main issue considered in the latest round of re-deliberations of the proposed new global lease accounting standard after last year's second exposure draft (ED2).
The joint standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) – failed to reach agreement on a few of the issues involved and will be returning to them later.
However, it is already clear that the S&LB rules will be extensive; and in the case of international financial reporting standards (IFRS) they will be more complex than current rules.
Even though all leases will generally be going on-balance-sheet to the lessee under the new rules, the standard setters seem to feel that S&LB transactions could still be structured to obtain undue accounting advantages in the absence of special rules.
Recognizing a sale
The main issue concerns the conditions for both parties to recognize a sale and a return lease. Where a sale is not recognized, the alternative accounting treatment is for the S&LB transaction to be treated as a refinancing of the underlying asset. Under existing rules there are no restrictions on recognizing a sale, except for some real estate leases in US GAAP. As proposed in ED2, the Boards confirmed that the S&LB sale recognition rules will be mainly aligned with the general rules for recognizing sales of assets in the separate converged accounting standard for revenue recognition (Rev Rec). That standard has now been finalized and issued as IFRS 15, or Topic 606 in US GAAP. There will be only a few additional “override” criteria specific to S&LBs in the leasing standard.
The Rev Rec standard has a number of sale recognition criteria relevant to S&LB transactions. Each factor could count one way or the other; and none on its own would be conclusive. It would seem that three of the Rev Rec criteria as follows would operate in favour of recognizing a sale:
• The buyer/lessor takes legal title to the asset;
• The seller/lessee has a “present right to payment” for the transfer; and
• The buyer/lessor has “accepted” the transfer of the asset.
On the other hand one other Rev Rec criterion – the fact that the seller/lessee retains possession of the asset – would always count against sale recognition. The final criterion would be that of whether the buyer/lessor has assumed “significant risks and rewards of ownership of the asset”.
This would of course depend on the extent of any unguaranteed residual value (RV) in the return lease.
The Boards' staff report before the latest meeting acknowledged that simply cross-referring to the Rev Rec standard would mean that “in some circumstances there will be significant judgement in determining whether a sale has occurred” in typical S&LB structures. However, Board members were divided as to whether application guidance should be given in the leasing standard.
The IASB initially voted by a large majority against providing application guidance. However, some FASB members felt that guidance could be useful. FASB eventually decided to leave its decision on this until after receiving a further staff report on aspects of possible “override” conditions.
FASB's re-deliberation of these issues will be done at a joint meeting of the Boards. It is therefore possible, though it does not seem likely, that the IASB could then reconsider its decision not to provide application guidance in the IFRS version of the standard.
There was a further non-convergent decision on the “override” criteria, resulting from the earlier divergent decisions as to whether to retain lease classification (for profit and loss account expensing purposes) in lessee accounting. FASB decided that in US GAAP there will be no recognition of a sale in S&LBs where the lease is classified as “Type A” (i.e. a capital or finance lease under current rules). The IASB will have no corresponding override based on lease type.
Other S&LB issues
The Boards considered several aspects of the S&LB accounting rules in cases where the sale is recognized. The major one of these concerned whether any gain or loss compared with the initial carrying value of the underlying asset should be recognized up-front by the seller/lessee.
In ED2, given the proposal to change current practice by precluding sale recognition in some cases, no restriction was proposed on the up-front recognition of gains on the sale, where the sale itself could be recognized. However, the IASB has now adopted a more restrictive and complex rule on this aspect compared with the ED2 proposal; and here again the two Boards have adopted non-convergent solutions.
FASB decided that in the US GAAP version, there should be no deferral of gains (or losses) realized on the sale value under Type B (i.e. operating lease) deals. For IFRS the IASB agreed that while any losses on the sale would be recognized up-front, any gains would be subject to a partial deferral formula.
For this purpose, where the sale price giving rise to a gain is at a fair market value, the lessee under IFRS would first measure the PV of the lease payments as a proportion of the sale price. That proportion of the gain would be deferred; while the remainder (based on the RV as proportion of the sale price) would be recognized up front. The valuation of the lessee's “right of use” (ROU) asset would then be based on the PV of the lease payments less the deferred part of the gain.
Both Boards agreed that where a sale is recognized, both parties should account for the return lease in accordance with the normal lessee and lessor accounting rules.
The Boards agreed to defer their consideration of the detailed accounting rules for cases where a sale is not recognized, until after the further requested staff report is received.
The staff report had contained recommended transition rules for applying the new S&LB requirements to return lease contracts running at the date when reporting entities first have to apply the new standard. However, the Boards decided to defer consideration of this until they decide the general transition rules for all leases, towards the end of the re-deliberation process.
Lessor disclosure rules
The other issue re-deliberated this time concerned the disclosure rules for lessors in the notes to their accounts. Most of these rules were agreed on the same lines as the ED2 proposals. There were some changes reflecting the subsequent decision to retain the main current lessor accounting models, rather than moving to a new lease classification line as proposed in ED2.
The agreed rules will include several specified tabulations, with breakdowns between Type A and Type B leases, covering lease income and a maturity analysis of undiscounted future cash flows; asset class breakdowns of Type B leases (where the underlying asset, rather than receivables and RVs, will appear on the lessor's balance sheet); and narrative disclosures on such aspects as RV risk management. The IASB decided to drop a proposed ED2 disclosure that would have required a roll-forward reconciliation of opening and closing balances of Type A lease receivables and RVs. Instead it agreed a requirement to explain significant changes in the outstanding balance of the lessor's net investment in these leases (or in their receivables and RV components if these amounts are presented separately on the balance sheet) in the latest reporting period.
However, FASB has a separate current project on accounting for the credit impairment of financial instruments, which would include impairment of lessors' Type A lease portfolios. It therefore decided to defer consideration of a possible roll-forward disclosure for Type A receivables (which is not required at present in either US GAAP or IFRS) until it reaches the relevant stage of this impairment project. FASB nevertheless concurred with the IASB requirement for an explanation of changes, without a roll-forward reconciliation, in respect of RVs.
Some remaining issues
It now seems likely that the new lease accounting standard will be finalized in the foreseeable future, perhaps early next year. Possible longer delays from difficulties not yet anticipated by the Boards can nevertheless not be ruled out on past form; and some significant issues remain to be re-deliberated.
Apart from the deferred decisions on S&LB, the major remaining issues will be:
• possible exemptions from the lessee capitalization rule for small ticket assets;
• the disclosure rules for lessees;
• the transition rules for leases running at the adoption dates; and
• the general effective date of the new standard.
The further report on small ticket exemptions was called for when the Boards first considered this in March, but has been long delayed. It is now expected in September