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Next Round of Debate Set to Begin for Lease Accounting Project

March 12, 2014

After discussing ideas in January, the FASB and IASB plan to use a March meeting to discuss two major elements of their proposal to overhaul lease accounting. The boards are scheduled to decide on the best approaches for lessee and lessor accounting. The topics represent the crux of the joint project—and the areas that have stirred the most controversy.

The FASB and IASB have scheduled a March 18-19, 2014, meeting to make some important decisions on their much-watched project to require businesses worldwide to own up to lease expenses on their balance sheets.

On tap are discussions about how companies should tally up expenses associated with leased office space and equipment, and how lessors—landlords and equipment rental companies—should account for their liabilities. The boards also plan to discuss ways to make the whole process simpler, perhaps by excluding leases of so-called “small-ticket” items, such as water coolers or photocopiers, from the proposed accounting plan entirely, according to memos released in advance of the meeting, which will be held at FASB headquarters in Norwalk, Connecticut.

Current accounting allows the vast majority of lease obligations to stay off company balance sheets, which critics say makes businesses look less indebted than they really are. The FASB and IASB’s proposals, released in June 2013 via the FASB’s Proposed Accounting Standards Update (ASU) No. 2013-270 Leases (Topic 842), and the IASB’s Exposure Draft (ED) No. 2013-5, Leases, set the boards on course for a sea change in accounting practice for almost all businesses that rely on rented office space, airplanes, or heavy equipment for their operations.

Under the proposals, companies would have to recognize things like rented offices and trucks as assets and the contractual payments for them as liabilities.

The draft standards divide leases into two categories—those akin to rentals and those similar to financing arrangements. Companies would draw the distinction based on how much of the asset is consumed over the life of the contract.

An asset with most of its life left at the end would be recorded in a manner that’s similar to a rental expense, with even payments over time—a “Type B” lease. A leased asset where most of the life is used up would be accounted for as a financing transaction—”Type A.” As a shortcut, the boards decided that almost all leases of office buildings or storefronts would receive the even, or straight-line, expense-recognition treatment, while almost all leases of equipment would receive financing treatment, with interest and amortization calculated with the rental expense. Because interest is calculated on a declining balance over time, the cost to rent a piece of equipment would look more expensive at the beginning of the lease term.

The division pleased real estate companies but has continued to rankle companies that lease equipment to businesses. Many businesses and auditors also complain that the division between the two types of leases is overly complicated and would not improve existing accounting.

Because settling the accounting for lessees and lessors is such a major undertaking, the FASB and IASB prepared for the discussion in January, when they reviewed concerns raised in the proposals and tried to brainstorm the best responses to these criticisms. The boards did not take formal action at the January meeting but used it to lay the groundwork to take significant steps in March. (See Planned Lease Standard Faces Hurdles Before It’s Completed in the January 24, 2014, edition of Accounting & Compliance Alert.)

The agenda for the March meeting is very similar to the one presented in January, with some slight changes.

On the lessee model—the crux of the project—the FASB and IASB plan to discuss four potential alternatives, none of which are identical to the approach used in the exposure drafts.

The first alternative calls for accounting for all leases, regardless of type of asset, as a financing transaction, a proposal that likely will gain support from some IASB members but is not likely to gain traction on the U.S. board.

A second option calls for a dual approach that would permit, but not require, lessees to account for most property leases as Type B leases, or as rentals. This is a new approach that was not discussed in January.

A third alternative is the most similar to the 2013 proposal, but with some tweaks: A lessee would account for all leases of assets other than property as Type A leases and most property leases as Type B.

A fourth option also calls for a dual approach, with lease classification determined in accordance with existing lease requirements in U.S. GAAP and IFRS. Under this method, a lessee would account for the vast majority of existing capital or finance leases as Type A and the vast majority of existing operating leases as Type B.

Notably, the FASB and IASB research staff do not include a recommendation in the meeting memo. The agenda paper instead states that staff members are divided in their views, which underscores the difficulty of this complicated topic.

For lessors, the boards plan to discuss three options.

The first is similar to the accounting in the 2013 proposals, in that a lessor lease classification would be based on whether the lease is effectively a financing or a sale, rather than an operating lease. A lessor would make the call based on whether the lease transfers substantially all the risks and rewards of ownership of the asset being rented.

The second would determine the classification based on the same assessment. This second approach would not allow recognition of selling profit and revenue at lease commencement for any financing lease that does not transfer control of the underlying asset to the lessee.

The third alternative would require a classification distinction based on the lessor’s business model.

The FASB and IASB staff recommend the second approach, which they say would better align the lessor accounting guidance with the boards’ forthcoming, separate accounting standard on revenue recognition.

“Approach 2 would retain, in the final leases guidance, the present link with respect to sale accounting between existing U.S. GAAP and IFRS leases and revenue guidance, which the staff view as beneficial,” according to the meeting memos.

Finally, the boards plan to discuss how to offer relief to businesses that have dozens or even hundreds of small-dollar leases.

The boards will be presented with three options: provide explicit guidance about which leases should be considered “material;” allow the leases guidance to be applied at a portfolio, rather than individual, level; or spell out an explicit recognition and measurement exemption for leases of small, nonspecialized assets.

The boards also plan to discuss how to fine-tune a part of the 2013 proposals that called for exempting short-term leases from the proposed accounting overhaul.

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