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Remi Forgeas
Remi Forgeas

Accounting for Leases

In August 2010, the IASB and the FASB jointly issued a draft standard on the accounting treatment of leases that intended to replace the current literature on leases under U.S. GAAP and IFRS.

March 3, 2011
by Remi Forgeas, CPA

The main feature of this exposure draft is the recognition of all leases in the statement of financial position of the lessee, without distinguishing between operating and financial leases. For lessor accounting, a hybrid model based on the economic characteristics of the contract was proposed, leading to the application of either the partial-derecognition approach or the performance-obligation approach.

A lot of responses were received (about 800 comments letters). The International Accounting Standards Board (IASB) staff has just published a summary (PDF) of the comments received in letters and during the round tables and workshops organised during the second half of 2010.

Comments on Accounting Models

Lessee accounting

There was broad support for the boards' efforts in developing a single, comprehensive and converged model for lease accounting. The proposed model consists of the recognition of a right of use and a financial liability. Beyond this basic principle, criticisms are numerous and relate to:

  • The complexity and the cost of implementation, specifically the initial and subsequent measurement of lease assets/liabilities;
  • The reduced comparability due to the level of estimation and judgement required (e.g. determination of lease term and calculation of variable lease payments);
  • The recognition in the statement of operations, which will no longer be straight-lined.
Lessor accounting

Comments are almost unanimous in censuring the proposed hybrid model. Many judge this model to be less comprehensive than the one developed for lessees. Many commentators suggest that substantial work should be undertaken by the two boards before any amendments to lessor accounting can be made.

The responses express doubts that the draft generates improvements compared to the current standard. Moreover, many consider the current lessor accounting model works just fine. In addition, many emphasized the complexity of the hybrid model and the unfavorable cost/benefit ratio that would result from implementing such a model.

The views of stakeholders differ, however, as to whether the lessee accounting should be finalized first before addressing the lessor accounting or to cover both models in a single project while accepting further delay in the adoption of the standard.

Comments on Key Features

Definition of a lease

A majority of commentators considers the definition of a lease as proposed in the draft is not narrow enough. Another complaint is that this definition makes the assessment whether a contract should be accounted for as a lease or as a service sometime impossible.

The general view is that with an appropriate definition of a lease contract and an appropriate definition of a sale (in the Revenue From Contracts With Customers exposure draft), no additional guidance on distinguishing a lease from a purchase/sale contract would be needed.

Lease term

There is a clear consensus among the respondents: almost everyone disagreed with the definition of the lease term as the longest possible term, that is more likely than not, to occur.

The main alternatives proposed were:

  • Retaining a "reasonably certain" term, which comes close to retaining the existing IAS 17 definition;
  • Reflecting options to cancel/extend leases but only when the lease contract includes incentives for the lessee or lessor to exercise the options, in other words when, it is highly probable that options will be exercised.
Estimating lease payments

Many respondents disagreed with the proposal to estimate-lease payments, term-option penalties and residual-value guarantees using an expected outcome technique.

The general view is that estimating variable lease payments would be costly. Doubts exist on the reliability of these estimates. In the absence of a reliable measurement of lease/liabilities, unjustified volatility would be reflected in profit or loss.

Nor was there unanimous support for taking account of all contingent-lease payments.

Short-term leases

Responses welcomed the introduction of a simplified treatment for short-term leases. However, many proposed that this simplified approach should be consistent with current operating lease accounting for both lessors and lessees (the exposure draft requires lessees to continue to recognize a lease asset and a lease liability in their statement of financial position).

Other matters
  • Responses also revealed that stakeholders were concerned about the following aspects:
  • The accounting for purchase options;
  • The criteria for recognising a transaction as a sale and leaseback;
  • The presentation in the income statement or in the statement of financial position, which should be left to the judgement of each entity;
  • The extend of disclosures;
  • The choice between a full retrospective accounting at the adoption date or the simplified retrospective basis proposed in the exposure draft (ED);
  • The determination of the discount rate;
  • The accounting for leases between the signature of the lease and the commencement date.
What emerges from the staff analysis?

Overall responses to the single model proposed for lessee accounting are fairly favorable. However, critics focused on the reliance on estimates and judgements, especially on the following:

  • Estimation of the lease liability and the lease asset;
  • Determination of the lease term;
  • Measurement of contingent lease payments.

On the flip side, the hybrid model of lessor accounting was heavily criticized and the staff has been asked to conduct a thorough re-examination of this model.

The definition of a lease also provoked calls for clarification, in particular in order to differentiate lease contracts from in-substance sale.

Given the short deadline (June 30, 2011 is the expected issuance date) and the extent of the outstanding work, commentators have strongly recommended that the staff should focus on drafting a standard based on sound principles, even if this implies additional delay in the issuance date of the standard.

What Should Be the IASB/FASB Action Plan for the Coming Months?

The two boards have published a working document presenting a proposed timetable for their re-deliberations. They have identified five main themes to be addressed:

  • Definition of a lease;
  • Lessor accounting model;
  • Lease term;
  • Contingent-lease payments;
  • Profit & loss (P&L) recognition pattern.

Two sessions were held in January 2011 and two others in February 2011:

  • The Boards have considered a method to distinguish a lease contract from a service contract;
  • The Boards have noted that many responses stressed the reasons for which an entity chooses to enter into a lease contract rather than an acquisition. The choice is generally motivated either to finance the use of the underlying asset or to gain on operational flexibility. This observation led the two Boards to wonder if it might be necessary to develop two approaches to the 'right of use' model both for lessor and lessee accounting, to take account of the economic reasons that persuade entities to opt for leasing;
  • The definition of a lease was revisited;
  • The Boards requested the staff to initiate a targeted outreach to help them to make their final decisions.

Conclusion

The nature of the subjects debated by the Boards in January illustrates the complexity of the topics and the fact that major topics may have to be revisited, which will take some time.

However, the IASB and the Financial Accounting Standards Board (FASB) reiterated that the current timetable is unchanged and the standard is still expected in June 2011.

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Remi Forgeas, CPA, is an audit and assurance partner for Mazars US and provides his views on international convergence of GAAP and whether progress is really being made in light of recent developments. For U.K. IFRS, you can contact, Steven Brice who is a technical partner in the financial reporting advisory group for Mazars UK and provides his views on international convergence of GAAP and whether progress is really being made in light of recent developments

* The views expressed in this article are the author’s own and do not necessarily reflect the views of the AICPA or AICPA Corporate Finance Insider.