Potential Impacts of the New Lease Accounting Exposure DraftBy Scott Stafford
Article Date: 12-01-2010
Copyright(C) 2010 Associated Equipment Distributors. All Rights Reserved.
Understand the lessee and the lessor perspectives, because for many dealers, both situations apply.
In August of this year, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a joint exposure draft on lease accounting that, if adopted, would create significant changes for both lessees and lessors. This exposure draft is a product of the ongoing convergence project between the FASB and IASB to steer the United States into a successful adoption of international financial reporting standards.
While the issuance of this exposure draft provides us a much clearer picture of the future of lease accounting that these two standard setting-bodies have in mind, it has generated a lot of discussion and it remains open for further public comment until Dec. 15 of this year. As a result of this discussion, the final form of the new lease standard cannot be predicted with certainty. However, it continues to appear certain that a change is coming, so let's examine the key points of the exposure draft and what they might mean to your dealership's financial statements.
As expected, the exposure draft proposes to eliminate for almost all U.S. leases the generally accepted accounting standards (USGAAP) operating lease concept and the off balance sheet treatment that these leases currently enjoy. The elimination of this concept is intended to result in companies' financial statements being more transparent of their leases' economics by requiring companies to record assets and liabilities that reflect their rights and obligations under the lease contract.
The best way to examine the proposal's potential accounting impact is to view it from two perspectives: (1.) the lessee perspective and (2.) the lessor perspective. In the equipment distribution industry, a dealership is frequently both a lessee and a lessor. Property such as a branch location and equipment assets such as service trucks are often leased by a dealership, placing you in the "lessee" bucket. Additionally, many dealers lease equipment to their customers, which places you in the "lessor" bucket as well.
From the lessee perspective, the principle vehicle for bringing leased assets onto the balance sheet is the new concept of the "right-of-use asset" (ROUA). The ROUA would be offset by a corresponding liability to recognize the future rental payments due under the lease contract. Both the ROUA and its related liability would be measured at fair value, which would be computed as the present value of the lease payments using the lessee's incremental borrowing rate (i.e., your dealership's current borrowing rate) or, if known, the borrowing rate charged by the lessor in the lease contract as the discount rate in the present value calculation. This calculation would be heavily influenced by both the lease term and the lease payment requirements. As such, each has to be carefully determined.
Lease Term Determination – In evaluating the lease term, the lessee would have to consider both contractual and noncontractual factors. Contractual factors include but are not limited to:
And noncontractual factors include but are not limited to:
- Renewal options
- Termination penalties
- Residual value guarantees
After considering these factors, the term used would be estimated as the longest possible term that is more likely than not to occur. To illustrate this concept, let's assume a lease has a 10-year, noncancellable term with two 5-year renewal options. The lessee would consider these contractual factors, as well as the noncontractual factors, and perform a probability weighting of each possible term scenario. As an example: n 10-year term only – 40 percent likely n 15-year term (10 initial years plus exercise of one 5-year renewal) – 30 percent likely n 20-year term (20 initial years plus exercise of both 5-year renewals) – 30 percent likely
- Legal requirements
- Business concerns (such as whether the leased asset is crucial to their operations)
- Existence of significant leasehold improvements
- Their own intentions and past practices
Under these probability scenarios, there is a 70 percent chance that the term will be at least 10 years, a 60 percent chance it will be at least 15 years, and only a 30 percent chance it will be 20 years. As 15 years is the longest possible term that is more than 50 percent likely to occur, it would be deemed the longest period more likely than not to occur, and would be used as the term for calculation of the ROUA and related liability.
Lease Payment Requirement Determination – The lessee would also take a probability-weighted approach in considering the lease payment requirements. Factors in this calculation include the base rental rate, potential contingent rental payment requirements, residual value guarantees, and any term option penalties that may be present in the lease agreement. For contingent rentals that are tied to an index (such as the Consumer Price Index, which is common in long-term property leases) the lessee would consider readily available forward rates or indices as a projector of the future movements of the index in the calculation. If there are no such projections available, the lessee would simply use the current index rate for all years included in the calculation.
After the ROUA is established, it would be amortized on a systematic basis over the determined lease term, or the useful life of the asset if shorter. The lease liability would be amortized using the interest method (like a mortgage, a portion of the lease payment would be attributed to interest expense and a portion attributed to reducing the lease liability).
The proposal would also require lessees to continually reassess the ROUA and lease payment liability for significant changes in the assessed term or expected lease payments each reporting period. Changes in the assessed term of the lease would be recognized through offsetting charges to the ROUA and the lease liability. (For example, the probability-weighting shifts in response to a change in the company's satisfaction with the asset.) Changes in the lease liability caused by changes in expected lease payments that relate to the current or a prior period would be charged to earnings, but if they relate to future periods, the liability adjustment would once again be offset by a change to the ROUA.
On the balance sheet, the lessee would present the lease payment liability separately from other financial liabilities. ROUAs would be presented as a leased asset (i.e., separate from other nonleased assets) within the property, plant, and equipment assets. On the income statement, the amortization of the ROUA and the lease payment liability would be presented separately from other amortization expense charges and interest expense charges that may be present. This presentation could be done on the face of the income statement or within the financial statement footnotes. On the statement of cash flows, all cash payments would be presented as financing cash flows.
The proposal outlines two accounting approaches for the lessor: The performance obligation approach and the derecognition approach. The deciding factor as to which approach must be applied lies in whether or not the lessor retains exposure to the significant risks or benefits associated with the leased asset either during or after the lease term. If such risks and benefits exposure is not retained by the lessor, then they must use the derecognition approach. For all other circumstances, the performance obligation approach would be applied. This analysis must be performed at the inception of the lease and includes, but is not limited to, consideration of such factors as:
This determination will require judgment, but once it is made it drives the lease accounting you must follow under each approach.
- Whether the duration of the lease term is significant or not to the remaining useful life of the asset
- Whether a significant change in the value of the asset at the end of the lease term is expected
- Whether any residual value guarantees may be present.
Derecognition Approach – Under the derecognition approach the lessor recognizes an asset for the right to receive lease payments with a corresponding recognition of lease income. Additionally, the lessor "derecognizes" a portion of the carrying amount of the leased asset with a corresponding charge to lease expense. The
remaining carrying value of the leased asset would then be reclassified as a "residual asset." In calculating the amount of the lease asset to derecognize, the lessor would use the following formula:
(Carrying Value of the Asset) x (The Fair Value of the Lease Receivable) The Fair Value of the Asset
The lessor would use the same approach to determine the fair value of the lease receivable as used by a lessee to calculate the present value of the lease payment liability with the following three exceptions:
Because the lessor is a separate entity than the lessee, it is accepted that they may reach different judgments than the lessee concerning the factors that influence the determined lease term and amount of lease payments to be received. As a result, the accounting for a lease can differ between the lessor and lessee's financial statements.
- The lessor must be able to reliably estimate any potential contingent rentals in order to include them in the calculation of the lease payments to be received
- The lessor must use the actual borrowing rate being charged to the lessee as the discount rate in the present value calculation
- The receivable would also include any recoverable initial direct costs incurred by the lessor
In calculating the fair value of the asset, the lessor would use the generally accepted methods of determining an asset's fair value such as: (1.) Use of a valuation company to perform an appraisal, (2.) Use a compilation of market comparative data for the leased asset in question, or (3.) Use a discounted cash flow model related to the expected cash generation of the leased asset over its remaining useful life. If your equipment is subject to periodic appraisals by a lender, those appraisal reports can serve as a quick source of the needed fair value data as well.
Again, similar to the lessee requirements, the lessor would have to continually reassess the lease payments receivable for significant changes each period. Adjustments to the term of the lease would be recognized as an adjustment to the residual asset's carrying value and the amount to be adjusted would be calculated using the previous formula. Changes in the expected lease payments to be received would be recorded into earnings.
On the balance sheet, the lessor would present the lease payments receivable asset separately from other financial assets, and the residual value asset would be presented separately within the property, plant, and equipment assets. On the income statement, the lessor would generally present the lease income and expense as a component of their respective gross revenues and cost of goods sold accounts. However, the interest income component of the lease payment received would be presented separately from any other interest income that may be present. On the statement of cash flows, all the cash receipts from the lease payments received would be reported as a component of operating cash flows.
Performance Obligation Approach – Under the performance obligation approach, the lessor would also recognize an asset for the right to receive lease payments using the same approach as required under the derecognition approach; however, under this approach this asset is offset by the establishment of a performance obligation liability. This liability represents the obligation of the lessor to permit the lessee to use the lease asset. Under this approach, a portion of the carrying value of the leased asset would not be derecognized in any manner.
Once again, the lessor would have to continually reassess the lease payments receivable for significant changes each period. Adjustments to the term of the lease would be recognized through offsetting charges to the lease payments receivable and the performance obligation liability. Adjustments to the lease payments receivable caused by changes in the expected lease payments to be received would be recognized in earnings to the extent the lessor has satisfied the related performance obligation (i.e., it is related to a current or prior period) and would be recorded against the performance obligation liability if it relates to future periods.
On the balance sheet, the lessor would present the leased asset, the lease payment receivable, and the performance obligation liability together as either a net lease asset or net lease liability. On the income statement, the lessor would present the interest income component of the lease payment, the lease income component of the lease payment, and the depreciation expense from the leased asset together as a net lease income or net lease expense. Similar to the derecognition approach, on the statement of cash flows all the cash receipts from the lease payments received would be reported as a component of operating cash flows.
A Word About Short-Term Leases
If you are like most equipment dealers, you execute a number of short-term leases with your customers. The proposal defines a short-term lease as, "A lease that, at the date of commencement of the lease, has a maximum possible lease term, including options to renew or extend, of 12 months or less." The proposal's intention is that both the lessee and the lessor should be able to objectively look at the lease and determine whether the maximum possible lease term is 12 months or less.
For short-term leases the proposed accounting would allow the lessee to make an election at the inception of the lease to measure the ROUA and associated lease payment liability using the undiscounted amount of lease payments. Such lease payments would be recognized in the income statement over the determined lease term. A lessor could elect to not recognize assets or liabilities from a short-term lease, nor derecognize a portion of the leased asset. Under this approach, the lessor would simply recognize lease income into earnings over the determined lease term, which is essentially the same treatment as today's USGAAP operating lease accounting.
One area of the proposal that is ripe for discussion and comment from the equipment leasing industry relates to how a lessor would determine whether a lease that simply contains a daily, weekly, or monthly rental rate and is completely open ended as to the term of the lease would qualify as a short-term lease and be afforded the short-term lease accounting described in the proposal. While the proposal does not directly address these types of leases, it appears reasonable that two of the possible outcomes for these leases could be: (1.) Since the lease contains no contractual factors that obligate the customer to a lease term longer than one year it would qualify as a short-term lease, or (2.) The lessor would perform a probability-weighted analysis of the possible lease terms likely to occur based on their evaluation of the noncontractual factors previously discussed, with the longest lease term more likely than not to occur being deemed the lease term.
It is certain that discussion of this exposure draft will continue for some time to come as the FASB has stated that the effectiveness of the new standard will not be before the year 2012, but it remains apparent that the momentum behind the issuance of a new lease standard remains strong and a new lease accounting standard is coming. So stay tuned, stay engaged in the discussion, and begin preparing your dealership for the changes ahead.
Scott Stafford, is the assurance senior manager with BDO Seidman, LLP, in Dallas, Texas, and has more than 11 years of audit experience. He is a Certified Public Accountant, a member of the American Institute of Certified Public Accountants, and a member of BDO Seidman's Dealership Industry Group Steering Committee.
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