Accounting Journal Entry FASB and IASB Continue Making Decisions on Lease Accounting March 28, 2011 At recent meetings, the FASB and IASB (the boards ) have continued to make progress on the leases project, making numerous tentative decisions. (See Deloitte s February 21, 2011, journal entry for other recent decisions.) All of the boards decisions are subject to change before any final standard is released. Editor s Note: Although it seems unlikely that the boards will complete the project by their target month of June 2011, it won t be for lack of trying. The boards continue to meet several times each month to discuss the project, and we expect them to keep doing so over the next several months. We think that the standard will most likely be finalized by the end of 2011; however, if the boards decide to reexpose the revised standard, the project may not be completed until 2012. Right-of-Use Model The boards reaffirmed the right-of-use model. A lessee will recognize an asset for the right to use the underlying asset and a liability to make lease payments. The lessor model will be discussed at a future meeting. Scope The boards tentatively decided to affirm the scope of the exposure draft (ED) but plan to make a few changes to it. In addition, the boards tentatively decided not to include the following items in the scope of the final leasing standard: leases of intangibles; leases for the right to explore for or use minerals, oils, natural gas, and similar nonregenerative resources; and leases of biological assets, including timber. Decisions about leases of internal-use software (under the current guidance in ASC 350-40-25-16, 1 entities must apply ASC 840 2 by analogy in determining whether the present value of software license installment payments should be capitalized) and inventory were postponed because the boards determined that more analysis was needed. Short-Term Leases The ED had proposed guidance on how lessees and lessors should account for a short-term lease (defined as a lease that has a maximum possible lease term, including options to renew, of 12 months or less). Under the ED, a lessor that has a short-term lease can elect, on a lease-by-lease basis, not to recognize a lease receivable or a liability; however, the lessor would continue to recognize the underlying asset and to recognize lease payments in the income statement over the lease term. A lessee would still record a lease-related asset and liability on the balance sheet, but at an undiscounted 1 2 FASB Accounting Standards Codification Subtopic 350-40, Intangibles Goodwill and Other: Internal-Use Software. FASB Accounting Standards Codification Topic 840, Leases.
amount. Several comment-letter respondents expressed concern that the ED s exception for short-term leases for lessees was not consistent with that for lessors and that the lessee exception did not provide entities with significant relief. For leases that have a maximum possible lease term of 12 months or less, including any options to renew, the boards have tentatively decided to allow lessors and lessees to account for them by not recognizing lease assets or lease liabilities and by recognizing lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset (i.e., a short-term lease could essentially be treated as an operating lease). Another change from the ED is that the decision will no longer be on a lease-by-lease basis but will be an accounting policy decision made by asset class. Editor s Note: The boards also discussed potentially requiring additional disclosures about short-term leases, including annual rent expense and future commitments. Because an entity might need to perform lease tracking to provide any additional required disclosures, the extension of operating lease treatment to lessees for short-term leases might not be as cost-effective as initially expected. In addition, the definition of a short-term lease did not change significantly from the ED. Therefore, even month-to-month leases in which a lessee has the unilateral right to continue using the leased asset on a month-to-month basis at the end of the contractual lease term would not meet the definition of a short-term lease. Purchase Options In a change from the ED, the boards tentatively agreed that purchase options should be accounted for similarly to options to renew. Therefore, purchase options with a significant economic incentive to exercise will be included in lease payments. The boards could not agree on whether purchase options should be reassessed during the lease term, similarly to renewal options, or not reassessed at all after lease commencement. Some FASB members were concerned that changes in market prices alone could change the conclusion about whether there was a significant economic incentive to exercise a purchase option. Therefore, the boards will perform additional analysis before making a final decision about reassessment of purchase options. In-Substance Purchase/Sale The ED had proposed excluding, from the leasing standard, contracts that (1) automatically transferred title to the underlying asset at the end of the contract or included a bargain purchase option and (2) transferred all but a trivial amount of the risks and benefits associated with the underlying asset. The boards have tentatively decided that this guidance is not necessary and will not incorporate it into a final standard.
Inception Versus Commencement The ED had proposed that a lease arrangement should be measured as of the lease inception date 3 and then recognized at lease commencement. 4 The boards believed that measuring the assets and liabilities at inception would capture the nature of the transaction. However, there was some concern that gains and losses could develop between inception and commencement and that assumptions regarding renewal and purchase options or contingent rent could change between the two dates, which could lead to accounting changes before lease commencement. To simplify this accounting, the boards have tentatively decided that initial measurement and recognition will both be as of the date of commencement of the lease rather than at lease inception. Editor s Note: The boards discussed concerns about which impairment model a lessor should apply between the inception and commencement dates and the potential for onerous contracts. The FASB staff intends to present an impairment paper to the boards at a later date. Build-to-Suit Leases Although ASC 840 includes requirements on how to account for build-to-suit lease arrangements, the ED did not address these arrangements. In build-to-suit lease arrangements, the lessee typically is involved with the construction of the asset. IFRSs do not contain any specific guidance on these arrangements. The boards have tentatively decided that the new lease standard will not include any specific accounting requirements related to the lessee s involvement in the construction of an asset. The boards will provide additional guidance on (1) construction costs incurred by the lessee before the commencement date and (2) prepaid rents. Editor s Note: We suspect lease accountants everywhere will applaud the official demise of the guidance formerly contained in EITF Issue 97-10. 5 However, because of the lack of specific guidance on these arrangements in the final lease standard, lessees involved in the construction of the asset will need to consider other accounting literature for these arrangements during the construction period (e.g., consolidation guidance if the asset is included within an entity). 3 4 5 The ED defines date of inception of the lease as the earlier of the date of the lease agreement and the date of commitment by the parties to the lease agreement. The ED defines the date of commencement of the lease as the date on which the lessor makes the underlying asset available for use by the lessee. EITF Issue No. 97-10, The Effect of Lessee Involvement in Asset Construction.
Lease Payments Before Commencement Date and Lease Incentives The boards tentatively decided that any lease payments made by the lessee before the asset is available for use (commencement date) should be accounted for as prepayments for the right-of-use asset. These prepayments would then be added to the right-of-use asset on the commencement date. In addition, because the ED did not discuss lease incentive payments, a common question in comment letters was how these payments should be accounted for. The boards have tentatively decided that a lessee should include lease incentives in the initial measurement of the right-of-use asset (i.e., receipts from the lessor would reduce the right-of-use asset). However, up-front cash payments made by a lessor to a lessee would reduce any profit recognized by the lessor under the derecognition approach and reduce the lessor s lease liability under the performance obligation approach. Editor s Note: Rent holidays or free rent periods that simply affect the timing of cash flows under the lease would be accounted for by accruing interest during the rent holiday period and amortization of the right-of-use asset. Discount Rate The boards tentatively decided that the guidance on determining the appropriate discount rate for initially measuring the lease payments would be generally consistent with that in the ED. One exception is that the new guidance would clarify that if the rate the lessor charges the lessee is available, that rate should be used rather than the lessee s incremental borrowing rate. In addition, the boards tentatively decided that if the lessee is using its incremental borrowing rate as the discount rate, this rate should be determined at lease commencement rather than at lease inception. The ED had noted that the rate the lessor charges the lessee could be the lessee s incremental borrowing rate; the rate implicit in the lease; or, for property leases, the yield on the property. The boards clarified that when more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used. The boards also tentatively decided to provide guidance on how entities should calculate the discount rate when considering the use of a group discount rate and determining the yield on property. Sale-and-Leaseback Transactions Under the ED, in a sale-and-leaseback transaction, the threshold for achieving a sale would have been higher than that in the revenue recognition project. Many respondents to the ED noted this inconsistency. The proposed conditions precluding sale recognition were mostly carried forward from ASC 840 (formerly Statement 98 6 ). Because the boards are eliminating the off-balance-sheet accounting for leases, they believe the structuring opportunities afforded by a sale-and- 6 FASB Statement No. 98, Accounting for Leases.
leaseback transaction are minimized. Therefore, the boards have tentatively decided that this guidance is no longer necessary. Under the final guidance, entities would consult the revenue recognition project to determine whether the conditions of a sale are met. In addition, the boards tentatively decided that if the consideration is at fair value, gains or losses would not be deferred; this decision is consistent with the ED. Editor s Note: The boards plan to discuss transition issues related to existing sale-and-leaseback transactions at a future meeting. Contracts That Contain Lease and Nonlease Components Under the ED, for a contract that contains both lease and service elements, the services that are distinct would have been separated and accounted for separately from the lease payments (nondistinct elements would have been accounted for as part of the lease contract). The boards have now tentatively decided that for a multiple-element contract that contains a lease, an entity would be required to separate all nonlease elements from the lease element and to account for them in accordance with other GAAP that is, all nonlease elements would be separated from the lease accounting, regardless of whether the nonlease elements are distinct. Lessors would allocate payments to lease components and nonlease components in a manner consistent with the allocation methods in the revenue recognition project. Lessees would allocate payments to the lease and nonlease components on the basis of the relative purchase price of individual components. In the absence of observable purchase prices, all payments would be accounted for as a lease. This publication is provided as an information service by Deloitte s National Office Accounting Standards and Communications Group, and may be a summary of Deloitte s observations at meetings of accounting standard setters. This summary is believed to be accurate; however, no representation can be made that it is complete or without error. Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication. As used in this document, Deloitte means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright 2011 Deloitte Development LLC. All rights reserved.