Open Letter to Customers and Potential Customers

This page was first written in Sep. 2006, and is maintained for historical and background purposes. 

 

For additional updates, please visit the Lease Accounting blog

 

On July 19, 2006, the Financial Accounting Standards Board (FASB) announced that it is adding to its agenda a comprehensive reconsideration of the standards on accounting for leases (FAS 13 and the related pronouncements). Part of the purpose for this is to coordinate lease accounting standards with the International Accounting Standards Board (IASB), which sets accounting standards for Europe and many other countries. The IASB and FASB currently have substantial differences in their treatment of leases; particularly notable is that the “bright line” tests of FAS 13 (whether the lease term is 75% or more of the economic life, and whether the present value of the rents is 90% or more of the fair value) are not used by the IASB, which prefers a “facts and circumstances” approach that entails more judgment calls. Both, however, have the concept of capital (or finance) and operating leases, however the dividing line is drawn between such leases.

As part of the FASB’s announcement, the Board stated that in their view “the current accounting in this area does not clearly portray the resources and obligations arising from lease transactions.” This suggests that the final result will likely require more leasing activity to be reflected on the balance sheet than is currently the case. In other words, many, perhaps virtually all, leases now considered operating are likely to be considered capital under the new standards. Thus, many companies with large operating lease portfolios are likely to see a material change on their primary financials. It is perhaps worth noting that the staff of the Securities and Exchange Commission is also on record, in a report mandated under Sarbanes-Oxley, criticizing the amount of operating leases which are kept off the balance sheet (which they estimate at $1.25 trillion in future rent commitments) and calling for a rewrite of FAS 13 which would move much of this onto the primary financials, changing the current “all or nothing” approach to something that reflects the sharing of economic interests between lessee and lessor.

In the announcement, FASB made reference to two Special Reports on lease accounting published in 1996 and 2000, which outlined a “New Approach” to lease accounting that the staffs of the accounting standards boards of the US, UK, Canada, Australia, and New Zealand, plus the IASB, were recommending for use. (The reports are titled “Accounting for Leases: A New Approach” and “Leases: Implementation of a New Approach,” and are available from the FASB.) This New Approach in essence does away with operating leases; all leases (unless immaterial) would be capitalized using the present value of the minimum lease payments. The conceptual basis for lease accounting would change from determining when “substantially all the benefits and risks of ownership” have been transferred, to recognizing “right to use” as an asset and apportioning assets (and obligations) between the lessee and the lessor. The FASB seems to be suggesting that this New Approach will be the starting point for its deliberations, although a number of details are unresolved in the Special Reports and will need to be finalized in an actual accounting standard.

Another significant change recommended in the New Approach is using estimates of both contingent rentals and expected residual values (when the lessee has an interest in or responsibility for the residual) as part of the process of valuing the asset (and obligation) of a lessee lease. For instance, the working group that prepared the Implementation Special Report recommends that contingent rents based on price indexes or sales volume be estimated and added to the minimum lease payments (with the difference between the estimate and actual booked to income or expense when incurred, as currently). They further call for this estimate to be reviewed and, if needed, updated yearly. This is likely to be a more contentious issue in the FASB’s deliberations because of the uncertainties surrounding the estimates and the effort involved in a yearly review.

For lessor leases, a significant change recommended is to account for lease receivables and residual values separately, with different interest rates assigned to each to reflect the varying risk levels. On sales-type lessor leases, profit would be allocated between the receivable and the residual, with only the portion applicable to the receivable recognized at the start of the lease.

FASB’s due process moves slowly. They are now taking nominations for a working group which will provide input to the process, which will have its first meeting in January 2007. Later in 2007, the Board (or Boards, counting the IASB) will meet to discuss proposals generated by the staff including the working group’s input, with the intent to release a Preliminary Views document to the public for comment sometime in 2008. The plan is for an Exposure Draft in 2009 with a final statement later that year; implementation would not likely be required before 2010, though FASB statements typically “encourage” earlier implementation. We presume that the IASB and Canada’s governing body will adopt the same standard on a similar schedule.

It goes without saying that we will carefully monitor developments. Our offices are located just a few miles from the FASB headquarters, and we expect to be present at any meetings held there that deal with leases. We will update our software as soon as the new standard is released, and will provide you with the ability to compare old and new results. Both EZ13 and our lease accounting service offer reports based on the New Approach concept of capitalizing all leases at their present value; please contact us for details if you would like to run such reports. To the extent that any changes in regulations require altering lease information in a systematic way, we will endeavor to provide automated update facilities. However, depending on the regulations adopted, it may be necessary to go through your lease database record by record to review and make changes. It may also be necessary to add other agreements to your lease portfolio; the Implementation Special Report, for instance, recommends including leases of intangible property, such as copyrights and mineral exploration rights, which have previously been excluded from the standard. We cannot know the exact situation until the new standards are published. We will provide updates on our website as new information is released.

Return to FCS home page for more information on how we can help you with your lease accounting needs, now and in the future.