In our September/October 2010 issue of Accounting Insights, Baker Tilly provided you with an overview and white paper on the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) (collectively “the Boards") exposure draft, Leases.
Since they were published, the Boards have tentatively agreed to a number of changes, some of which are significant. Still, the Boards are hopeful that a final standard will be issued during the third quarter of 2011.
Some of the more significant changes are highlighted below.
The exposure draft defined a lease term as the longest possible lease term more likely than not to occur (i.e., a greater than 50 percent probability of occurring). The Boards jointly proposed changing the definition of a lease term to the noncancellable period of a lease plus any periods with options to extend or terminate the lease term when there is a significant economic incentive to extend, or not terminate, the lease. Examples of economic incentives include: bargain renewal rates, penalties related to not extending or opting to terminate a lease, and/or economic penalties such as installation or customization costs. While the exposure draft required ongoing reassessment of the lease term, the Boards also tentatively agreed that reassessment of the lease term would only be required when there is a change in the factors relevant to determining whether a significant economic incentive to extend or not terminate a lease exists.
This is a significant change from the original exposure draft and could affect certain industries more than others. For example, an entity renting office or retail space may be able to move from one location to another without incurring significant economic penalties, and therefore, might not be required to include renewal periods in the lease term, while a manufacturer might incur significant economic penalties related to installation, customization, etc., and therefore, might be required to include the renewal periods.
Variable lease payments
The exposure draft included a requirement to estimate variable lease payments (e.g., performance-based contingent rents) using a probability-weighted expected outcomes approach. The estimated variable lease payments would have been included in the leased assets and liabilities recorded on the balance sheet. The Boards propose that variable lease payments should only be included in the leased assets and liabilities if one of the following criteria are met:
- the payments depend on an index or rate
- the variability of the payments lacks commercial substance
- the payments meet a high recognition threshold (such as reasonably certain)
While this change will likely reduce the size of the leased assets and liabilities that entities will be required to record on their balance sheets, for some entities, the dollar amount of variable lease payments required to be recorded could still be significant.
The exposure draft required that all leases, including those with lease terms of 12 months or less, be recorded on entity balance sheets. The Boards suggest making the accounting for short-term leases an accounting policy decision (by asset class). Entities would be allowed to elect to not recognize short-term leases as assets and liabilities on the balance sheet. Short-term leases would be defined as leases with a maximum possible lease term, including any renewal options of 12 months or less. Under this accounting policy election, entities would recognize lease payments in the statement of financial performance on a straight-line basis (unless another systematic and rational basis would be more representative of the use of the leased asset).
The exposure draft required that sale-leaseback transactions meet certain specific criteria to be accounted for as sales and leases. Transactions not meeting these criteria would have been accounted for as financing transactions. The Boards tentatively agreed that instead of the more restrictive sale-leaseback criteria included in the original exposure draft, entities should apply the transfer of control criteria included in the Boards’ proposed revenue recognition standard to determine whether the transactions should be accounted for as sales, and the resulting gains/losses recognized.
Eliminating the additional sale-leaseback criteria from the proposed standard would represent a significant change in US generally accepted accounting principles (GAAP), especially for transactions involving real estate, and could result in more sale-leaseback transactions being accounted for as sales and leases instead of as financing transactions.
The Boards have proposed a number of other changes to their original exposure draft. Read more on the Lease Project Update page on FASB’s website which details the changes discussed above as well as the Boards’ other tentative changes.