Accounting for Leases Are You Ready for a Major Change

8/8/2019 Accounting for Leases Are You Ready for a Major Change

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Accounting for Leases: Are You Ready for a Major Change?

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December 2010 Segment 3


TRANSCRIPT

1. Upcoming Changes

QUINLAN: Operating leases may soon be a thing of the past. Earlier this year, the twostandard setters in accounting and financial reporting - the International AccountingStandards Board, or IASB, and the Financial Accounting Standards Board, or FASB,published a joint exposure draft on lease accounting. If finalized, the proposal wouldrepresent a fundamental change in how leasing transactions are accounted for - by both

lessees and by lessors.

The purpose of the proposed changes to lease accounting, as we've reported to you in thepast, stems from the longstanding goal of the two standard setters to increase transparencyby bringing consistency to lease accounting.

In other words, the exposure draft would also eliminate the differences in treatment of leasecontracts between International Financial Reporting Standards, or IFRS, and U.S. generallyaccepted accounting principles, or GAAP.

QUINLAN: As anticipated, the proposal requires both lessors and lessees to provideextensive financial statement disclosures. In addition, lessors would be required to makesignificant judgments around developing estimates of renewal periods and contingentrentals.

The exposure draft requires lessees to book assets and liabilities for all their leases. In otherwords, so-called off-balance-sheet accounting would no longer be allowed.

The dates for the end of the comment period - December 15th - and for the publication of the final standard - June 2011 - have been set. However, it should be pointed out that theeffective date of the new leasing standard is still uncertain. Because the proposed transitionrequirements would not grandfather any existing leases, both lessors and lessees need toconsider the potential affect of the proposed rules on existing leases.

We asked Rebecca Surran to find out if the standard, if implemented as proposed, will really

significantly increase the liabilities on a typical balance sheet.


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2. Move to Capitalization

SURRAN: Needless t o say, Mike, Im very excited to introduce todays expert commentatorfor a number of reasons.

Hes Dr. Peter Chant, and hes a partner in the national assurance and advisory group atDeloitte & Touche LLP. Some viewers may recall that hes a former membe r, and a formerchair, of the Canadian Accounting Standards Board.

Other viewers may recall his book - "IFRS for Canada" - drawing upon his ongoingexperience in helping companies make the transition to the international financial reportingstandards.

Before I even ask you a question, Peter, I want to remind our viewers: the opinions thatPeter expresses here today are his own, and not necessarily those of Deloitte ToucheTohmatsu, or any of its member firms. As always, thanks for joining us again this month.

CHANT: Nice to be here, Becky.

SURRAN: Obviously, I've got a lot of questions about the exposure draft, Peter. But first,let me ask you more of a baseline question. Why is the subject of leasing so difficult forstandard setters in accounting and financial reporting?

CHANT: Weve got ingrained habits. For those of us who are steeped in North AmericanGAAP, and even IFRS GAAP, weve all become used to the notion that there are sometransactions that we dont capitalize, and now weve come to a point in time where we say,

OK, those transactions we will capitalize. There have been major industries developedaround this, such as the leasing industry, on the supply side, and many of the userindustries.

Airlines are well known as being major uses of l eases. In many cases those obligations dontshow up on their financial statements. Perhaps the argument is this is news to nobody, andmaybe its not really a burning platform.

CHANT: From a practical point of view, we know the credit rating agencies get copies of theleases and do their own math. So we dont believe theyre out to lunch on this. So, the issuemay be, whose ox is being gored?

I think the issue is the general user, who is not a sophisticated accountant, would besurprised that obligations that have a high degree of certainty, and assets which have ahigh degree of productivity, are neither on the balance sheet as liabilities or as assets,respectively. Users take things at a prima facie value. They expect the financial statementsto say what they mean. Here are the assets that we use and the obligations that we owe.However, leasing is one of those cases where we dont do that. While we all get used to it,


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being the source of the problem, conceptually and realistically it is the exception that is aweakness from a fundamental point of view.

SURRAN: It's one thing to propose a new standard or a new set of rules for everyone tobegin following. But what about existing leases and current contracts? Is there some kind of transition roadmap to get from where we are to where they want us to be?

CHANT: Its interesting that you bring up the transition issue. That is another hot potatothat I think is being handled by both the FASB and the IASB.

The transition proposal for leases doesn't stipulate a date. Interestingly, the date is open, orTBD. But what they do is not permit any grandfathering or exemption of existing leases. Sothat means enterprises that have signed a lot of leases under one accounting regime willnow have to go book those, recognize the liabilities, and deal with the contractualconsequences of that. Theyre saying, they get to recognize some assets too, but this will bea significant adjustment.

When leases were first capitalized, even to the extent that they are today, they weregrandfathered, and that is the transition date was leases after a specific date. The problemwith that is you have such a long runoff on some leases, leases for property in Europe, forexample, might runoff 200 years. Thats not an unusual circumstan ce, which means thetransition effect would be so long that the comparability of financial statements would becompromised for such an extended period of time that one almost has to go grandfatheringor go bust.

Perhaps the issue is that its a contest b etween doing it all correctly, and recalculatingeverything, or doing nothing. The middle road just doesnt seem to satisfy anybody.

3. Question of Ownership

SURRAN: According to the exposure draft, a lease exists whenever you've acquired anasset that you've got a right to use, and whenever you've got an obligation to make leasepayments. Is that controversial, Peter? I mean, it sounds like common sense to me.

CHANT: In the good old days, when I first started teaching, we used to have some rulesthat were not principles- based, but were, lets say, pragmatically based. One is, we found itdifficult to put an S on your balance sheet for what you didnt have title to. Leasing isactually borrowing somebodys asset. They usually keep the title. You get to use i t for aportion of the assets life, and then you give it back.

A borrowed asset that you dont own, but you control a portion of - is that really your assetor is that the leasing companys asset? Perhaps it was a different world where they weremore like day-to-day car leases than life of the asset aircraft leases, but the original answerwas that title is a key determinant. Whos got risk in ownership? They ought to drive thetruck.


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CHANT: Nowadays, the legal community has gotten clever and can allocate the risks andrewards around title with ease. The title has become almost secondary if not tertiary inimportance. Thats why, were now looking at, OK substantively the risk and rewards belongto the lessee. That person, even though they dont own it, even though they dont have alegal title, they may not even have an insurable risk, although they probably do pay for theinsurance, really theyre using the asset and that should be how its measured.

I also think were far more comfortable with fair va luing intangible assets such as contractsnow, whereas 20 years ago, people were pretty nervous about that. But the technology of derivatives and of valuation has moved so far past the basic cash flow models that I doubt if theres a complex contract that would challenge the more sophisticated valuation people.

SURRAN : That makes sense, Peter, in the context of the bartered purchase or thechartered aircraft. But what about the DVD that I rented last night? Or the tuxedo that I'mmaking my husband rent next weekend for a wedding that we're going to? Clearly, notevery rental transaction involves "holding" an asset, does it?

CHANT: Well, you are using the asset and if possession is 9/10th etc., then Im not surewhy one would see an exception. I know from personal experience that when one leases acar, even on a day-today basis, youre pretty well responsible for that car. If I run oversomebody while driving that car, or damage it, its as if I owned it. Its not clear why theaccounting would differ.

Now, give this to the board, say simplify the approach. The simplified approach basicallyreflects the entries that would be automatically made for short-term transactions like that. Iwould see the accounting systems and the accounting proposals for short-term leases beingquite aligned. I dont think the short -term lease is a big challenge.

It is maybe a big challenge for lessees who have gotten used to just paying the bill once amonth and not accruing anything, but I think realistically thats probably a tweak in asophisticated platform. OK, maybe thats an understatement, but not a sophisticatedaccounting adjustment to get there.

4. Derecognition and Lease Types

SURRAN: In this context I often hear the word, "derecognition." Why is it that lessors areso concerned about derecognition?

CHANT: Derecognition is an accounting word. The idea is if you can recognize somethingand put it on your balance sheet, you should be able to do the opposite, which means takeit off your balance sheet.

The issue for the lessors is that there are two competing models. This I think the boardsonly straightened out near the end of the project. Theres one model where you have anasset and you lease it out. As the lessor, you undertake the obligation to let somebody


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borrow t he asset. That would show up as a liability. In exchange for that, youre going toget a receivable. In essence, for the same asset, there will be three entries: the asset, theobligation to let somebody use it, and the receivable.

If youre a big time lessor, you can see how that balance sheets going to kind of explode.There will be three entries for every underlying asset. Sooner or later there is a model thatsays, Weve probably substantively leased that asset out, so, when it comes back, theresno t a whole lot of risk here. For those types of lease transactions, the IASB board membersoriginally, and the FASB by the end, got around to the view that when you get to thosepoints, you have actually disposed of the underlying asset.

Instead of having an obligation to lease the asset out, you actually have transferred theasset to a third party. It comes off your balance sheet, so you just have a receivable inplace of a long- term asset. You wont have an exploded balance sheet that has all sorts of what one might have called, double counted assets on it.

SURRAN: I know some people who are, what you and the standards call, "lessors."Sometimes they enter into sub-leases. Other times, they do "sale and leaseback"transactions. Is this another one of those situations, Peter, where the devil is in the details?

CHANT: This is an area where, again, principles count. If youve leased in an asset and thenyou sub- lease it out, its generally recognized as a business practice that youve assumedthe obligation to pay. When you sub- lease it, youve assumed that it is somebody elsescredit risk to let them use the asset. So you have two transactions. It is difficult to see whyyou can offset the two, especially if the sub-lease goes sour, but the lease that y ouve gotback with your original lessor still has to be paid. Its difficult to see how you could net allthose transactions into one tiny little sum. I dont think its realistic.

CHANT: Tax leases, another big area. There has been, is a big industry in tax leasing. For awhile there was an accounting standard that actually facilitated the recognition of the leaseas a tax- motivated transaction. Unfortunately, that doesnt conceptually jive too well withthe IASB, and the global point of view was primarily a U.S. driven phenomenon for a time.We remember the notion of wash leases. So, with those types of structures, essentially,there has been no forgiveness and it is what it is.

If youve done a tax deal, then account for it. If youve done a sub -lease, then account forit. If youve got an asset leased, then thats a separate transaction. I think that would be anecessary condition to sell this project globally to make amendments for a purely U.S.environment issue. It would probably not be a good way to go about drafting internationalstandards.

SURRAN: Thanks, Peter. We'll return to your commentary in a minute.


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5. Financial Statement Impact

QUINLAN: As Peter Chant indicated, under the new proposal, the requirement to classifyleases as either capital or operating is gone. As a result, lessees must capitalize all of theirleases. This one-size-fits-all model, which treats "dollar-outs" and "FMV leases" the same,will account for very different transactions in the same way.

Under the new rules, all leases will be treated essentially the same as current capital leases.In a significant departure from FAS 13, though, lessees must now assess the impact on thelease term of options to return, renew, or purchase the leased asset.

For example, if the lessee expects to renew the lease, the base term plus the renewalpayments now must be capitalized. Furthermore, these assumptions are reassessed each

reporting period.

In addition, lessees would be required to estimate - and to capitalize - the amount of anycontingent rents and residual guarantees that are likely to be paid under the lease.

SURRAN: Let's turn to the consequences of the exposure draft for lessees, Peter. I supposethis could have a major impact to their income statement as well as their cash flowstatement, couldn't it?

CHANT: Absolutely. Its almost signaled in the exposure draft, I think the boards wanted tomake sure that lessees were aware of this. The way the standard essentially works is itsays, You would have an asset for the thing you've leased that youre going to have todepreciate. Straight - line depreciation, if its got an asset lifetime of n years, is going tobe 1/nth a year.

Youre also going to have a liability when you start the lease, which is the present value of all futur e lease payments. As a good liability, youre going to be accruing interest on it andits going to be equal to the asset. Now what that means is before you start paying thatlease down, the interest on the lease liability is going to be bigger than the lease paymentyou made coupled with depreciation on that asset. There are going to be fewer, largercharges for that asset combo of amortization and financing. Net income is going to go down.

Flip side is, near the end of the lease, the asset may be depreci ated, thats fine, but therewill be very little interest charge for the remaining balance of the lease. Its possible that,for older assets that are coming to maturity, there will be less lease expense from the

combination of these factors than the cash payment, which is currently the basis forexpense these days.

SURRAN: That makes sense. But what about their balance sheet and their businesspractices? Is it likely to have an impact there as well?


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CHANT: Well, the balance sheet, its pretty clear. Lots of new assets that have been aroundfor a while. Lots of new liabilities bearing interest that probably do factor into long-termdebt calculations. On the income statement, depending upon the vintage and thedistribution of the assets, for new leases, definitely expenses go up. An interesting outcomeis on the cash flow statement. It may be a little accounting dogma, but currently leasepayments, when a lease is off the balance sheet and classified as operating or consideredoperating expenses. So they go through margins, theyre expensed, theyre cash so theresno cash income difference. Its pretty straightforward.

Under the new model, where leases are capitalized and treated as financing obligations,theres no more operating expense except perhaps the interest on the debt to the extentthat thats in the operating cash flows. The payment for the lease will primarily be viewed asthe repayment of the principal amount of a debt, and thats a financing transaction.

So, significantly whats going to happen for enterprises with operating leases, theyre going

to see their operating cash flows climb. And for those who compute, free cash flow or othernumbers, you will see that as the free cash flow goes up, the financing outflow goes down inan equal and opp osite amount. But, sometimes people dont get that far down the cash flowstatement and sometimes management likes to tout the operating cash flow, and this willsignificantly migrate an outflow from operations to financing. So, there may be some netenhancement.

6. Commenting on the Exposure Draft

SURRAN: I'm no exception, Peter. Everybody likes to receive invitations. But what about in

this case? Our viewers received an invitation to comment from FASB and the IASB on theexposure draft. To what extent would you encourage people to send their comments to thestandard setters? Or is this proposal a "done deal" and they're just satisfying due process byasking for comments?

CHANT: I think its a serious comment period. In the case of leases, the FASB and the IASBhave commenced actually a questionnaire post publication of the exposure draft on theextent to which enterprises use leases. Im not exactly sure of the motive for thequestionnaire at this point in the process, but I think there may be some suggestion thatthey may want to find out the scope of this and how significant it is. You may want to lookat the IASB web site. If you want to participate in that questionnaire, you can hit the URLand probably get a copy of it.

If you are a user of the FASB standards or the IFRS standards, I would write a letter. In myexperience, when I was in active standard setting, we counted those cards and letters. If there were points made, I assure you the staff did not just put them in File 13. They lookedat them. They brought them to the board. The board is not always in some religious fervorwhere its just got to do the right thing. In some cases there is a question as to whether ornot its net improvement.


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CHANT: If you have a true practical issue, for example, the nature of your leasingarrangements is so convoluted that determining a fair value may be difficult, then I thinkthats worthy of communicating to the boards. There is no discussion of lease incentivepayments, translation, or payments by the lessor to the lessee at the front end of the lease.In my experience, many sales-type leases are negotiated with incentives upfront.Frequently startup enterprises, theyre given the working capital by the lessor as a conditionof using the asset. They go hand in h and. Thats a very complicated area to try to get thefinancial reporting right. If you are familiar with that and if that deficiency and the exposuredraft is a significant weakness, I think the boards would like to know.

At the same time, if your experi ence is, weve been using operating leases for years. Yes, Iknow the financial statement consequences. But no, I have not met a person that didntunderstand what was going on. Then wed have bigger fish to fry. That may be a messagethat the board may want to hear from you, is, where are we in the priorities of things? Wehave so many things coming down the pipe that may be more important. Maybe thats a

message that needs to be expressed.

7. Going Forward

SURRAN: In terms of the goal of a single set of high-quality global accounting standards,the buzzword used to be "convergence." Now, I hear people talking about the"harmonization" of accounting standards. Aren't those essentially the same thing, Peter?

CHANT: Well, I think the difference is the mechanics of execution. Convergence means youboth end up on the same road, same standards, virtually identical, probably without a

significant word, even without a significant word, maybe some basis of conclusion changes.

Harmonization, thats a little more like voices on the same wavelength. Occasionally theycan get out of touch, or maybe theyll have a slightly different pitch.

I think, functionally, harmonization is probably easier to get to. Probably from a users pointof view, its not that significan t. You get the same melody effect, essentially, out of theapplication of the principles, but its a little easier to execute harmonization than it isconvergence where youre fighting over every comma. Thats a little more drawn outprocess.

SURRAN: That makes sense. But what about lease accounting specifically? Is this one of those accounting standards that's likely to be merely harmonized, rather than trulyconverged? Where do you think they're going to go in terms of accounting for leases?

CHANT: I th ink this will be a converged standard. I dont see any basis for having differentwords. This is a global industry, global practices, trans-border, tax transfer leases,international organizations, theres no justification in this case for a unique nationa lpractice.


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Where will this go? The intellectual, conceptual arguments I think are reasonably sound. Icant think of one other than inconvenience or "nobody cares" that makes good sense. Thereal roadblock here is this will significantly change financial statements and cause forsignificant recontracting in some circumstances. If this comes down the pike at the sametime as revenue recognition, financial statement presentation, fair valuation, or some otherissue, or simply the adoption of IFRS in the United States, which would be a fairlycataclysmic event if it occurs, then this may be just a little too much to swallow. That Iwould see is perhaps the practical argument.

Whos going to make that judgment? I would say the FASB and the IASB putting all th efactors on the scale including their predisposition to capitalize. But timing and the ordering,and maybe even some cutoff, thats a totally arbitrary remark on my part, but who knowswhat the outcome might be. I think those are the issues that might defer theimplementation. As it is, I think its conceptually and realistically a good standard. But,there are many realistic things that will make it through the process, because bigger issuescontrol the day.

SURRAN: Deloitte's Dr. Peter Chant, thanks, once again, for bringing us up-to-date.

CHANT: Youre welcome, Becky. Its been a pleasure to be here.

Accounting for Leases Are You Ready for a Major Change

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