accounting

The US Financial Accounting Standards Board (FASB) has now decided the transition rules in US GAAP for those leases that will be running at the time when the planned new lease accounting rules first have to be applied.

This follows recent decisions on the same subject by the International Accounting Standards Board (IASB) for the international financial reporting standards (IFRS) version of the new converged standard (see AFI report February 26).

Following the latest decisions, the two Boards have now agreed almost the entire new lease accounting rules. The new standard is not likely to be issued in its final form until towards the end of this year.  Its effective date – together with earlier dates that become the “dates of initial application” (DIAs) for listed companies who will be required to produce comparative figures on the new basis for prior periods – has yet to be agreed.

However, the transition rules for leases running at those dates are now fully agreed for the US GAAP version and mostly agreed for IFRS.

Several of the transition rules will differ as between US GAAP and IFRS. Some, but not all, of these differences are consequential on the non-converged rules for lessees' profit and loss (P&L) accounting for the presently off-balance-sheet operating leases when these have to be capitalized. FASB has agreed that in US GAAP operating leases can continue to be expensed on a straight line basis, whereas in IFRS the expense will be front loaded like current finance leases.

Lessee transition model

Both Boards have always been committed to some degree of retrospective application of the new standard, rather than allowing lessees to “grandfather” the previous accounting for pre-existing leases for as long as they run.

FASB has now agreed what it calls a “modified retrospective approach” (MRA) for lessees' transition. However, this differs from the IFRS transition rule for operating leases, also described by the IASB as MRA (which, unlike the US GAAP version, had to address the problem of a possible hit to P&L accounts from switching running leases on to the front loaded expense profile).

Unlike the IFRS version, US GAAP will not permit fully retrospective application – i.e. restating the accounting for all running leases on the new basis back to their inception dates – as an alternative to MRA.

Like the IASB, FASB has agreed a limited form of grandfathering for lessees in respect of leases due to terminate early in the transition period. However, the US GAAP version of this concession will not go as far as the IFRS one. FASB has agreed only that there will be no transition accounting for leases that terminate before the DIA (but within the accounting period that includes the DIA). The IASB agreed a similar concession for all leases due to end within 12 months after the DIA.

In US GAAP there will be no reassessment of the capital versus operating lease classification of a contract on transition. This was a potentially important issue, since although US GAAP will retain a lease classification principle for lessees, it was agreed earlier that the classification line will move to the IFRS version in the current IAS 17 standard (even though this will be retained in IFRS itself only for lessor accounting).

That differs from the current lease classification rule in the US standard Topic 840 (originally coded as FAS 13), which unlike IAS 17 contains “bright line” numerical rules.

For pre-existing operating leases, the lessee will recognize a lease liability at the DIA, based on the present value of the minimum lease payments, measured at the discount rate under the new rules - normally the lessee's incremental borrowing rate (IBR) at the time. As a consequence of FASB's straight line P&L expensing for these leases, the “right of use” (ROU) asset will be recognized at the DIA (and under subsequent amortization) at the same value as the liability.

For pre-existing capital (i.e. finance) leases, at the DIA lessees will recognise an ROU asset, and - at a different (normally higher) value – a lease liability, generally at the carrying amounts of the respective  asset and obligation at that date under existing rules. This will not amount to a full grandfathering rule for these leases, as in the IFRS transition rules, although on most leases the effect on the balance sheet and P&L numbers will be much the same as with grandfathering.

This difference results from the two Boards having adopted different transition approaches to initial direct costs (IDCs) incurred at lease inception. The Boards jointly agreed earlier on changes to the extent to which IDCs can be capitalized, by both lessees and lessors, under the new standard. However, in practice such costs are rarely substantial for lessees. 

On the relevant transition rules, the IASB agreed last month that lessees need not include IDCs on pre-existing leases in the measurement of the ROU asset; but FASB has now made a different decision.

Under US GAAP transition, any unamortized IDCs that would have qualified for capitalization under the new rules will be added to the values of the lease liability and ROU asset in the case of operating leases, and subsumed within the ROU asset for finance leases. However, those unamortized IDCs that would not qualify for capitalization under the new standard will be written off as an adjustment to equity.  

Lessor transition model    

The two boards agreed last year that there will be few accounting changes for lessors under the new standard. The IASB agreed last month that on transition there will be full grandfathering of the IFRS accounting treatment of pre-existing leases by lessors.

However, for lessors in general FASB has now agreed prescriptive transition rules.

The accounting effect of these rules would seem close to grandfathering in practice, particularly for finance leases. In the case of operating leases, any unamortized IDCs that would not have qualified for capitalization under the new rules must be taken as an adjustment to equity at the DIA. As on the lessee side, the lease classification itself will be grandfathered for US lessors on transition, notwithstanding the future switch to the IAS 17 lease classification line.

FASB has agreed the same limited concession as on the lessee side for leases terminating early within the transition period – i.e. no transition accounting for lessors where leases end before the DIA.

For one particular category of leases, shaped by the US tax rules, FASB agreed some months ago on full grandfathering on transition in the course of deciding the relevant future accounting rules. These are “leveraged leases”, largely funded by third party financiers and classified as finance leases for the lessor but operating leases for the lessee.

Current accounting for these leases under Topic 840 allows for the effect of the lessor's tax benefits in determining the constant rate of return on the lessor's net investment. Last August FASB confirmed its earlier proposal to converge with IFRS by ending the special leveraged lease accounting for leases to be incepted after the effective date of the new standard; but at the same time agreed on grandfathering of current accounting for such leases running at the DIA.

Other transition issues

FASB has also now agreed the transition rules for certain issues affecting both lessees and lessors, where the new standard will bring changes for future leases. On the question of where a lease must be recognized, within what would otherwise be a pure service contract involving the use of fixed assets, FASB has converged with the recent IASB decision for full grandfathering on transition.

On sale and leaseback (S&LB) contracts, which raised a variety of transition issues, FASB has likewise very largely concurred with the IASB's transition decisions, which are mainly on the lines of grandfathering for pre-existing deals. Thus decisions under existing rules by lessees and lessors on whether to recognize a sale and return lease (rather than treating the S&LB deal as a refinancing of the asset previously owned by the seller-lessee) will not have to be reassessed where the lease is still running at the DIA.

A previously recognized leaseback will be subject to transition accounting on the same basis as for other running leases. Although this represents a converged transition principle as between US GAAP and IFRS, it will not result in converged accounting in the case of an operating leaseback because of the divergent P&L accounting for all operating leases.

Grandfathering will also apply to a large extent to any profit (or loss) on the sale of the asset previously recognized by the seller-lessee in a S&LB deal. The US GAAP version of these rules as now agreed by FASB will, however, be slightly different from the recently agreed IFRS version, resulting from a difference in the respective existing rules for recognizing such gains or losses.

Both Boards have agreed to full grandfathering of such gains or losses in the case of finance leasebacks. For operating leasebacks, both Boards have also agreed that any deferred recognitions that under existing rules resulted from “off-market” terms (i.e. from the sale price of the asset and/or the lease rentals not being at market rates) are to be accounted for as a remaining financial liability in the case of a deferred gain, or as an adjustment to the leaseback ROU asset in the case of a deferred loss.

Where gains or losses on the asset sale have been deferred by the seller-lessee in US GAAP as a result of residual value (RV) factors in the leaseback – a situation that does not arise for operating leases in IAS 17 – FASB has decided that these should be recognized as a “cumulative effect adjustment” to equity at the DIA. 

For transition-related disclosures in notes to the accounts, FASB has decided simply to apply most of the general disclosure rules for changes in accounting policies, specified in Topic 250. This differs from the corresponding decision of the IASB, who decided on specific transition disclosures for the new leasing standard (but has not yet fully agreed them), rather than cross-referring to the general IFRS standard on accounting policy changes (IAS 8).   

Variable rentals

In addition to the above transition issues, FASB has now reconsidered a permanent new rule where the two Boards had previously failed to converge. This concerns mid-term reassessments by lessees of leases where variable rentals depend on an index or rate. FASB has now concurred with the IASB decision that the lease payments accounted for in these contracts should be reassessed only where the lessee has to re-measure the lease for other reasons, such as an expected change in the length of the lease term.

This reverses an earlier tentative FASB decision requiring reassessments of these leases in a wider range of conditions. It therefore brings some simplification to the US GAAP version of the new standard.