Into the second half of 2012

The FASB recently updated their project timeline for the new lease accounting standard, and they've now officially pushed back the date for release of the revised exposure draft (RED) to the second half of 2012. This is at least a 9-month delay from the original plan: last July they expected to finish the redeliberations in September 2011 with the RED to come shortly thereafter. But, of course, the whole project has been a story of delays; it's mind-boggling to think that when they announced the project in 2006, they expected to be finished in 2008.

Is a person having significant influence (to an entities) considered a related parties

We received a very good question from our Accounting & Auditing blog's royal readers with regard to related parties, as follows:

"I would like to inquire that related company or related party does not necessary to own shares in the other company but also have great influence in the decision making. Am I right? What if they do not own shares but has great influence in the decision making, does it still consider as related?"

According to International Accounting Standard 24, the definition of a related party does not only include shareholders, but also many other parties. A person who may exercise significant influence over the entity's decision making is also considered a related party.

Why is it important to identify an individual having significant influence as a related party? This is because we need to consider whether the transaction entred into between the Company and the invidiual ( having significant influence) are conducted on an arms-length basis. There are instances / cases where the said transactions were not entered into on an arms-length basis but not detected by audit committee or auditors.

Hence, the responsiblity of auditors include obtaining the list of related parties from audit client, identify potential related parties not identified by management, pay reasonably sufficient attention to related parties transactions, and ensure that related party transactions are disclosed appropriately in accordance with IAS 24.

Recommendation of new accounting procedures: Investment-equity reconciliation

A good exercise can be undertaken by the holding company is to prepare appropriate documentation to reconcile investor's cost of investment to investee's share capital for any investment-equtiy relationships within the Group.

The procdure appears to be straight forward, simple and non-complex on first thought. However, the reconciliation can turn into a complex procedure, due to:

- impairment been recorded for cost of investment
- difference exchange rate was used to translate the funding (i.e. investor used exchange rate A, while investee used exchange rate B)
- funding remitted / received is not recorded in appropriate account, etc

This recommended procedure is particularly useful for entities with significant number of subsidiaries. Discrepancies (between cost of investment and share capital) are usually expected for large group of entities.

This reconciliation excercise help to ensure that appropriate figures are recorded in respective source ledger, and ensure that appropriate elimination are done at group level.

Yet another delay

As previously mentioned, the last substantive issue the boards are discussing is the expense profile of lessee leases. Capital lease accounting under FAS 13/IAS 17 results in more expense in the early months/years of the lease than at the end, because interest expense is accrued on the remaining obligation, which declines over the life of the lease, while depreciation expense is usually equal through the lease's life. Operating leases, on the other hand, show level rent expense throughout their life (even if the rent increases).

There has been a great deal of pushback from lessees about applying this expense profile to all leases. They argue that front-loading the expense doesn't reflect actual usage and costs; it also means a mismatch with likely benefits, since income tends to rise over time. If managers are reviewed based on profitability, front-loaded expenses may skew the view of how well or poorly they're actually doing.

At the FASB/IASB meeting Feb. 27-29, the boards considered two alternatives to current capital lease accounting, each of which would reduce or eliminate the front-loading of expenses. The alternatives are:

• Interest-based amortization: Depreciation would be based on the "present value of remaining economic benefits." As a practical matter, unless there's a reason to think the benefits provided by the asset will dramatically change in value during the lease, the depreciation recognized will be equal to the reduction in the obligation balance if the rent is equal over the life of the lease. If rents are unequal, the depreciation will be equal to what the reduction in obligation would be if the rents were leveled.
  
  The expectation is that if this method is chosen, it would not apply to all leases. More or less all leases that currently are considered capital would be accounted for the same way as they are now, to keep their accounting more consistent with purchase accounting.
  
  
• Underlying asset approach: Depreciation would be based on a combination of the portion of the underlying asset expected to be consumed during the lease term plus unwinding the discount on the expected residual value. The effect is that for a real estate lease, where the expected future value is the same as or more than the current value, depreciation would be the same as for interest-based amortization, and the expense profile would be flat. For an asset expected to be fully consumed by the end of the lease term (zero residual), the expense profile would be the same as current capital lease accounting. A residual value in between would give a proportionally interim result.

Each approach has advantages and disadvantages, both practically and conceptually. Interest-based amortization is simpler in most cases, but is different from typical amortization of PPE (property, plant, & equipment). The underlying asset approach in some ways seems more conceptually correct, but is dependent on determining the expected consumption of the asset at the end of the lease term, which many lessees will have no simple way to determine, and there is concern that trying to determine it will be 1) an expense that serves no other purpose, and 2) a subjective exercise that is difficult to audit.

The boards split in their positions. Some board members want to maintain capital lease accounting for all leases, but a majority of the FASB favors interest-based amortization, while a majority of the IASB favors the underlying asset approach. However, the overall conclusion was that more "outreach" is needed, discussing the options with both statement preparers and users; the underlying asset approach in particular is a very new concept which has received little review. Therefore, the boards are going to take two months to meet with interested parties, and plan to continue discussions in April with the results of their outreach.

Given that once this is settled, the boards need to decide if there is any impact on lessor accounting, and then they need to talk about final details such as the comment period and interim disclosures, it looks like we're not going to get a revised exposure draft before June.

IASB/EFRAG meeting
The IASB met March 9 with EFRAG, the European Financial Reporting Advisory Group, to discuss several current IASB projects. EFRAG wants to keep the current distinction between capital and operating leases, with just minor improvements to determining when leases ought to be considered financing transactions and therefore capitalized. That seems unlikely.