Two expense profiles

At the joint meeting of the IASB & FASB yesterday (June 13), the boards came to an agreement on the expense recognition patterns for lessee leases to be presented in the Revised Exposure Draft (RED). (My thanks to Asset Finance International for their summary of the board meeting.) If you're looking at the meeting papers prepared by the staff (available here), the choice made was for Approach 3, meaning that some leases will be accounted for using current finance/capital lease accounting (recognizing interest and depreciation expense, with the effect that expenses are higher at the beginning of the lease), while others will be accounted for with a single lease expense item which is recognized straight line over the life of the lease. If the rent payments are equal over the life of the lease, the asset and liability balances will be equal at any date. If they are unequal, the adjustment required to balance cash rent vs. accrual expense (what is shown under current operating lease accounting as a deferred rent liability) will be taken to the asset. The asset will also be adjusted for any initial direct costs or impairments, both of which are to be recognized over the life of the lease (or remaining life, for an impairment).

The second decision was where to draw the line between the two types of expense recognition. The boards opted for Option 3 (as described in agenda paper 3D/237):

(a) Leases of property (defined as land or a building – or part of a building – or both) should be accounted for using a straight-line presentation in the income statement ... unless:
(i) The lease term is for the major part of the economic life of the underlying asset; or
(ii) The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

(b) Leases of assets other than property should be accounted for under Approach 1 [finance accounting] ... unless:
(i) The lease term is an insignificant portion of the economic life of the underlying asset;
(ii) The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

The boards' push for convergence was in evidence in the voting. A solid majority of the IASB preferred a single methodology for all leases, using finance lease accounting. However, members of the FASB very strongly felt that straight line expensing was a necessary part of the standard, and the IASB agreed in the interest of having a common standard.

The implications are that virtually all equipment (except leases of 12 months or less, which have previously been excluded from the standard and will be treated like current operating leases) will use finance accounting, while the vast majority of property leases will use straight line accounting. Only when a property lease is for nearly all of an asset's useful life (or there is an ownership transfer or bargain purchase option) will finance accounting be used. We'll have to see how this sorts out in practice, but this probably means that a lease of a building for less than 30 or 40 years will use straight line unless there are very special circumstances.

Lessor accounting

Having made that decision, the boards discussed the implications for lessors. Since they previously decided that lessors of "investment property" could use operating lease accounting, and this would cover virtually all property lessors, the focus was on equipment lessors. The boards decided that they would use accounting more or less symmetrical with lessee accounting, so the "receivable and residual" model will apply to equipment leases unless the lease has an "insignificant" term or receivable. This is similar to current capital lessor accounting, but with the benefit to lessors that they are permitted to recognize a portion of profit at inception (proportional to the value of the receivable compared to the residual), whereas currently profit is recognized over the life of the lease.

Next steps

There will be some wrap-up decisions to make at the July joint boards meeting, related to the RED comment period, transition, and disclosure adjustments. After that, the staff will prepare the RED, with the expectation that it will be released in Q4 2012. (If no further hitches come up, early in the quarter would seem likely.) With an expected 4-month comment period, then time to redeliberate based on comments received, a mid-year 2013 release date of the new standard seems possible, unless there's strong pushback. However, the boards seem to have met the biggest objections, so I think any changes this time around are likely to be modest (tweaks of wording, adjustments of disclosures, etc.), not the wholesale rewrite that we got between the original ED and the RED.

At this point, I wouldn't expect an effective date before 2016, to allow companies time to update their systems and gather any needed information. However, the requirement to restate prior years remains, so U.S. companies will generally need to recalculate 2014 & 2015 when they first apply the standard in 2016. If early implementation is permitted, the recalculation period would move forward commensurately. In other words, 2016 isn't that far away.

EZ13

Here at Financial Computer Systems, we're finishing up the latest update of EZ13, which will be released this summer. We won't have the new level expense capital methodology in that version, but will be working on it later this year. We'll have it in place, including transitions from current accounting, long before implementation is required. We do right now provide for pro forma capitalizing operating leases according to current capitalization rules, so you can see what your balance sheet exposure is under the RED.

Presentation & Disclosure: Gross revenue vs net revenue - Principal vs Agency Relationship

Revenue recognition is a crucial and important topic in the auditing profession. One of the key challenges auditor face is: auditor need to review the substance of the transaction to determine if an entity is a principal or an agent in certain business arrangement. An entity need to present the revenue on a gross basis if the entity is deemed to be a principal, whereas an entity need to present the revenue on a net basis if the entity is deemed to be an agent.

To illustrate, insurance agent is selling insurance contract worth US$300 dollar. Insurance agent is able to earn a commission of US$20 dollar by selling such contract. What should be the revenue for insurance agent upon successful selling of this insurance contract ? US$300 or US$20? IAS18 states that 'in an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission.

Determining whether an entity is acting as a principal or as an agent requires judgement and consideration of all relevant facts and circumstances. An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of services.

Features that indicate that an entity is acting as a principal include: (a) the entity has the primary responsibility for providing the goods or services to the customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer; (b) the entity has inventory risk before or after the customer order, during shipping or on return; (c) the entity has latitude in establishing prices, either directly or indirectly, for example by providing additional goods or services; and (d) the entity bears the customer's credit risk for the amount receivable from the customer.

An entity is acting as an agent when it does not have exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. One feature indicating that an entity is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer. In the example above, insurance agent should recognise US$20 as its revenue (instead of US$300) as the insurance agent is not entitled to the full economic benefit of entire US$300.

"We need to be ready to make a decision"

The FASB & IASB had separate "education sessions" on June 6, to review the materials the staffs have prepared for next week's joint meeting regarding the new lease accounting standard (and other projects). The FASB session is available here; the discussion on leases starts at about 1 hour, 30 minutes in from the beginning. You can view the IASB session by clicking on the "Register" link on this page. The discussion won't make a lot of sense without having the agenda papers available to look at; those are available here (right-click to download the zip file).

The staffs have, as directed by the boards last month, prepared three possible approaches for expense recognition:

1. The current plan: All leases are treated using current finance lease accounting.
2. What was called "Approach D" last month: level expense recognition, with the asset and liability linked throughout the life of the lease (if rent payments are equal throughout the lease life, asset and liability will be equal at all times).
3. A combination of the two approaches, with the necessity to decide which leases need which treatment.

More information was provided about Approach D, now Approach 2. It hadn't been clear last month how to account for leases where the rents change over the life. I speculated that there might be a deferred rent liability, as with current operating lease accounting. Now the staff has clarified that such adjustment should be recognized in the asset, rather than in a separate account. Other adjustments to the asset could also result in assets and liabilities being unequal, such as initial direct costs (added) or impairments (subtracted).

If Approach 3 is desired, then the boards need to decide where to "draw the line" to determine which leases get which treatment. Four options were presented:

1. Finance lease accounting when the lease transfers substantially all the risks and rewards of ownership (the language used currently in IAS 17, which is also the concept behind FAS 13; the determination, however, would be made using IAS 17 principles, rather than FAS 13's "bright lines" of 75% and 90%).
2. Finance lease accounting when the ROU asset represents the acquisition of a more than insignificant portion of the underlying asset.
3. Determination based on the nature of the underlying asset:
   
   • Property leases would use Approach 2 (straight line) unless the lease term is for the major part of the economic life of the underlying asset or the present value of the rent accounts for substantially all of the asset's fair value;
   • Equipment leases would use Approach 1 (financing) unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the rents is insignificant relative to the asset's fair value. 
4. Determination based on the lessee’s business purpose for entering into the lease arrangement.

Most of the FASB board members (at least 5 of the 7) felt that it was appropriate to draw a line, considering that there are different purposes and intentions for different types of leasing transactions, and that it is appropriate to recognize those. Outreach indicated that virtually all property lessees see their transactions as generally not having a financing component; they see it as simply gaining use of an asset for a period of time. Equipment lessees are more split; some deny a financing component, but major aircraft lessees admit that that's part of the transaction.

Option 4 seemed to have the least support; while it seemed superficially to allow preparers to account for their actual intentions, there was substantial concern of gaming the system and a lack of comparability between different companies. Options 2 & 3 were seen as effectively the same, simply stated differently; Option 2 might be seen as more principles-based, while Option 3 is perhaps easier to put into practice. Some thought that Option 1 would be the simplest to apply, since everyone is familiar with the concept already; however, that would result in most aircraft leases getting straight-line rather than finance accounting, which was troubling. (Aircraft operating lease accounting is a poster child for the need for a new lease accounting standard.)

One board member indicated that he thought in-substance purchases were scoped out of the new lease standard. That's news to me; it had been discussed at one point, but I thought that was long since discarded. I don't see any support for that in the FASB's summary of tentative decisions to date.

During the outreach, most users of financial statements (i.e., financial analysts and investors) expressed a preference for a single approach to lessee accounting, but generally the more important issue to them was getting everything on the balance sheet. It was felt that proper disclosure could enable users who prefer to see leases a different way to make the adjustments they need.

There was some discussion regarding the implications for lessor accounting. Some board members consider symmetry important. Others consider the different business models and purposes on the two sides of the transactions sufficient that symmetry doesn't matter; at least one suggested that no change at all to lessor accounting from current practice is necessary.

The boards are concerned that their decision not seem arbitrary, recognizing that some people will be unhappy with whatever decision they make. They want to be able to defend it on a theoretical, not just practical, basis.

At the end of the session, a FASB board member asked the staff for what preferences had been expressed at the IASB education session held earlier in the day. It was reported that a majority of the IASB seems to have a first preference for Approach 1, but also that the strength of preference for that over Approach 3 would depend on where a line was to be drawn. So we have a difference of opinion between the boards; we know that they want very strongly to release a unified standard, so we'll have to see how that gets resolved.

To wrap up, though, the comment was, "We need to be ready to make a decision." The staff said a similar sentiment was expressed by the IASB. They've scheduled 5-1/2 hours of discussion for Wednesday & Thursday, June 13 & 14.

The staff expects this meeting to include the last substantive decisions on the new standard to be presented in the revised exposure draft (RED). They plan to follow up in July with wrap-up decisions, such as the comment period for the RED and interim disclosures, plus any decisions that may need to follow on from June decisions (such as adjusting disclosures if the approach to lessee accounting changes). After that, they would be ready to draft the RED and release it later in the year. The FASB Current Technical Plan is now reporting that the RED is expected to be released in Q4 2012 (that's a recent development; just a few weeks ago, it was simply "second half of 2012").

What is provision for reinstatement costs and how to account for it

It's common for an audit client to enter into rental lease agreement to lease the office building, warehouse, etc with the landlord of certain premises for certain period (e.g. 5 years). For operation purpose, the client may renovate the lease premises, such as installing cubicle in the said lease office.

 A landlord might require the our audit client (i.e. the audit tenant) to reinstate the office building upon moving out from the office while the lease has expired. Audit client may have to incur certain costs to reinstate the lease premises to its original state. Hence, a clause will be stated in the agreement to state cleary that the audit client is required to reinstate the lease premise to its original state. [ note: auditor must read the agreement in a cautiour manner to review of the obligations of our audit client].

In this instance, audit client is required to accrue for reinstatement cost. The question is, how to accrue for it, and who much to accrue for it? Audit client is required to obtain a quote from relevant contractor to estimate the reinstatement cost required to reinstate the premise to its original state (after factoring in the inflation in the future years till the end of the lease period). T

he following accounting entries need to be recorded: Dr. Reinstatement Cost (to be recorded in Fixed Asset) Cr. Provision for reinstatement cost (to be recorded in Accrual) The reinstatement csot capitalised as fixed asset need to be depreciated over the lease period. Consequently, it is evident that the reinstatement cost is expensed off on a straight line basis till the end of the lease period.