Two Roads Diverge on Leases

The drive to converge U.S. and international accounting standards is sputtering out, and accounting for leases may be the first place in the financial statements where different reporting starts to return.

For years the U.S. Financial Accounting Standards Board and the International Accounting Standards Board have worked together to find a common approach to lease accounting, and the boards are still firmly committed to the goal of bringing all leases onto the balance sheet. How to reflect those costs on the income statement, however, is another story—one where U.S. and international rulemakers have burned through multiple ideas while trying to find consensus. They never did.

Now IASB has affirmed its plans to part ways with FASB on a key element of the accounting for those who lease, rather than purchase, assets to do business. Ultimately that will mean reporting different numbers for companies publishing financial statements in both U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards.

In their most recent proposals on lease accounting in 2013, both boards proposed dividing leases into two categories: those that would be treated like the financed purchase of an asset, with interest cost front-loaded in the income statement; and those treated more like rental agreements, with the associated costs reflected in a more straight-line pattern. Now IASB has decided to revert to an earlier view held by both boards, that all leases should be treated like the financed purchase of an asset.

“We’re going to have a grand experiment to see which model wins market acceptance, provides better information, and is most workable. That may not be a bad thing.”
John Hepp, Partner, Grant Thornton

FASB says it plans to stick with its two-model approach, although the board has revised its thinking since the 2013 proposal on how it will define the differences between the two models. Its most recent decisions focus on requiring companies to follow guidance (oddly enough, found currently in international rules) for how to distinguish between today’s operating and capital leases.

The criteria are meant to distinguish leases that look like purchases from those that look like rentals, says Betty Davis, a partner with EY. “They are moving the bright lines out, but the same concepts are there,” she says. “Am I buying and financing the asset, or am I just using it?” Both boards expect to issue their final standards at some point in 2015, with effective dates yet to be determined.

If IASB and FASB adopt their standards as now envisioned, leased assets will look different on the balance sheet and income statements under the diverged requirements. “We’re going to have a grand experiment to see which model wins market acceptance, provides better information, and is most workable,” says John Hepp, a partner with Grant Thornton. “That may not be a bad thing.”

The differences will be somewhat visible in the balance sheet, but much more distinct in the income statement, Hepp says. “Under IFRS, you would have higher expense, and it would be most significant for longer-term leases,” he says. “The longer the lease term, the more significant it would be.”

The difference in expense that hits the income statement also leads to difference in depreciation, which is reflected on the balance sheet, he says. “I don’t know how important those differences are going to be to users of financial statements. They’re going to be much more interested in the income statement.”

Much Ado About Nothing?

IASB says in a recent project update document that it expects the separate approaches to lead to “little difference for many lessees for portfolios of leases.” For large companies with large portfolios of leases, that may be true, says Richard Stuart, a partner with McGladrey, but he believes the differences will be significant for many companies that lease their assets, and they will be difficult for analysts to parse. “I think it’s going to get pretty hairy,” he says. “Users of financial statements will have a good amount of work to do to make sure they are doing any comparison correctly.”

ACCOUNTING MODELS


Lessee Accounting Model
The FASB decided on a dual approach for lessee accounting, with lease classification determined in accordance with the principle in existing lease requirements (that is, determining whether a lease is effectively an installment purchase by the lessee). Under this approach, a lessee would account for most existing capital/finance leases as Type A leases (that is, recognizing amortization of the right-of-use (ROU) asset separately from interest on the lease liability) and most existing operating leases as Type B leases (that is, recognizing a single total lease expense). Both Type A leases and Type B leases result in the lessee recognizing a ROU asset and a lease liability.
The IASB decided on a single approach for lessee accounting. Under that approach, a lessee would account for all leases as Type A leases (that is, recognizing amortization of the ROU asset separately from interest on the lease liability).
Lessor Accounting Model
The Boards decided that a lessor should determine lease classification (Type A versus Type B) on the basis of whether the lease is effectively a financing or a sale, rather than an operating lease (that is, on the concept underlying existing U.S. GAAP and on IFRS lessor accounting). A lessor would make that determination by assessing whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset. In addition, the FASB decided that a lessor should be precluded from recognizing selling profit and revenue at lease commencement for any Type A lease that does not transfer control of the underlying asset to the lessee. This requirement aligns the notion of what constitutes a sale in the lessor accounting guidance with that in the forthcoming revenue recognition standard, which evaluates whether a sale has occurred from the customer’s perspective.
Lessor Type A Accounting
The Boards decided to eliminate the receivable and residual approach proposed in the May 2013 Exposure Draft. Instead, a lessor will be required to apply an approach substantially equivalent to existing IFRS finance lease accounting (and U.S. GAAP sales type/direct financing lease accounting) to all Type A leases.
Sources: FASB/IASB.

The Equipment Leasing and Finance Association is happy to see FASB stick with a two-model approach, but it also expects a bumpy ride, especially for global companies with operations under both GAAP and IFRS. “It is going to create big complexity and confusion when you look at U.S. companies compared with the rest of the world,” says Ralph Petta, chief operating officer of ELFA. “It is going to create a bit of uncertainty for companies that will have to report under both standards.”

Eddy James, technical manager for the Institute of Chartered Accountants in England and Wales, says the final standards in GAAP and IFRS will still have plenty in common, especially the notion that leases will appear as assets and liabilities on balance sheets. He believes the income statement effects may not be as dramatic as they first seem.

“Entities applying IFRS and U.S. GAAP tend to be large and complex organizations, often with a large portfolio of leased properties,” he says. “The IASB staff are confident that in such instances things will often balance out across the portfolio, meaning the overall expense recognized under IFRS wouldn’t be all that different to the expense under U.S. GAAP.”

Julie Valpey, a partner with BDO USA, expects comparability to be a concern. “You’re going to have two different companies with the same type of lease, and depending on the accounting model two different methods of recognizing the expense over the life of those leases,” she says. “It is not going to be easy to normalize.”

Neither board has finalized their intended disclosure requirements, so it’s not clear whether either board might choose to add disclose requirements that would facilitate comparability, experts say.

For leases under GAAP that would be reported under a straight-line approach, users of financial statements may not have all the data they would need to adjust those figures to make them comparable to similar leases that would be capitalized under IFRS, she says. Davis believes GAAP financial statements likely will include the data in some fashion that would facilitate comparability.

Chad Soares, a partner at PwC, says global companies with thousands of leases may feel the stress of having to account for leases under two different methods if required to do so.

“Public statements from the boards suggest that their positions are firm, but it will be interesting to see what feedback they get from their stakeholders and regulators, and whether that affects the positions the boards ultimately take,” he says. “The boards have gotten a tremendous amount of feedback on this project, sometimes conflicting, but they are trying to sift through it and land in the right place.”