Bill Bosco, who will be our speaker at today’s Roundtable, sent along the text of his comment letter on leasing to the IASB.  Here it is, in its entirety:

Sir David Tweedie                                                                              July 12, 2009

Chairman

IASB

Dear Sir:

I support the theory that operating lease obligations arising from material operating leases should be capitalized.  The issue of capitalizing operating lease obligations was cited by the SEC as a major financial reporting deficiency.  Rating agencies capitalize the lease obligations in their credit analysis.  This is a criticism of current GAAP, but the rating agencies do not adjust the current GAAP P&L treatment of rent expense nor do they adjust the cash flow classification of rent as an operating cash outflow.  As a result I submit that the new approach and its theoretical conclusions result in the consequences that the liability side of the balance sheet may be “fixed” but the asset, the P&L and the cash flow statement treatment are changed such that they misrepresent the economic reality of a right-of-use lease.  When I met with Fitch, the rating agency, they said they may have to make new adjustments given the direction of the new approach.  My position is that the new approach should only adjust what the rating agencies adjust and stop there – why try to fix what is not broken?  The P&L expense under the new approach will be front ended (as much as 21% more lease expense will be reported in the first year of the lease term by a bank that has a 10 year branch office lease and in the first half of the lease term the expense will be 63% higher than current GAAP) caused by replacing straight line rent expense with depreciation and imputed interest expense.  Treating the expense in a right-to-use vs. right-to-own lease as a purchase and a loan does not reflect the operating expense nature of the rent.

I support the idea that the rights and obligations in a material lease contract should be accounted for as assets and liabilities assuming they meet the current definitions of assets and liabilities.  I submit that the new approach claims to do that but fails to analyze the rights and obligations in a lease contract to determine if the rights are ownership rights or merely rights of use.  The Boards seem to be stuck on the theory that all leases are right of use contracts when in fact many are right of ownership contracts.  It is a major flaw in the new approach to lease accounting.  My position is that there are many equipment leases that are equivalent to a purchase and a loan and there are many leases (the former operating leases) that merely give the lessee the temporary right to use the leased item.  My position is that the economics to the lessee are significantly different and the accounting and presentation of the two types of leases should be different.  Readers of financial statements should know which assets are owned and which must be returned.  Readers should also know what the operating earnings and operating cash flows are.  The failure to either scope out capital/finance leases or to classify leases means that the new approach is form driven rather than substance driven.  The prior Boards wrestled with the same issues in drafting current GAAP and came to the conclusion that all leases are not right-of-use leases and the facts and market have not changed.  In the US, the tax and legal systems recognize the substance of leases and treat the two types very differently. The UNIDROIT model lease law recognizes the issue as well and gives guidance as to how to differentiate leases versus financings.  Right of use leases create contract rights while right to own leases create physical property rights.  The criticism that current GAAP allows similar transactions can  be accounted for very differently, reducing comparability for users will be replaced by a new criticism that very different transactions will be accounted for the same, reducing clarity in financial statements.  I did notice an inconsistency with the thought that all leases are the same in that section 5.40 of the discussion paper that says “For leases of items in which it is expected that the lessee will obtain title at the end of the lease term, the amortization period would be the economic life of the leased item.”  This sentence presumes that one analyzes the rights in a lease to determine if the lessee will obtain title and the sentence recognizes that some leases are not right of use leases and that the accounting should be different.

My position on the lease asset in a capitalized right-to-use lease (a former operating lease) is that the asset and liability are linked.  Neither can be settled without the other.  The values are the same over time except for impairment, that is, the value of both are the present value of the future payments.

The new approach treats the asset as though it is PP&E and depreciates the asset straight line over the term.  Rather it is an intangible whose value declines as the linked liability’s value declines. The Boards concluded that the best proxy for the initial value of the lease asset is the PV of the rents – then why not keep that same logic throughout the lease term – that is, the best proxy for the value of the lease asset continues to be the PV of the remaining rents?  Aren’t we trying as best as possible or practical to present assets and liabilities at fair value?

Additionally the new approach treats the capitalized lease obligation under the former operating leases as a loan with imputed interest.  My position is that right-of-use leases have unique characteristics and using PP&E and loan accounting should be re-thought.  The lease asset in a right of use asset is an intangible right, while in a right-to-own lease the lease asset is a physical asset (PP&E).  An intangible right to use an underlying asset does not have the same characteristics as the underlying asset.  My position is that the asset and liability should be amortized to rent expense.  Rent should be accrued as it is under current GAAP – that is the average rent is the expense.  As rent is paid it should be charged to accrued rent payable.  This approach best presents the economics to the lessee, avoids deferred tax accounting and will be understood by readers of financial statements.

The new approach initially focused on the components of a lease as the unit of account.  It was an ambitious undertaking that may have been theoretically sound but proved to be unworkable.  The approach to consider the contract as the unit of account is a much more practical approach.  It seems to lead one to the approach used in current GAAP where potential payments are analyzed as to whether they are minimum lease payments.  Additionally the definition of the lease term under US GAAP includes the concept of extending the term if the lessee would suffer a penalty for failure to renew. It is much like the new approach where the lessee must determine the likely lease term.  Since the new approach is moving so close to current GAAP why not use IAS 17/FAS 13 and merely modify it to capitalize the former operating leases but leave the P&L and cash flow treatment unchanged?  Some guidance would have to be added for determining the lease term, minimum lease payments, disclosures and presentation, but it would save time and build on the decisions that previous boards did plenty of work on.  For lessor accounting you could have amended FAS 13/IAS 17 to continue to use operating lease accounting where the lessor leases parts of assets (commercial real estate and fractional share leases) or leases the entire asset for less than one year or even daily (those types of lessors can be characterized as truly being in the operating lease business where the leased asset is the earning asset, rent is revenue, depreciation is an expense and they bear the operating expenses of maintaining the asset).  Direct finance lease accounting would be used for all leases where the entire asset was leased to one lessee and the lease term is one year or longer (those types of leases should result in the asset being derecognized and converted into a financial asset  – the rent portion and a physical asset – the residual).

I support simplicity and clarity in accounting.  My suggestion is to book leases with whatever estimates you must include and only adjust in the event of a material change.  The new approach is overly complex in its implementation requirements and results in financial results and presentation that do not reflect the economic affects of right-of-use leases (the former operating leases).

  • The P&L pattern should be straight line, reflecting the operating expense nature of the lease.  Since the tax regime in the US treats rents as the deductible expense every right-of-use lease will have book tax differences and will require deferred tax accounting.  As an aside, the idea that leases that are financings (the former capital leases) and should not use the implicit rate in the lease will create book tax differences as well since the tax regime in the US treats right-to-own leases as loans and the implicit rate is the rate used to calculate the deductible interest expense.  This means that all leases will create book tax differences where substantially all did not under current GAAP.  Why the added complexity?  (You will see this as you work on the transition rules for the former capital leases as all will have to be rebooked since you will no longer allow the implicit rate to be used.  This is a seemingly minor, but very illogical change that will result in a lot of work for an immaterial adjustment.)  The answer is the added complexity is the result of illogical accounting under the new approach. The lack of logic seems driven by the Boards’ need to create anti-abuse rules as the Boards feel that lease classification gives the opportunity for abuse.
  • Additionally the requirement to review lease assumptions on each reporting date and perform complex adjustments is a burden for 99+% of equipment leases.  ELFA market statistics show that 0.4% of equipment leases as measured by the number of lease contracts are $5 million or greater (large public companies have thousands of equipment leases).  Equipment leases are a minor part of the operating lease market and most equipment leases are not structured to be off balance sheet.  The following are some facts about the US equipment leasing market which is about 30% of the world leasing market.  Regarding the equipment leasing market, 81% of equipment leases by dollar volume are less than $5 million, primarily being leases of computers (22%), cars/trucks (16%) office equipment (12%), and medical equipment (7%) with short terms, leased mostly to small and medium sized companies.  When measured by numbers of leases, 99.6% of the transactions are less than $5 million in size.  Over 65% are currently classified as finance leases in the US and thus are not off balance sheet.
  • Real estate leasing is the big issue which seems to be ignored.  Real estate leases make up 70-75% of the reported off balance sheet leases in the US primarily representing retail, office, bank branch and warehouse space leases that are only available as operating leases as the commercial real estate owner/lessor will not allow a purchase option to the lessee.  They are not structured to be off balance sheet as they are operating leases/rentals by their nature.
  • In my opinion the boards are overly concerned with financial engineering as once all material leases are capitalized, the objectives of the financial engineers will disappear.  To what ends will they be financial engineering?  .   I ask the Board to do a more thorough test of the market and to do a cost benefit study now.

My position on contingent rents is they do not meet the definition of a liability at lease inception.  Capitalizing estimates of contingent rent is another example of focusing too much on anti-abuse in writing the rules.  For the few real estate leases that may have the amount of rent as contingent rent, you require all contingent rents to be estimated and capitalized.  I submit that in all third party equipment leases that have contingent rents, the contingent element is immaterial.  Yet all those leases will be burdened by the requirement to estimate, capitalize, re-measure and rebook for the minor contingent element.  The abuse might be the attempt to minimize capitalization, but that can be solved by stating the principle that the preparer estimate the lease term and include any contingent rents that are disguised minimum lease payments, including guidance which says if the lease term includes minimum rents that are immaterial compared to rents in leases of comparable assets, an estimate of contingent rents must be capitalized.  The big 4 accounting firms apply that principle in the US currently.  The most common contingent rents in the equipment leasing business in the US are contingent rents based on usage in vehicle, copier and medical equipment leases and floating rate based leases with large company lessees.  In the case of usage based contingent rents my position is that current GAAP should continue to be followed – that is the rent should only be accounted for when it is incurred as the lessee can stop using the equipment to avoid the liability.  Regarding floating rate based rents, current GAAP seems logical – that is capitalize the rents assuming today’s interest rate used to project future rents and discount those projected rents using today’s floating rate.  Changes in the rate should be accounted for on a cash basis.

The proposed rules also may represent the next big capital hit for large financial institutions as billions of dollars in new capitalized lease assets added will need new capital and earnings/capital will decline by hundreds of millions due to the new front ended pattern of lease expense.  The capitalized assets may be a regulatory accounting issue.  I have seen cases where GAAP and regulatory accounting may have different objectives and one can easily treat the right-to-use asset as subject to different capital rules.  The P&L is a different case.  It will not be easy to adjust the new approach to a straight line operating expense method, but more importantly – straight line matches the commercial effects of a right-to-use lease.

I strongly recommend reconsidering the splitting of lessor accounting from the scope.  I realize that the boards agree but had to make that decision to speed up work and meet the 2011 target for the more important lessee changes.  It is evident from the lack of detail and direction in the sublease accounting section in the discussion paper that decisions need to be made now on lessor accounting.  I have also noted that the failure to classify leases has raised lessor accounting questions regarding sales-type leases.  Lessor and lessee issues are linked.

I support the need to capitalize operating leases, but the proposed rules are too complex, fail to reflect their economic effects and fail to account for rental contracts differently from leases that are the equivalent to financings.   I remain available to help the boards in any way they see fit to produce workable rules that reflect the economics of lease transactions in the financial statements of lessees.

Sincerely,

William Bosco

Leasing 101

17 Lancaster Dr.

Suffern, NY  10901

Wbleasing101@aol.com

914-522-3233

Answers to questions for respondents

Introduction

Chapter 2: Scope of lease accounting standard

Question 1

The boards tentatively decided to base the scope of the proposed new lease accounting

standard on the scope of the existing lease accounting standards. Do you agree with this

proposed approach?

Answer

I agree that the scope should be leases of PP&E, but lessor accounting should be included and there is a need to deal with leases that are not right of use leases.

As an aside, now that the project has moved away from a components approach, it is looking awfully much like current GAAP.  Why not merely amend FAS 13 or IAS 17 or take the best of both?  Wasn’t the real objective to capitalize operating leases?  That is accomplished by just requiring that the minimum lease payments in operating leases be capitalized and if you amortize the asset and liability, charging and crediting rent expense, most of the work is done in existing GAAP and the economic effects of operating leases are preserved in the P&L and cash flow statement.

The scope has to be expanded to include lessor accounting as you need to settle that before you try to do sale leaseback and sublease accounting.

If you disagree with the proposed approach, please describe how you would define the

scope of the proposed new standard.

Answer

To deal with leases that are not right of use leases there are two choices as I see it.  Either you include all transactions that are nominally leases and include a process to differentiate those that transfer ownership rights from those that merely transfer the right to use the leased asset or you exclude transactions that transfer ownership rights as they are financed purchases.  In the latter case you will have to provide guidance as to differentiate those leases.

Question 2

Should the proposed new standard exclude non-core asset leases or short-term leases?

Please explain why.

Answer

Because of the large numbers of small ticket short term leases of assets like copies, fax machines, PCs, automobiles, etc some provisions must be included to simplify the complex and burdensome requirements of the proposed approach.

Please explain how you would define those leases to be excluded from the scope of the

proposed new standard.

Answer

It is difficult to develop materiality thresholds or definitions of core assets.  The best approach is to simplify the new standard’s subsequent accounting and then one would have no need to provide a scope exception.  The areas that need simplification are:

  1. 1. P&L – straight line is simpler than imputing interest and depreciating the asset and it avoids deferred tax accounting in the US.
  2. 2. Continuous adjustments –  I would only require adjustment if changes in assumptions were material.  I also would not require probability weighted average calculations of estimates.

Of course another alternative is to include a materiality threshold.  I suggest that right-to-use (vs. ownership rights) equipment leases with expected lease terms of 60 months or less and less than $250,000 in equipment cost should be accounted for as operating leases.

Chapter 3: Approach to lessee accounting

Question 3

Do you agree with the boards’ analysis of the rights and obligations, and assets and

liabilities arising in a simple lease contract? If you disagree, please explain why.

Answer

Agreed that some leases have rights that are rights of use, but many leases transfer ownership rights and the economic effects are very different.  Right of use leases transfer contract rights (an intangible asset) while leases that transfer ownership rights transfer physical property rights (PP&E).  The board avoids analysis of the rights in the lease contract and I feel this is motivated by an  anti-abuse mind set that is clouding better judgment.  This is a basic issue that was recognized buy prior boards as well as US tax and legal authorities and legal and tax authorities in many other countries.  Claiming that doing away with lease classification simplifies the accounting is wrong – it simplifies the standard writing process and avoids a necessary but difficult task.  It seems that some members of the board or staff agree with the view that the accounting for leases that are financed purchases should be different from right-to-use leases as evidenced by section 5.40 which says “For leases of items in which it is expected that the lessee will obtain title at the end of the lease term, the amortization period would be the economic life of the leased item.” In order to make that section operational the staff or board must provide guidance to identify or classify) those leases.

Question 4

The boards tentatively decided to adopt an approach to lessee accounting that would

require the lessee to recognize:

(a) an asset representing its right to use the leased item for the lease term (the right-of-use

asset)

(b) a liability for its obligation to pay rentals.

Appendix C describes some possible accounting approaches that were rejected by the

boards.  Do you support the proposed approach?

Answer

Yes but with suggested simplifications and only for material right-to-use (the former operating leases) leases.  Leases that are the equivalent of a financed purchase (where the rights are ownership rights) should use the current capital lease accounting method, including the use of the implicit rate in the lease.  Small ticket, short term leases should be accounted for as operating leases, but if the board does not agree, then certainly those leases need a simpler method.

If you support an alternative approach, please describe the approach and explain why you

support it.  Right-of-use leases need a simpler method that reflects the fact that rent is an operating expense and certainly small ticket, short term leases need a simple approach if not an actual scope out.

Answer

The reason for using the capital lease method for leases that transfer ownership rights is that that method accomplishes that. Right-of-use leases need a simpler method that reflects the facts that the asset and liability are linked as to value and that rent is an operating expense.  Certainly small ticket, short term leases need a simple approach if not an actual scope out.

Question 5

The boards tentatively decided not to adopt a components approach to lease contracts.

Instead, the boards tentatively decided to adopt an approach whereby the lessee

recognizes:

(a) a single right-of-use asset that includes rights acquired under options

(b) a single obligation to pay rentals that includes obligations arising under contingent

rental arrangements and residual value guarantees.

Do you support this proposed approach? If not, why?

Answer

The components approach is more theoretically correct, but I am pleased to see that the board decided on a more practical approach as it is the only workable approach.  Although it is more practical, more work has to be done to maintain the attitude of practicality and workability as opposed to theoreticality.

Chapter 4: Initial measurement

Question 6

Do you agree with the boards’ tentative decision to measure the lessee’s obligation to pay rentals at the present value of the lease payments discounted using the lessee’s

incremental borrowing rate?

Answer

Yes, for right-of use leases, but no for rights-of-ownership leases.

If you disagree, please explain why and describe how you would initially measure the

lessee’s obligation to pay rentals.

Answer

Where a lease transfers the right of ownership the lessee knows the cost of the asset and knows the minimum lease payments, therefore the implicit rate in the contract can be calculated.  The implicit rate is the rate that the US tax and legal authorities recognize in that type of lease as the financing rate.  Failure to use that rate means that the lessee will have to account for deferred taxes since it  creates a book/tax difference.  The way the board is going all leases will require deferred tax accounting where few do under current GAAP.  That is a complexity and burden issue that begs to be addressed as it is out of step with economic reality and will add confusion rather than clarity to readers of financial statements.

Additionally on implementation all the former capital leases will have to be adjusted using the then current incremental borrowing rate.  I think this is illogical as the implicit rate is the right rate.  It will also mean a lot of work for a very minor adjustment.  It also brings to mind the original objective which was to capitalize the former operating leases.  In my opinion there is no need to revise the accounting for the former capital leases.

Question 7

Do you agree with the boards’ tentative decision to initially measure the lessee’s right-of-use asset at cost?   If you disagree, please explain why and describe how you would initially measure the lessee’s right-of-use asset.

Answer

The cost of the asset in a right-of-ownership lease is the cost of the leased asset and it is also the present value of the expected minimum lease payments using the implicit rate as the discount rate.  For right-of-use leases it is difficult to value the asset so the practical approach is to say the value or cost is the present value of the estimated minimum lease payments in the lease contract, but it also should follow that the value of that asset over time is the present value of the remaining estimated minimum lease payments

Chapter 5: Subsequent measurement

Question 8

The boards tentatively decided to adopt an amortized cost-based approach to subsequent

measurement of both the obligation to pay rentals and the right-of-use asset.  Do you agree with this proposed approach?  If you disagree with the boards’ proposed approach, please describe the approach to subsequent measurement you would favor and why.

Answer

I agree that an amortized cost approach is the most practical and representative approach, but not the one that most of the board members favor.  Right-of-use leases should be viewed as a unique transaction where the lessee has a temporary intangible right to use an asset.  Just because the scope limits the standard to PP&E should not mean that PP&E accounting should be used for the asset.  Using PP&E accounting for right of use leases is accounting for the underlying asset but not accounting for  the intangible right to us the asset.  I thought in previous FASB board discussions they were adamant about not accounting for the leased item but rather accounting for the rights.  On the other hand it is appropriate to use PP&E accounting for a lease that transfers ownership as in that case the lessee does own the underlying asset.   The board tends to look for other areas or decisions made on similar things to decide on accounting for the asset and liability.  I agree that is a starting point, but they always should also consider the nature of the transaction is question – in this case the right-of-use lease contract.  The asset and liability are linked in a right-to-use lease.  One cannot be extinguished without the other.  The asset is an intangible.  The liability bears no interest.  In bankruptcy if the lease is rejected the asset is returned and that legally extinguishes the obligation to pay rent.  That confirms the legal reality that the asset and liability are linked as to value.

Question 9

Should a new lease accounting standard permit a lessee to elect to measure its obligation

to pay rentals at fair value? Please explain your reasons.

Answer

No, as it would be too complex for the vast majority of leases by number of leases. For equipment leases there are sources of information to base fair value judgments on.   I think the simplest and most practical approach is to use mortgage amortization for the leased asset.  This is the best proxy for fair value over the life of the lease and maintains the linked nature as the value of the liability will be the same.  In my opinion they are linked.

Question 10

Should the lessee be required to revise its obligation to pay rentals to reflect changes in its incremental borrowing rate? Please explain your reasons.

Answer

No.  For small ticket and short term leases this is a complex, burdensome task that will result in immaterial adjustments for 90+% of leases.  I ask the Board to consider proportionality in their decisions as the complex rules will be a tremendous burden for virtually all leases creating little value in terms of meaningful financial information.    For all right-of-use leases my theory is the value of the asset equals the value of the liability absent impairment so if the changes in that asset and liability values are the same there would be no financial impact.

If the boards decide to require the obligation to pay rentals to be revised for changes in the incremental borrowing rate, should revision be made at each reporting date or only when there is a change in the estimated cash flows? Please explain your reasons.

Answer

For practical purposes, the fewer adjustments the better for equipment leases as they are generally short term, small ticket and high volume.

Question 11

In developing their preliminary views the boards decided to specify the required

accounting for the obligation to pay rentals. An alternative approach would have been for

the boards to require lessees to account for the obligation to pay rentals in accordance with existing guidance for financial liabilities.  Do you agree with the proposed approach taken by the boards?  If you disagree, please explain why.

Answer

I agree that the obligation to pay rent should be capitalized at the present value of right-to-use lease payments.  For lease that transfer ownership rights the cost of the leased asset should be the capitalized value.   I don’t agree to impute interest expense for leases that are right-to-use leases.  In my opinion that does not reflect the economic impact of the lease, complicates and confuses P&L and cash flow statements, and creates a book/tax temporary difference requiring deferred  tax accounting.

Question 12

Some board members think that for some leases the decrease in value of the right-of-use

asset should be described as rental expense rather than amortization or depreciation in the

income statement.  Would you support this approach? If so, for which leases? Please explain your reasons.

Answer

I support this approach for right-of -use leases as opposed to leases where the lessee’s rights are ownership rights.  Since the right-of-use contract merely allows a temporary right, the expense should be considered a level operating expense and the cash flow should be considered an operating cash outflow.  The major reporting deficiency that needs to be corrected is the failure to recognize the obligation to pay rent as a liability.  The SEC stated this at a meeting I attended at the FASB offices  in 2006 and they said further that time was important and we should let lesser but more theoretically perplexing issues get in the way of getting that done.  The P&L and cash flow presentation of operating leases did not seem to be at odds with economic reality and were never cited as a reporting deficiency.  In fact the rating agencies do not adjust the P&L or cash flow statements when they make their adjustments to capitalize leases.  I interviewed the rating agencies and one said that the new rule may prompt them to make new and different adjustments.  More time has been and will be spent on issues other than the major issue of capitalizing operating lease rents.

Chapter 6: Leases with options

Question 13

The boards tentatively decided that the lessee should recognize an obligation to pay rentals for a specified lease term, i.e. in a 10-year lease with an option to extend for five years, the lessee must decide whether its liability is an obligation to pay 10 or 15 years of rentals.  The boards tentatively decided that the lease term should be the most likely lease term.  Do you support the proposed approach?  If you disagree with the proposed approach, please describe what alternative approach you would support and why.

Answer

I support the approach and in the US we have been operating under that approach under current GAAP.  FAS 13 as amended by FAS 98includes conditions that might extend a lease term such as the presence of a bargain renewal rents and purchase options, a renewal term that precedes a bargain purchase option and the concept of a penalty that compels a lessee to renew.  The Big 4 have also interpreted FAS 13 to include lessee behavior and other factors that indicate the lease term contractual lease term will be extended.  What I do no support is the idea that a probability weighted approach should be used and result in an outcome that is not legally possible under the contract and this approach automatically results in a need for at least one adjustment.  It seems to violate the concept that we are accounting for the contract, yet the answer is not possible under the contract.  We should be striving for simplicity.  I support the FASB view of using best estimate.

Question 14

The boards tentatively decided to require reassessment of the lease term at each reporting

date on the basis of any new facts or circumstances. Changes in the obligation to pay rentals arising from a reassessment of the lease term should be recognized as an

adjustment to the carrying amount of the right-of-use asset.  Do you support the proposed approach?  If you disagree with the proposed approach, please describe what alternative approach you would support and why.  Would requiring reassessment of the lease term provide users of financial statements with more relevant information? Please explain why.

Answer

In my opinion there has to be a high materiality threshold before an adjustment is made.  The vast majority (99.4%) of equipment leases in the US are less than $5 million in equipment cost 90% are less than $250 thousand and 54.4% are less than $25 thousand.  Continuous review and adjustment is burdensome and will result in minor adjustments.  We need simple workable rules that provide meaningful information.

Question 15

The boards tentatively concluded that purchase options should be accounted for in the

same way as options to extend or terminate the lease.  Do you agree with the proposed approach?  If you disagree with the proposed approach, please describe what alternative approach you would support and why.

Answer

I agree that a bargain purchase option should be included in minimum lease payments to be capitalized.  The presence of a bargain purchase option means that the lease has transferred ownership rights and that lease should be accounted for as a purchase of PP&E financed by a loan bearing interest at the implicit rate.  That is the substance of the transaction and it results in simple and logical accounting mirroring the  tax treatment  that I feel few people have issue with under current GAAP.

Chapter 7: Contingent rentals and residual value guarantees

Contingent rentals

Question 16

The boards propose that the lessee’s obligation to pay rentals should include amounts

payable under contingent rental arrangements.  Do you support the proposed approach?

If you disagree with the proposed approach, what alternative approach would you?

recommend and why?

Answer

Only contingent rents that meet the definition of a liability should be included in minimum lease payments.  Contingent rents based on usage where the lessee controls the use can be managed or avoided by lessee actions.  There may be instances where a contingent rent is a disguised minimum lease payment such as “if the sun rises contingent rent is due” and in that case an estimate of contingent rents  should be recorded based on a principle rather than a rule. The principle should be to capitalize contingent rents if they are disguised minimum lease payments and material to the lease and let the preparer make the estimate and defend it to the auditors.

Question 17

The IASB tentatively decided that the measurement of the lessee’s obligation to pay

rentals should include a probability-weighted estimate of contingent rentals payable. The

FASB tentatively decided that a lessee should measure contingent rentals on the basis of

the most likely rental payment. A lessee would determine the most likely amount by

considering the range of possible outcomes. However, this measure would not necessarily

equal the probability-weighted sum of the possible outcomes.  Which of these approaches to measuring the lessee’s obligation to pay rentals do you support? Please explain your reasons.

Answer

I do not agree with the probability weighted approach as it is too complex and results in answers that are not that different than the best estimate.  The use of probability weighted methods creates too much work and needs to be documented for audit review.  The idea of having to reassess equipment leases of less than $5 million in cost with contingent rents on a quarterly basis using a probability weighted calculation is too burdensome considering the minor adjustments that will result.

Question 18

The FASB tentatively decided that if lease rentals are contingent on changes in an index

or rate, such as the consumer price index or the prime interest rate, the lessee should

measure the obligation to pay rentals using the index or rate existing at the inception of

the lease.  Do you support the proposed approach? Please explain your reasons.

Answer

I agree for floating rate leases and I believe that subsequent changes should be accounted for on a cash basis.

Question 19

The boards tentatively decided to require re-measurement of the lessee’s obligation to pay rentals for changes in estimated contingent rental payments.  Do you support the proposed approach? If not, please explain why.

Answer

As per above, I do not agree that contingent rents that are not disguised minimum lease payments  should be capitalized. This is an anti–abuse rule that deals with a handful of all contingent rent leases yet affects all leases with minor contingent rent clauses.  In my experience I never encountered an equipment lease that had material contingent rents.  The impact of a quarterly assessment on 99.4% of equipment leases w ill result in immaterial adjustments.

Question 20

The boards discussed two possible approaches to recognizing all changes in the lessee’s

obligation to pay rentals arising from changes in estimated contingent rental payments:

(a) recognize any change in the liability in profit or loss

(b) recognize any change in the liability as an adjustment to the carrying amount of the

right-of-use asset.

Which of these two approaches do you support? Please explain your reasons.  If you support neither approach, please describe any alternative approach you would prefer and why.

Answer

I do not support not capitalizing contingent rents unless they meet the definition of a liability and are material disguised minimum lease payments.  My preferred accounting method is to account for them as incurred through P&L.

Residual value guarantees

Question 21

The boards tentatively decided that the recognition and measurement requirements for

contingent rentals and residual value guarantees should be the same. In particular, the

boards tentatively decided not to require residual value guarantees to be separated from

the lease contract and accounted for as derivatives.  Do you agree with the proposed approach? If not, what alternative approach would you recommend and why?

Answer

I agree that residual guarantees are a liability and should be measured at the present value of their likely pay out amount.

Chapter 8: Presentation

Question 22

Should the lessee’s obligation to pay rentals be presented separately in the statement of

financial position? Please explain your reasons.  What additional information would separate presentation provide?

Answer

I agree as I think the obligation is unique.  The rating agencies recognize that the liability may be rejected in bankruptcy, so they view it as a separate class of obligation.

Question 23

This chapter describes three approaches to presentation of the right-of-use asset in the

statement of financial position.  How should the right-of-use asset be presented in the statement of financial position?  Please explain your reasons.

Answer

Lease  assets should be classified separately but with PP&E.  Right to use lease assets and right to own lease assets should be presented separately.  Users of financial statements need to know which lease assets are merely the temporary right to use an asset as they must be returned at lease expiry and replaced somehow.  The reason it should be placed with PP&E is to give the reader the full picture of the PP&E that is needed to generate the revenue in the business.

What additional disclosures (if any) do you think are necessary under each of the

approaches?

Answer

The lessee should describe its right-of-use leasing activities, explain its intentions at expiry, provide a schedule of material expiring leases, provide a schedule of expected payments under current leases and a schedule of expected payments under replacement leases.

Chapter 9: Other lessee issues

Question 24

Are there any lessee issues not described in this discussion paper that should be addressed

in this project? Please describe those issues.

Answer

If the board continues with its view that right-of-use lease assets and liabilities are not linked, then when should a lessee adjust its assets and liabilities when bankruptcy is probable?

Chapter 10: Lessor accounting

Question 25

Do you think that a lessor’s right to receive rentals under a lease meets the definition of an asset? Please explain your reasons.

Answer

Yes. Direct finance lease accounting is appropriate where the lessor is leasing the entire asset to one lessee for a material term of one year or longer.  Operating lease accounting is appropriate for all other leases (short term leases, fractional share leases and multiple lessee leases like commercial real estate).

Question 26

This chapter describes two possible approaches to lessor accounting under a right-of-use

model: (a) derecognition of the leased item by the lessor or (b) recognition of a

performance obligation by the lessor.

Which of these two approaches do you support? Please explain your reasons.

Answer

View (a) is the logical choice as the two assets in a right-of-use lease are the right to receive rent and the economic benefits after the asset is returned.  In view (b), the leased asset is no longer an asset of the lessor as the lessee and only the lessee has the economic benefits during the lease term.  Also in view (b), the boards had previously decided that the lessor’s obligation to provide the asset to the lessee ends on delivery and acceptance, so no such liability exists during the lease term.

As in my answer above, a one-size-fits-all approach to lessor accounting does not work.  There is a need to retain operating lease accounting for leases listed above.

Question 27

Should the boards explore when it would be appropriate for a lessor to recognize income

at the inception of the lease? Please explain your reasons.

Answer

Yes.  The current sales-type lease model should still apply where the lease transfers ownership rights and the lessor has a gross profit.  In substance it is a sale financed by a loan.

Question 28

Should accounting for investment properties be included within the scope of any proposed new standard on lessor accounting? Please explain your reasons.

Answer

I cannot comment as I am not familiar with the product.  If it is included then the same concepts should apply to all leases.

Question 29

Are there any lessor accounting issues not described in this discussion paper that the

boards should consider? Please describe those issues.

Answer

Leveraged lease accounting should be given serious consideration.  The after tax yield should be considered for amortizing unearned income for lessors