In prior Lease Tips about the forthcoming changes, we reported that the FASB and IASB (the “Boards”), promised to consider the numerous comments they received regarding the proposed rule changes detailed in their joint Exposure Draft (ED) dated August 17, 2010. That process is underway and significant positive changes to some of the more controversial and costly proposals have already been tentatively agreed to.

Lease Term to Continue to Include Options,  But on a Revised Basis 

The ED currently requires that the lease term include option periods if it is “more likely than not” that the options will be exercised. This determination would need to be made at lease inception and for each subsequent reporting period and the reported asset/liability/income/expense amounts changed when circumstances change affecting the prior determination. This would have caused an administrative nightmare and most of the determinations would be highly subjective, if not outright guesses.

When Options Would Be Included 

Hearing the outcry, the Boards have tentatively agreed to the following revised definition regarding how the lease term will be determined by both lessees and lessors:

“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”

Therefore, at initial measurement and/or subsequent re-measurement, option periods reasonably certain to be exercised should be included in the lease term. To make this determination, among other factors, the economics of the option will need to be compared to current market condition, and if significant commercially advantageous terms exist, the lease term should include the option period.

What remains unclear is whether this is a objective or subjective decision.  That is, is it that there is a significant economic incentive inherent in the option (does the option present a compelling incentive to be exercised because of market forces), or is it that it is reasonably certain that the lessee, given its business condition, will exercise the option.  We intend to further communicate with the Boards on this issue.

Frequency of Reassessment 

The Boards also tentatively agreed that a lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.

Therefore, it would appear that the goal of this modification to the ED is to only require the inclusion of lease options when the economic benefit of exercise becomes clear and is significant. These conditions may, or may not, present themselves prior to the date upon which the lessee must notify the lessor that the option is being exercised. In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the significant economic incentive becomes apparent, notwithstanding that the lease required notice date has not yet arrived.

This revised definition of the lease term should significantly reduce the administrative burdens of complying with the new rules and make the determinations regarding exercising options more objective, as they will be based on changes in current relevant economic factors. 

Most Leases to be Considered “Finance” Leases and Capitalized

The ED currently considers nearly all leases to be finance leases, thus requiring the lessee to report a right-of-use (ROU) asset and liability to make lease payments on its balance sheet. Instead of annual straight-line rent expense being reported on the income statement, the ED currently requires the annual reporting of straight-line depreciation of the ROU asset plus interest expense for carrying the liability to make lease payments. But because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.

The Boards received many comments regarding this proposal, as the front-loading of reported expenses [that, from a cash basis, is not actually occurring] could have a negative impact on many lessees, especially those in start-up situations. To address all the concern, the Boards have tentatively agreed to recognize the fact that not all leases are entered into to effectively finance an asset purchase. In these “other-than-finance” leases, although there is some finance element to the transaction, the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.

To further recognize the distinction between a finance and other-than-finance lease, the Boards have tentatively agreed that the other-than-finance leases will not be required to report front-loaded income/expense in the earlier lease years, but rather show straight-line recognition similar to today’s “operating” leases. Although a right-of-use asset and liability to make lease payments will apparently still need to be reported on the balance sheet for these other-than-finance leases, the front-loaded interest expense problem will be eliminated.

How to determine which leases are finance-type, as opposed to other-than-finance-type, remains an open issue. The Boards tentatively decided to establish new indicators to distinguish a finance lease from an other-than-finance lease and their staffs are currently working on establishing these indicators.

The Separation of Lease Payments from Payments for Services Received

The Boards are still contemplating this issue. Current GAAP already requires the separation of all lease and non-lease cost components. However, during the recent FASB/IASB roundtables, investors/lessors appeared to favor the non-separation of service costs, while lessees favored the annual expensing of those service costs that are distinct and can be easily identified. A recent paper by the Boards’ staff indicates that this topic is currently being studied in greater detail and the staff’s recommendations regarding the appropriate accounting treatment for these service costs will be presented at future Board meetings.

We will keep you apprised of any further developments regarding this very important issue for the real estate industry.