‘More than insignificant’ is key judgement in leases proposal

Accountants may have difficulty at times determining what constitutes “more than insignificant” consumption of a leased asset by a lessee under a proposed standard being jointly developed by the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), according to a webcast conducted by the boards on Thursday.

On rare occasions, a lessee and lessor may even reach different conclusions about which recognition model to use for the same asset as leases are placed on the balance sheet, according to the boards’ staff.

But the boards intend to provide significant guidance to minimise these application concerns when they issue a second exposure draft on leases in the fourth quarter of 2012.

“We will be including in the revised exposure draft a number of models,” said FASB Practice Fellow Cullen Walsh. “…Following the publishing of the exposure draft, the boards will continue to perform a significant amount of outreach to make sure the proposals are well understood.”

The proposed leases standard provides for two different ways for both lessors and lessees to recognise leases, depending on the characteristics of the lease. When the lessee consumes a more than insignificant portion of the asset, the lessee must recognise the lease as a non-financial asset measured at cost, less accumulated amortisation. The combination of the amortisation charge and the interest expense on the lease liability would result in a total lease expense that would generally decrease over the lease term.

But if the lessee is paying only for use of the asset and does not consume a more than insignificant portion of the asset, recognition can follow a straight-line pattern, with total lease payments allocated evenly over the lease term.

Meanwhile, the lessor accounts for the lease as a sale of a portion of the lease asset, recognising a receivable and a retained interest in that residual asset, when the lessee consumes a more than insignificant portion of the leased asset. When a more than insignificant portion of the leased asset is not consumed, the lessor recognises straight-line lease income.

The question, of course, is what constitutes a “more than insignificant” portion of the leased asset. FASB and IASB staff members provided examples. In general, equipment and vehicle leases tend to depreciate heavily during the life of a lease, so significant consumption occurs, staff members said.

In property leases, the asset usually does not depreciate—and sometimes can increase in value—over the lease period. So consumption of the asset by the lessor generally is considered to be insignificant.

A three-year real estate lease and a ten-year lease on commercial property with an assumed economic life of 40 years were listed as examples where insignificant consumption occurs. Examples of leases with more than insignificant value consumed by the lessee included:

• A ten-year airplane lease.

• A three-year lease on a car with an assumed economic life of six years.

• A four-year lease on a truck with an economic life of ten years.

But two examples did not definitively fit into either category and would require judgement, according to the staff. The “more than insignificant” benchmark could be difficult to apply to a five-year lease on a vessel with an economic life of 40 years, and a 30-year lease on commercial property with an economic life of 40 years.

IASB Senior Technical Manager Patrina Buchanan said that in those cases, a broader set of circumstances would be needed to determine which recognition model to use. She said the boards are unlikely to define “insignificant” using numbers, but plan to include application guidance and examples to be helpful in the re-exposure draft.

She said it is possible that in rare instances a lessor and lessee could make different decisions on how to classify the same lease, even though they will be looking at the same wording and guidance within the standard.

“Depending on exactly how they apply those words, it may be possible that they might get to different conclusions,” Buchanan said. “I think we would expect the vast majority of the time that they reach the same conclusion, but each might be looking at the same words, maybe, in a slightly different way.”

Buchanan said it should be easy in most cases to decide which method to use.

“Deciding what side of the line you are on should be a pretty straightforward task, and really judgement should only need to be applied to relatively few leases,” Buchanan said. “However, in saying that, I think this will be an area where we will be particularly keen to hear from constituents in terms of the operationality of the proposal.”

Financial instruments stalled

FASB’s joint convergence project with the IASB on financial instruments hit a snag Wednesday when FASB’s staff revealed stakeholder concerns on the model’s treatment of impairment.

Before proceeding to an exposure draft, FASB has a number of topics it wants to address, including constituent concerns regarding the operability, auditability, and understandability of the proposed model.

The FASB staff is summarising the feedback received and will present it to the board and seek direction. The staff said flexibility exists in the calendar and that should not have an adverse effect on the project.

But IASB Chairman Hans Hoogervorst was frustrated. He said he finds it “deeply embarrassing” that the boards have not been able to come up with an acceptable answer in the project after three years.

“I find that unacceptable,” Hoogervorst said. “So I would really hope that, when your staff does this outreach, that they do it with an attitude of getting things fixed and not letting it unravel.”

FASB Chairman Leslie Seidman said the staff plans to work expeditiously to keep the project moving forward. It had been hoped that a final standard in the project would be issued by the middle of 2013.

“In order to move forward confidently that the exposure draft is going to represent an understandable, operational improvement in financial reporting, we believe it’s important to address these issues now,” Seidman said.

—Ken Tysiac (ktysiac@aicpa.org) is a CGMA Magazine senior editor.