August 11, 2011
Standard Setting Update: FASB/IASB Decisions from the July 2011 Joint Meetings
On July 20 - 21, NAREIT attended the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) joint meetings in London, UK. Projects discussed that are of particular interest to NAREIT members include:
The agenda papers are available on the IASB website
. NAREIT reminds its members that all decisions reached during the Board meetings are tentative and are subject to change until final standards are issued.
FASB and IASB Agree on Re-exposure of the Leases Proposal
As previously reported in an SFO Alert on July 21, despite the fact that a number of decisions remain outstanding, the Boards unanimously decided to re-expose the proposed Leases standard. Thus, the Boards will provide constituents with the opportunity to comment on a revised proposal, which will include significant changes to the original Exposure Draft dated August 2010. The Boards expect to finalize the remaining outstanding decisions with respect to the Leases proposal during their September joint meetings before issuing a revised exposure draft for public comment by the end of 2011. The Boards have not yet established an effective date for the proposed Leases standard.
FASB and IASB Confirm that Lessors of Investment Properties Measured at Fair Value are Outside the Scope of the Proposed Leases Standard
Also reported in last month's SFO Alert, the Boards tentatively confirmed that lessors of investment property reported at fair value would be scoped out of the proposed Leases standard. This decision is consistent with previous comment letters submitted by NAREIT and its global partners in the Real Estate Equity Securitization Alliance (REESA), including the most recent letter dated July 11, 2011. Companies reporting in accordance with International Financial Reporting Standards (IFRS) would continue to apply International Accounting Standard 40 Investment Property (IAS 40), while companies reporting in accordance with U.S. Generally Accepted Accounting Standards (GAAP) would apply the FASB’s new Investment Properties Standard once it has been issued and made effective. NAREIT expects the FASB’s Investment Properties Exposure Draft to be issued for public comment during the third quarter of 2011. As a result, these lessors would continue to recognize the leased asset and recognize lease income over the lease term on a straight-line basis. The basis of this conclusion is that the fair value of the property includes the present value of payments to be received under in-place leases.
FASB and IASB Select One Lessor Accounting Model
The Boards tentatively agreed that the Receivable and Residual model (formerly the Derecognition model, included in the Leases Exposure Draft) should be applied by all lessors. However, lessors that measure their investment properties at fair value and all short-term leases (i.e., leases consisting of a maximum possible term, including options to renew or extend, of twelve months or less) continue to be scoped out of the proposed Leases standard.
By supporting a single lessor accounting model, the Boards rejected a staff recommendation that, if a lessor of investment property reported under the cost approach has entered into numerous lease contracts for physically distinct portions of a single larger asset, such as shopping malls and office buildings, the lessor should continue to report leases in accordance with the current accounting for operating leases. On July 11, 2011, NAREIT and its global partners in REESA submitted a comment letter in support of the staff’s position.
Under the Receivable and Residual model, lessors would:
Recognize a right to receive lease payments and a corresponding residual asset at lease commencement;
Measure the right to receive lease payments as the sum of the present value of the lease payments, discounted at the rate implicit in the lease; and,
Measure the residual asset as an allocation of the carrying amount of the underlying asset at lease commencement; subsequently measure the residual asset through accretion over the lease term using the rate implicit in the lease.
The lessor would recognize profit depending upon whether it is reasonably assured
. NAREIT understands that this new threshold will be further defined during the Boards’ September joint meetings.
If profit is reasonably assured, the lessor would recognize the profit at lease commencement. The profit would be equal to the difference between the carrying amount of the underlying asset and the sum of the initial measurement of the right to receive lease payments and the residual asset.
If profit is not reasonably assured, the lessor would recognize profit over the term of the lease. Under this scenario, the lessor would measure the residual asset as the difference between the carrying amount of the underlying asset and the right to receive lease payments. Subsequently, the lessor would accrete the residual asset using the constant rate of return to the carrying amount of the underlying asset at the end of the lease term as if the asset had been subject to depreciation.
At a minimum, the lessor would recognize a profit at lease commencement to the extent that the right to receive lease payments is greater than the carrying amount of the underlying asset.
Boards Reconsider Conclusions on Remeasurement of Variable Lease Payments
The Boards reconfirmed a previous tentative decision that variable lease payments that depend on an index or rate should be measured at lease commencement using the current spot rate. However, the Boards reversed a previous tentative decision with respect to remeasurement of variable lease payments. The Boards tentatively agreed that variable lease payments that depend on an index or rate should be remeasured
at the end of each reporting period. Previously, the Boards had tentatively agreed that no remeasurement would be required.
The Boards unanimously agreed that lessees should reflect changes in the measurement of the variable lease payments that depend on an index or rate as:
An adjustment of the right-of-use asset to the extent that those changes relate to future reporting periods for the remaining lease term; and,
An adjustment of net income to the extent that those changes relate to the current reporting period.
The lessor accounting treatment for variable lease payments that depend on an index or rate will be discussed during the Boards’ September joint meetings.
Accounting Treatment for Embedded Derivatives in Lease Contracts
The Boards tentatively agreed that companies should follow existing derivatives guidance in IFRS and U.S. GAAP in determining whether lease contracts contain embedded derivatives that should be bifurcated and accounted for separately.
FASB and IASB Agree on Effective Date for Revenue Recognition Standard
The Boards tentatively agreed that the Revenue Recognition Standard would be effective on or after January 1, 2015. This timing is consistent with what NAREIT and its global partners in REESA proposed in their comment letter in response to the Boards' Discussion Paper on Effective Dates and Transition Methods. On June 15, 2011, the Boards unanimously decided to re-expose the revenue recognition proposal during the third quarter of 2011, with a comment period of 120 days.
FASB and IASB Diverge on Early Adoption of the Revenue Recognition Standard
The Boards discussed the feedback that they received through their additional outreach on the effective dates of the priority convergence projects (i.e., Revenue Recognition, Leases, Insurance, and Accounting for Financial Instruments). The FASB unanimously agreed on a rebuttable presumption that no early adoption of the priority convergence projects should be permitted. Meanwhile, the IASB voted to permit early adoption of new IFRS by first-time adopters of IFRS. The IASB voted to consider whether other entities would be able to early adopt as the Board finalizes deliberations on each priority convergence project.
The Boards did not agree on whether they would allow early adoption of the proposed Revenue Recognition standard. The FASB voted unanimously to disallow early adoption, while the IASB voted to permit early adoption by a narrow margin (i.e., an 8 to 7 vote). The FASB reasoned that consistent and comparable financial reporting would not be achieved if companies were provided with the option to early adopt the proposed Revenue Recognition standard.
Boards Pursue Credit Risk Management Approach to Impairment Model
The FASB and the IASB continue to debate a converged credit impairment model for financial assets. At the joint meetings in July, the Boards tentatively agreed to pursue a credit risk management approach to determine the credit impairment for financial assets. By pursuing the credit risk management approach, the Boards effectively rejected the “event driven” approach that was discussed at previous meetings. NAREIT members, particularly mortgage REITs, will be interested in the new approach, as management would be able to utilize existing credit risk management practices in establishing expected credit losses for financial assets, including residential mortgage loans.
As previously reported in the June SFO Report, the Boards are considering a new approach where classification would determine the credit impairment as credit quality deteriorates during a financial asset’s life cycle. Classification of financial assets would be made into one of three buckets. Financial assets would move between buckets depending upon changes in credit loss expectations. For example, a loan would move from Bucket 1 to Bucket 2 when there is deterioration in financial performance of the borrower which leads to increased uncertainty about the ability to fully recover the cash flows. A loan would move from Bucket 2 to Bucket 3 when there is deterioration in the financial performance of the borrower and recoverability is not expected.
Some Board members supported the use of "watch lists" as one possible way to monitor the changes in credit deterioration of financial assets. These Board members indicated that commercial banks currently utilize “watch lists” to more closely monitor certain loans in their loan books.
During the July meetings, the Boards tentatively agreed with the staff recommendation to make the allowance balance operationally straightforward. Thus, the Boards encouraged the staff to pursue two methods for the measurement of expected losses in Bucket 1:
Method A: 12 months' worth of losses expected to occur on the financial assets, or for the remaining expected life if that is less than 12 months; and,
Method B: 24 months' worth of losses expected to occur on financial assets, or for the remaining expected life if that is less than 24 months.
In June, the Boards tentatively agreed that companies would recognize an allowance for credit losses immediately
in the income statement equal to the full expected lifetime losses
for financial assets in Buckets 2 and 3.
Disclosure as a Means to Reconcile Diverging Views on Offsetting
The Boards discussed disclosure as a possible means to reconcile the IASB’s and FASB’s fundamental difference between the gross versus net presentation of financial assets, derivative assets, financial liabilities and derivative liabilities on the statement of financial position.
The Balance Sheet Dilemma
The IASB chose to retain current guidance in IFRS on offsetting in International Accounting Standard 32 Financial Statement Presentation. That guidance requires financial assets and financial liabilities to be presented on a net basis only when both of the following criteria are met:
The company has a legally enforceable right to set off the recognized amounts, and
The company intends either to settle on a net basis or to realize the financial asset and settle the financial liability simultaneously.
Therefore, the IASB opted not to proceed with the guidance for balance sheet presentation in the Exposure draft, and only pursue disclosure requirements.
The FASB supported a different approach to presentation. Companies would be required to offset certain derivatives assets and derivative liabilities with the same counterparty subject to master netting arrangements, and thus present these derivatives on a net basis.
Views on Disclosure
The Boards reconfirmed the disclosure objective that was included in the Exposure Draft
. The objective from paragraph 11 of the Exposure Draft states:
An entity shall disclose information about rights of set-off and related arrangements (such as collateral arrangements) associated with the entity’s financial assets and financial liabilities to enable users of its financial statements to understand the effect of those rights and arrangements on the entity’s financial position.
The Boards modified the scope of the disclosure requirements to only apply to contracts that are subject to legally enforceable master netting arrangements. Typical contracts that would meet the scope of the proposed disclosure requirements include:
Sales and repurchase agreements (i.e., “repos”);
Reverse sale and repurchase agreements (i.e., “reverse repos”); and,
Securities lending arrangements.
The Boards tentatively agreed with the staff recommendation in paragraph 16 of IASB Agenda reference 3B/FASB Agenda reference 16B
that the following information would be required disclosure in the notes to the financial statements:
(a) The gross amounts of financial assets and liabilities;
(b) The amounts of financial assets and liabilities offset in the statement of financial position;
(c) The net amount after taking into account (a) and (b), which should be the same as the amounts reported in the statement of financial position;
(d) The effect of the rights of set-off that are only enforceable and exercisable in bankruptcy, default or insolvency of either party not taken into account in arriving at the amounts presented in the statement of financial position (including collateral); and,
(e) The net exposure after taking into account the effect of items in (b) and (d).
The staff included an illustrative example as a tabular presentation of the aforementioned requirements in paragraph 22 of IASB Agenda reference 3B/FASB Agenda reference 16B.