Accounting & Reporting of Executory Costs There are new developments in this controversial accounting issue.

Transcription

1 Financial Watch Accounting & Reporting of Executory Costs There are new developments in this controversial accounting issue. Executory costs such as maintenance, insurance, and taxes have historically played a pivotal role in the accounting and reporting for leases. Two recent accounting developments have profiled the importance of executory costs in determining lease classification and lessor reported revenues. On May 28, 2003, the FASB Board ratified the Emerging Issues Task Force (EITF) consensus on Issue No. 01-8, Determining Whether an Arrangement Contains a Lease. This ratification established March 28, 2003, as a watershed date in the characterization of new or changed arrangements involving specific property, plant and equipment used in their fulfillment. Under EITF 01-8, more arrangements involving the rendering of services or the production of commodities will likely be identified as containing embedded leases. Then, if a new or changed arrangement is determined to contain an embedded lease, lease classification (as either a capital or operating lease) could well turn on the estimation of executory costs. On February 25, 2003, the EITF Agenda Committee reported a potential new issue, Income Statement Characterization by a Lessor for Certain Executory Costs Paid Under EITF 01-8, more arrangements involving the rendering of services or the production of commodities will likely be identified as containing embedded leases. Directly by the Lessee. The Agenda Committee recommended that FASB issue a FASB Staff Position (FSP) to require gross reporting of property taxes (including those paid directly by the lessee without lessor involvement) and to provide guidance on determining the appropriate income statement display relative to insurance and maintenance costs. FASB staff subsequently determined not to issue an FSP, acknowledging that diversity in practice will likely continue with respect to how lessors classify reimbursements (or direct payments by lessees) of executory costs. However, in discussing the potential issue, the Agenda Committee and FASB staff agreed that lessors should apply the guidance in EITF Issue No , Reporting Revenue Gross as a Principal versus Net as an Agent. General Framework FAS 13 focuses its discussion of executory costs (such as maintenance, insurance and taxes) in the context of lease classification. FAS 13 also provides that, with respect to capital leases, that the footnotes disclose the amounts representing estimated executory costs, including profit 20 January 2004

2 thereon, included in total future payments to be made or received. Definition by example FAS 13 does not separately define the term executory costs. Instead, it includes the definition of executory costs within the definition of minimum lease payments (see paragraph 5(j)(i)). Further, it defines the included term by example as insurance, maintenance, and taxes incurred in connection with the leased property. Finally, in the calculation of the 90 percent test and the interest rate implicit in the lease, paragraph 7 of FAS 13 clarifies that minimum lease payments also exclude that portion of the payment representing executory costs including any profit thereon. Lease classification The only impact executory costs have on lease classification is to reduce payments to be used in performing the 90 percent test. At paragraph 8(b), FAS 13 addresses a potential lessor classification issue relating to estimation uncertainty. It provides that the lessor s requirement to estimate executory costs such as insurance, maintenance, and taxes to be paid by the lessor shall not by itself constitute an important uncertainty surrounding the amount of unreimburseable costs yet to be incurred by the lessor under the lease. The presence of an important uncertainty, such as a non-typical product performance guarantee, would cause the lessor to classify an otherwise qualifying capital lease as an operating lease. January

3 Capital lease accounting and reporting In its accounting and reporting sections for both lessees and lessors, FAS 13 requires that recorded minimum lease payments should exclude executory costs (see paragraph 10 and paragraphs 17(a) and 18(a), respectively). It also provides that executory costs should be reported separately as a deduction from minimum lease payments in deriving net minimum lease payments (see paragraphs 16(a)(i) and 23(a)(i), respectively, and Appendix D). In the case of leases involving land and building, paragraph 26 of FAS 13 provides that executory costs should be deducted from the minimum lease payments before allocating the remainder between the two elements. Important Interpretations Since the issuance of FAS 13, clarifications have been provided concerning the scope and impact of executory costs on profit or loss recognition. The following represents some of the more important interpretations and practices: Residual Value Insurance FASB Interpretation No. 19, Lessee Guarantee of the Residual Value of Leased Property, issued in October 1977, resolved the accounting nature of third-party residual value insurance (minimum lease payment or executory cost). FIN 19, paragraph 5, provides that [a]mounts paid in consideration for a guarantee by an unrelated party are executory costs and are not included in the lessee s minimum lease payments. Accounting for Sublease Loss FASB Technical Bulletin No , Accounting for Loss on a Sublease Not Involving the Disposal of a Segment, issued on December 28, 1979, resolved the relevance of executory costs in determining a sublease loss. FTB states that if costs expected to be incurred under an operating sublease (that is, executory costs and either amortization of the leased assets or rental payments on an operating lease, whichever is applicable) exceed anticipated revenues on the operating sublease, a loss should be recognized by the sublessor. Sale-Leaseback Transactions EITF Issue No , Consideration of Executory Costs in Sale-Leaseback Transactions, resolved whether or not executory costs should be included or excluded in calculation of profit to be deferred in a sale-leaseback transaction. On October 26, 1989, the Task Force reached a consensus that executory costs of the leaseback should be excluded from the calculation of profit to be deferred on a sale-leaseback transaction irrespective of who pays the executory costs or the classification of the leaseback. Use Tax on Rentals FASB has not issued interpretative guidance on whether minimum lease payments should include use tax, that is, the amount levied on rentals by the state or local taxing authorities. Accordingly, the author understands that practice in this area varies. However, its appears that most accountants interpret taxes as used in FAS 13 s definition of executory costs to mean all assessed taxes in connection with the leased property. This expansive view would appear to be an appropriate extension of the FIN 19 characterization of insurance to encompass residual value insurance premiums paid to a third party. In the situation where the lessor is merely acting as a collection agent for governmental authorities (i.e., where it is only obligated to remit the tax that it actually collects), it would appear rea- 22 January 2004

4 The only impact executory costs have on lease classification is to reduce payments to be used in performing the 90 percent test. sonable to exclude use tax on rentals as part of the consideration paid for the right to use leased property. EITF Issue No.01-8 As implied by its title, EITF 01-8 concluded that a lease can be embedded in a broader contractual arrangement and that, if so, the lease elements should be separately recognized. Accordingly, certain take-or-pay contracts, tolling contracts, power purchase agreements, transportation or pipeline capacity contracts and service contacts should be treated as multiple element arrangements that contain a lease. In short, if an arrangement conveys the right to control the use of specific property, plant and equipment in its fulfillment, the lease elements should be separately identified and accounted for in accordance with FAS 13. The classification of the embedded lease (as a capital or operating lease) could well turn on the separation of the total consideration between lease and non-lease elements and the further separation of the lease elements between minimum lease payments and executory costs. Requirement to separate EITF 01-8 bases its requirements for parties to contractual arrangements that contain a multiple elements to separately account for the service and right to use elements and executory costs associated with the right to use element on two key paragraphs in FAS 13: the scope paragraph (paragraph 1) and the definition of minimum lease payments (paragraph 5(j)). FAS 13 includes agreements that transfer the right to use property, plant or equipment even though substantial services by the contractor (lessor) may be called for in connection with the operation or maintenance of such assets. FAS 13 also explicitly requires the separation of executory costs from minimum lease payments in lease classification testing. Measurement guidance EITF 01-8 provides specific guidance on how arrangement consideration should be allocated (the measurement issue). The Task Force framed the issue as whether all products and services provided by the lessor in a multiple element arrangement are considered executory costs as that term is used in Statement 13 and, therefore, should be deducted from total consideration that the lessee is obligated to pay or can be required to pay in connection with the leased property in arriving at the minimum lease payments. The Task Force then decided that substantial services provided by the lessor (for example, significant operating services) are not executory costs as defined by FAS 13. In referencing EITF Issue No , Revenue January

5 If an arrangement conveys the right to control the use of specific property, plant and equipment in its fulfillment, the lease elements should be separately identified and accounted for in accordance with FAS 13. Arrangements with Multiple Deliverables, the Task Force agreed that the total consideration called for by the arrangement shall be allocated on a relative fair value basis between the services element and the lease element (which includes executory costs and any profit thereon). Separation methodology EITF 00-21, paragraph 4(a)(ii), provides the following implementation guidance on the separation methodology: For example, leased assets are required to be accounted for separately under the guidance of Statement 13. Consider an arrangement that includes the lease of equipment under an operating lease, the maintenance of the leased equipment throughout the lease term (executory cost), and the sale of additional equipment unrelated to the leased equipment. The arrangement should be allocated between the Statement 13 deliverables and the non- Statement 13 deliverables on a relative fair value basis using the entity s best estimate of fair value of the Statement 13 and non-statement 13 deliverables. 24 January 2004

6 (Although Statement 13 does not provide guidance regarding the accounting for executory costs, it does provide guidance regarding the allocation of arrangement consideration between the lease and the executory cost elements of an arrangement. Therefore, this example refers to the leased equipment and the related maintenance as Statement 13 deliverables.) The guidance in Statement 13 would then be applied to separate the maintenance from the leased equipment and to allocate the related arrangement consideration to those two deliverables. This would be applied to further separate any non- Statement 13 deliverables and to allocate the related arrangement consideration. In summary, EITF 01-8 requires that, if an arrangement contains a lease and related executory costs, as well as nonlease elements, the counterparties should apply the classification, recognition, measurement, and disclosure requirements of FAS 13 to the lease elements. Non-lease elements (substantial operating services) should be accounted for in accordance with other applicable GAAP. Consistent with the accounting for leases, the separation of arrangement consideration should be made at the inception of the arrangement or upon the occurrence of a triggering event (referred to as a reassessment event in EITF 01-8). Overall arrangement consideration should be separated into (a) consideration for the lease, including related executory costs and profits thereon, and (b) consideration for other services based on the relative fair values of each element. Theory vs. practice Although both parties to an arrangement that contains a lease theoretically should reach the same conclusion about the separated amounts, it remains a distinct possibility that each party might reach a different conclusion with respect to the ultimate amount that they allocate for lease classification purposes. Since at inception most of these arrangements involve customized turnkey solutions with proprietary pricing and since secondary market trades occur in a very limited, nondisclosed principal-to-principal market, any independent attempt to subject the accounting units to fair value measurement will likely require considerable judgment. In this sense, EITF 01-8 may introduce another source of asymmetry in the accounting for leases, particularly in the situation where limited market information is available and the lessor-service provider does not make its separation assumptions known to the lessee-service recipient. Without specific guidance and the presence of diversity in practice, lessors should consider the guidance of EITF and be prepared to justify the accounting policy they have adopted for reporting reimbursements or lessee payments of executory costs. Gross vs. Net Reporting As noted above, the EITF Agenda Committee discussed a potential new issue at its February 25, 2003, meeting regarding a conflict between practice and theory in the reporting practices of triple net leases by real estate lessors. Under a triple net lease, the lessee is responsible for all property taxes, insurance, and maintenance costs (executory costs) and often pays for these costs directly. Since real estate lessors generally do not report lessee paid executory costs as constructively received revenue, their reporting practice appears to be inconsistent with two recently issued EITF rulings on gross vs. net reporting. In EITF Issue No , Income Statement Characterization of Reimbursements Received for Out of Pocket Expenses Incurred, the Task Force reached a consensus that reimbursements received for out-of-pocket expenses should be characterized as revenue in the income statement of the reimbursed party. The Task Force viewed this conclusion as consistent with its earlier consensuses, specifically EITF (as discussed in more detail below) and EITF on reporting of shipping and handling costs paid by the customer. In EITF 99-19, the Task Force reached a consensus that the determination of whether to report revenue on a gross or net basis depends on an assessment of key indicators, none of 26 January 2004

7 which should be considered presumptive or determinative. Under EITF 99-19, if the reporting company is the primary obligor in the arrangement, that fact is to be considered a strong indicator that the company has risks and rewards of a principal in the transaction and that it should report revenue gross based on the amount billed to the customer. EITF also provides that, if a company assumes credit risk for the amounts billed to the customer, that fact may provide weaker evidence in support of gross revenue reporting. Other relevant factors pointing toward gross reporting include, among others, company discretion in selecting suppliers of a product or service and significant company involvement in the determination of product or service specifications. In applying the above referenced EITF consensuses to triple net lease arrangements, the EITF Agenda Committee and FASB staff took the position that property taxes paid directly by the lessee should be characterized as revenue (with a corresponding expense) in the income statement of the lessor. They were apparently persuaded by the following arguments advanced by proponents of gross revenue reporting for property taxes: (1) the lessor is primarily obligated to the taxing authorities for the assessed taxes; and (2) the lessor has credit risk relating to lessee s failure to pay when due. Opponents had noted that, since property taxes paid by the lessor never become receivable by the lessor, paragraph 19(b) of FAS 13 provides authoritative support for net reporting. Further, opponents had noted that net reporting or property taxes is a long-standing practice within the real estate industry. Additionally, opponents could have noted that EITF provides that credit risk that has been substantially mitigated is not an indicator of gross reporting. Substantial mitigation might be shown based on the investment grade standing of the lessee and the credit-related provisions in the lease and other operative documents, including credit guarantees and other forms of credit support. With respect to maintenance and insurance costs, the Agenda Committee and FASB staff also agreed that the related income statement display of insurance and maintenance expenses paid directly by the lessee is less clear and depends on specific facts and circumstances. Proponents of gross reporting of such costs believe that, at a minimum, revenue should be recorded by the lessor for insurance paid by the lessee in those circumstances in which the lessor is contractually required to maintain a minimum insurance policy under the terms of its financing. Proponents also note that lessors would record revenue when they pay insurance and maintenance directly and then invoice the lessee. However, opponents counter by noting that the lessee generally has full supplier discretion in the selection of the maintenance and insurance provider and that the service provider has no recourse against the lessor in the event of non-payment. Further, even in the situation where the lessor is obligated to obtain insurance under the terms of the financing, opponents note that the lessor generally fulfills its obligation without ever becoming a party to the insurance arrangement. The lessee generally is the sole obligor to the third party insurance provider. From a preparer s perspective, the main arguments against gross revenue reporting of executory costs include the concern that gross reporting would create a misleading trend line in revenue growth and impose a new cost of doing business (setting up a data collection system) with little or no commensurate benefits. Further, gross reporting would likely blur the distinction between gross lessors and net lessors. Finally, the imposition of a gross reporting requirement for executory costs would cause bank lessors to report significant top line revenues and corresponding operating expenses relating to executory costs which, by regulation, they are generally precluded from earning or incurring. This reporting issue will likely resurface at a later date, probably after FASB has completed its major projects on revenue recognition and liability extinguishments involving a primary legal release. Lessors may want to keep abreast of these FASB projects. Current Implications The accounting and reporting of executory costs has remained controversial over the years. With the issuance of EITF 01-8, lessees and lessors should consider developing policies and procedures for use in separating total consideration into its relevant elements. In the absence of specific guidance on the reporting of executory costs in triple net lease and the presence of diversity in practice, lessors should consider the guidance of EITF and be prepared to justify the accounting policy that they have adopted for reporting reimbursements or lessee payments of executory costs. ELT thanks Rodney W. Hurd, founding member, Montgomery Street Financial Group, Incline Village, Nevada, for this month s column. January