College of Business & Economics Department of Accounting PO Box 443161 Moscow, ID 83844-3161 208-885-6453 In State Toll Free 1-800-422-6013 FAX 208-885-6296

July 16, 2009

Financial Accounting Standards Board Technical Director 401 Merritt 7 P O Box 5116 Norwalk CT 06856-5116

File Reference No. 1680-100 Discussion Paper: Leases: Preliminary Views

Dear FASB:

As an accounting professor, I have been creating numerous lease-related assignments every semester for well over 20 years. During the last two years, I have been adding discussion and assignments so that students would be able to classify and account for leases under IFRS as well as US GAAP. My “practical” experience is therefore in the rather distant past before I entered academe. FASB Statement No. 13 was just becoming effective when I took the CPA exam in 1976. Because of the detailed rules, I have used lease questions as an opportunity to help students learn to research the authoritative literature – after all, there seems to be a pretty specific answer to locate on just about any issue related to leases! This is the expertise and background I bring to my examination of the discussion paper “Leases: Preliminary Views” (referred to hereafter as the PV-Leases). To make sure that I thoroughly understood the tentative conclusions, I have worked through of most the examples provided including creating amortization tables and the like in Excel. I’ve learned a lot about alternatives that I would prefer not to be forced to teach (and will comment on those aspects.)

I’d like to express my appreciation for a summer grant from the College of Business and Economics at the University of Idaho that has provided support for the many hours I’ve spent commenting on this preliminary reviews document as well as the one on revenue recognition earlier this summer.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 2

General Comment 

Overall, I am supportive of the FASB and IASB efforts to improve lease accounting. It is clear that an entire industry has developed to help companies use leases to obtain off-balance sheet financing. This is detrimental for those who use financial statements and may even drive unsound economic decisions. Thus, requiring the capitalization of almost all leases is the right direction to go. In fact, financial reporting would be greatly improved by retaining current standards with respect to lease terms and present value of minimum lease payments (PVMLP) and merely eliminating the possibility of having operating leases. When I began this review, I was of the tentative opinion that sticking with most of our current guidelines would be a sufficient improvement to financial reporting. In other words, the changes to accounting for contingent rentals and guarantees of residual value or the assumed extensions of leases even when the renewal option is not a bargain, seemed unnecessary. However, after many hours of “playing” with possible lease situations, I’ve concluded that the most of the proposed changes are reasonable and possibly necessary to discourage the kind of game playing that has led to off-balance sheet financing. The proposed changes related to computing lease term and lease payments are actually rather limited and should not be too much of a burden on preparers. After all, they are already familiar with the current standards regarding capital leases because the tests must be applied to classify leases as operating or finance. However, I encourage the Boards to minimize other changes to reduce the cost of implementation (such as frequent updating of the incremental borrowing rate). As requested, I have provided detailed responses to numbered questions in the PV-Leases.

Chapter 2: Scope of lease accounting standard 

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? If you disagree with the proposed approach, please describe how you would define the scope of the proposed new standard.

This seems to be a logical first step. To me, leases are related to physical assets but I’m aware that IASB also permits the lease of intangibles (sounds like royalty or licensing arrangement to me but I haven’t studied that aspect of IFRS yet). Requiring the capitalization of all assets should be an improvement to financial reporting although it is important that the changes do not adversely impact ratio analysis, particularly with respect to interest expense. (see Question 11.)

2. Should the proposed new standard exclude non-core asset leases or short-term leases? Please explain why. Please explain how you would define those leases to be excluded from the scope of the proposed new standard.

All leases should be included, whether or not the right-to-use asset is related to “core” versus “non-core” physical assets. I read the arguments in paragraphs 2.16 to 2.17 and found them lacking. With respect to the arguments for treating short-term leases differently, there is perhaps more justification. However, we are well aware that the majority of leases have been considered operating (i.e., there has been a willingness to use the standards to reach a particular accounting result) and I worry whether special rules for short leases would encourage

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 3

companies to structure leases at a year or less even when there are strong reasons to expect renewals or the like. On the other hand, permitting the presentation of very short-term leases within current assets (rather than plant, property and equipment – whether operating or investing) might alleviate certain complexities of disclosure as discussed later in the PV-Leases. In fact, an argument could be made that breaking apart the payments between interest and principal would serve little useful purpose on leases of a year or less. Instead of making specific rules, perhaps the boards can leave it to preparers to handle very short leases under the general rule that standards need not apply to immaterial items. In this case, an example might be the occasional rental of carpet cleaning equipment or the like for a few days. Elaborate accounting in such circumstances would be ridiculous! [See also my separate discussion of envisioned ways folks will try to cook the books under the proposed guidelines which appears just before the conclusion to this letter.]

Chapter 3: Approach to lessee accounting  

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.

Yes. The analysis of lease rights (asset) and lease obligations (liability) seem logical and reasonable.

4. The boards tentatively decided to adopt an approach to lessee accounting that would require the lessee to recognise: (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? If you support an alternative approach, please describe the approach and explain why you support it.

I was not particularly impressed with any of the rejected approaches described in Appendix C of the PV-Leases document. Accordingly, I’m in support of the conclusions regarding simple leases. However, the devil is in the details and I’m not sure I like some of the details related to initial and subsequent re-measurement. Financial reporting would be greatly improved if we did nothing more than apply existing guidance to the determination of the initial value of the right-to-use asset (for example, include a bargain purchase option but not a fair value purchase option among the cash flows). Of course, we should get rid of the operating versus finance lease rules and the bright line aspects. I’m concerned that the Boards might unnecessarily make lease accounting more complicated than it currently is, particularly if frequent complex adjustments to the lease liability and asset accounts are mandated. Most accountants are already familiar with capital or finance leases because they have to compute the present value of the minimum lease payments (PVMLP) to test one of the basic rules/principles even if the lease turns out to be operating. This is true even if the lease has a title transfer, bargain purchase option, or covers most of the assets economic life: the PVMLP must be computed to establish the lease obligation and asset amounts. In addition, some of the later material in the PV-Leases appears to be adding unnecessary complications to the determination of the initial value (particularly the tentative IASB views on weighted probability expected values). Fancy or complex computations will not necessarily add value for users since the result may be no more accurate than application of existing and well-understood standards to all leases. I complement

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 4

the Boards on already resisting the appeal of certain kinds of complications, e.g., approach (a) on page 26 and suggest that further simplifications might be warranted as will be pointed out later in this comment letter.

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 recognises: (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?

I concur with this decision. I believe there is a single asset and a single liability in a simple lease whether for equipment or something more exotic. Keeping the accounting consistent with existing standards governing debt contracts makes sense to me – that is, carrying the obligation at amortized cost using the initial effective interest rate. The component approach with respect to the physical asset would imply separating the value of roofs from elevators and the like (IASB) and a leased asset is actually an intangible right-to-use rather than different asset components with possibly differing economic lives.

Chapter 4: Initial measurement  

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? If you disagree, please explain why and describe how you would initially measure the lessee’s obligation to pay rentals.

My initial reading led me to a definite “NO” answer because I have been very impressed by the IASB guidance which says we should use the lessor’s implicit interest rate if it can be determined. Having added lease classification under IASB to my courses over the last two years, I have been fascinated to learn how much more likely one is to get a capital lease rather than an operating lease by simply using the implicit rate rather than the incremental borrowing rate. In situations where there is a title transfer, bargain purchase option, or fully guaranteed residual value, the implicit rate can be determined easily and accurately. The rate is more problematic if there is an unguaranteed residual value or in cases where the fair value of the leased asset is unknown at the inception of the lease. I explain to my students that the FASB rules came about in a time when we were pretty much stuck with using time-value of money tables – the first spreadsheet program had yet to be invented and a simple four-function calculator cost me about $150 as I recall, and I don’t think there were financial calculators available then, at least at a reasonable price! In other words, using the incremental borrowing rate unless the implicit rate was provided by the lessor was a practical solution in FASB Statement No. 13. The IASB had the advantage of learning from many years of FASB experience as well as a much higher level of readily available technology. An incremental borrowing rate is subjectively determined and there would be a bias to claim a high rate because that gives a lower present value. On the other hand, the lessor’s implicit rate can be likened to the actual rate of return the lessor believed would be necessary from a particular lessee. It is therefore a risk-adjusted rate of return essentially equal to a lessee-specific lending rate or the rate that the lessor would have charged the lessee for borrowing money to purchase the asset.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 5

Note that Paragraphs 4.12 and 4.13 make valid point as to the difficulty of estimating the lessor’s implicit interest rate, particularly for many leases currently classified as operating. Retaining the current IASB rule would mean that the incremental borrowing rate would be used in most cases when the leased asset must be returned to the lessor at the end of the lease term (because of the difficulty of obtaining information on residual values). I think the Boards may be trying to simplify something that is currently no problem at all for preparers (see Paragraph 4.17) who already have a (limited) choice for picking between two rates to use. The implicit rate, when available, is more valid than a subjectively determined incremental borrowing rate. I think financial statements users would be harmed rather than helped by this particular desire to “simplify” current standards.

Two issues have modified my original opinion. First, if we end up re-measuring the liability with a new discount rate, there would be no way to get or estimate a new implicit interest rate. Of course, I’m strongly recommending against changing the discount rate for subsequent measurements: if we decide to use the incremental borrowing rate, it should NOT be reassessed in subsequent reporting periods. (In other words, I prefer the FASB approach in Paragraph 5.24 to the IASB approach in Paragraph 5.25.) However, a more interesting problem arose as I got into exploring what lessor accounting will look like in the future. In the case of what are now operating leases, the value of the asset may not decline much between inception and termination of the lease. For real estate, the residual value might even be higher. Neither of these situations would prevent computation of an implicit interest rate. (See last example in my Appendix E.) However, that rate could be rather high and, in the cases where the asset is projected to increase in value, the interest expense for the lessee would exceed the rent payment leading to the nonsensical situation of “negative reductions” to principal in the lease obligation amortization table. Thus, the implicit rate could be higher than the incremental borrowing rate and that information (if disclosed to the lessee) might become a popular way to “cook the books.” Accordingly, a modification of the current IASB guidance would work better: Use the implicit interest rate if determinable unless it is higher than the incremental borrowing rate.

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.

Yes. I agree but would prefer a different interest rate rule (as discussed in my answer to Question 6). A lease is the right to use one or more tangible assets (at least under US GAAP). The accounting on the asset side should parallel the accounting for a purchased asset of the same type. In other words, the accounting for the liability side would be consistent with accounting for other loans which is generally done using the “historic” interest rate. However, a lease versus purchase situation has one very important difference. For a lease, we can only estimate the value using present value techniques applied to anticipated cash outflows. For an outright purchase, the initial value can be known with certainty. In many cases in the PV-Leases document, the Boards have talked about the right-to-use asset becoming more or less valuable as options are exercised or declined (for example, see Paragraph 6.51). I think this is the wrong language to be using. Instead, we should be talking about subsequent measurement in the light of changes in accounting estimates. When the estimated lease payments change, we discover the initial measurement was incorrect, not that the actual “value” has changed. At the

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 6

beginning of the lease, all the possible options were already known. Therefore, it can’t be worth more or less later merely because available options were later accepted or declined. However, with changes in assumptions, we do learn that our initial estimate of the initial value was incorrect. This recommended change in language is important and should also guide how we account for leases. For example, the analogy to purchased assets suggests that total depreciation expense should change when the estimates involved change. This does not happen in any of the three methods discussed (prospective, catch-up or retrospective) in the PV-Leases as described in my Appendix A, Table 1. None of the methods ends up with total depreciation expense equal to the revised value of the right-to-use asset. I have proposed a slightly different catch-up method that corrects this problem (see my Appendix B).

Chapter 5: Subsequent measurement  

8. The boards tentatively decided to adopt an amortised 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 favour and why.

This is a reasonable approach for both the liability and asset components of a lease and is similar to what we currently do for capital leases. However, it will become burdensome if frequent re-measurements are required, such as revision of the incremental borrowing rate (as envisioned by IASB) or for minor changes in estimated contingent rentals or residual value guarantees. In my hours of fiddling with the latter two issues, anything other than the proposed FASB method of taking the change in liability to P&L becomes unnecessarily complicated and time consuming because of the necessary changes in estimated depreciation expense as the right-of-use asset value changes. If we also had to change the incremental borrowing rate (which would surely be different at the end of every reporting period), the process would become exceedingly complex. Accordingly, I’m in strong support of the basic decision for an amortized cost approach -- assuming frequent adjustments are not mandated. My examples 9 and 9-RV Excel files explored both the IASB and the FASB approach at length (amortization tables, journal entries and t-accounts) but more on this later.

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.

Maybe. If a fair value option is available for other financial assets and liabilities, it wouldn’t make much sense to prohibit equivalent treatment for leases. The problem is that neither the asset nor liability side is not easily re-measured with level 1 or 2 market inputs. In addition, the fair value option was intended to facilitate an easier way of hedging and, in this case, the asset drops in value (through depreciation) as the obligation drops in value (through principal payments). Therefore, the hedge is basically automatic. However, if the boards see fit to simplify the “re-measurement” decisions, then it might make sense for companies that want to do a lot of fancy estimates of fair value be given that option. I’m having a hard time seeing that financial statement users would benefit given the difficulties in arriving at fair values for leased assets.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 7

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. 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.

NO. As stated in response to Question 6, I prefer the use of the lessor’s implicit rate (when feasible) and amortization based on the historic rather than current rates (see discussion under Question 7). I’d like to see the re-measurement occur (if we really need one) only when projected cash flows change substantially due to different conclusions regarding acceptance of renewal options or the like.1 Even then, current practice (for example, creditor accounting for troubled receivables) retains the historical interest rate. Changes in incremental borrowing rates happen with regularity as economic conditions drive interest rates up or down. This is true for all debt but, unless the fair value option has been adopted, other payables and receivables continue to be accounted for using the original effective interest rate. Therefore, I’m strongly opposed to re-measurement of lease obligations when the incremental borrowing rate changes. It adds unnecessary complexity to the accounting for leases. The historic discount rate should be retained and used as illustrated with the catch-up method in the examples provided in Chapter 5. See also example in my Appendix B. I would also rather avoid the complications of current standards for changes in estimated asset retirement obligations (AROs). In FASB Statement No. 143, downward changes are at the historic rate but increases in future costs are measured at the credit-adjusted risk free rate in existence at the re-measurement date. I think a lease situation is quite different because all of the variations in cash flows were possibilities from the beginning. For an ARO, increases in projected costs may arise from new laws or discoveries. In addition, we might end up with the complication of using a weighted-average incremental borrowing rate even for downward revisions! So, to reiterate, I’m strongly in favor of the use of the original “historic” discount rate to account for lease obligations including re-measurements trigger by revised estimates of lease term or cash flows.

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.

My initial reaction to reading Chapter 5 was to leave the accounting method up to the preparer as would be the case for changes in other accounting estimates. After many hours of exploring variations of Example 3, I became convinced that specifying the method is a good idea because of the extreme variations that could result from optional choices between the prospective, retrospective and catch-up methods. In some cases, application of the prospective and retrospective methods results in negative total interest expense being recorded over the life of the lease. Both of these methods would tend to distort any ratio analysis that uses interest

1 Unfortunately, leases with contingent rentals will probably need re-measurement frequently – every time actual contingent rent differs from expected. So let’s keep that as simple as possible as discussed under Question 21.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 8

expense to analyze liquidity and debt coverage. As shown in my Appendix A, I’ve carefully weighed the pros and cons of the three methods in settings where the lease term increases (like Example 3) and where the lease term decreases. It is exceedingly difficult to handle the prospective and retrospective methods when estimated lease term decreases since technology like Excel and calculators were not designed to compute negative interest – something that makes no sense in any real world setting! As an instructor, I would also evaluate these methods as very hard to teach. My laboriously reached conclusion: catch-up methods using the original interest rate should be the only permitted method. As mentioned earlier and assuming that I’ve properly implemented the catch-up method as intended by the Boards, adoption of the alternative catch-up method illustrated in my Appendix B could ameliorate the identified problems with little increase in complexity unless revisions become very frequent.

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 amortisation or depreciation in the income statement. Would you support this approach? If so, for which leases? Please explain your reasons.

I had a hard time figuring out exactly what the question means – but I assume it goes along with Example 2. The approach in this example would book the rent payment as rent expense while amortizing both the obligation and the right-to-use asset by the same amount and recording no interest expense. While I can see that this a “best of both worlds” approach, it would only be reasonable for what would now be called an operating lease. However, retaining a distinction between operating and finance leases would add unnecessary complexity to the lessee accounting standard (although I’m becoming convinced that it is probably important to retain the distinction on the lessor side). My main objection to the Example 2 approach: a lease is often, if not always, a financing decision. The company could purchase the asset instead of leasing it. Therefore, it makes sense to divide the lease payments into principal and interest components so that the accounting is consistent between the two financing mechanisms.

On the other hand, I am not necessarily opposed to the use of a “mortgage method” of depreciation which produces a declining amount of depreciation expense. A lessee can arrive at the exact same constant effect on the income statement by adopting this depreciation method. However, the expense components should be labeled correctly! If companies are serious about wanting this “even impact” on the bottom line, they could adopt this currently obscure “mortgage-method.”2 I see no particular problem with permitting this method along with all the others like straight-line or double-declining balance that companies already have available. The complexity of the method might naturally limit its use given that it would probably not be acceptable for tax returns. However, when I prepared the third example in Appendix E for a lessor, I found it to be as easy as pie! Adopting mortgage-method depreciation while reporting interest expense, the Example 2 journal entry at the end of the first year would be:

2 As I understand it, this depreciation method was often used by regulated utilities. The material is no longer covered in intermediate accounting texts even though it is an excellent management accounting tool since it facilitates the evaluation of subunits on a “return on investment basis” consistent with capital budgeting decisions.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 9

End of Year 1, Example 2 (page 25 in PV‐Leases):  debit  credit Interest expense  11,180   Obligation for lease payments  23,820    Cash    35,000 Depreciation expense  23,820      Accumulated depreciation    23,820 

Note that the impact on the profit and loss statement is equal to the required rental payment on an annual basis (and therefore effectively equivalent to having an operating lease on the profit and loss statement with a capital lease on the balance sheet.3 But let’s call the expenses by the “right” name!

Chapter 6: Leases with options  

13. The boards tentatively decided that the lessee should recognise an obligation to pay rentals for a specified lease term, ie 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.

The most-likely lease term should work and the weighted probability method of computing the most-likely lease term is probably an acceptable alternative for situations where informed probabilities are feasible. However, I believe that the lease term used should be one that is actually possible. For example, the expected lease term for Example 5 turns out to be 14.75 years so it should be rounded up to 15 since the lease must be 5, 10, 15, 20 or 25 years. Most of the time, management will make its best guess, without any explicit probabilities available. If a company has sufficient information to apply probabilities to the various possible lease terms, then it should be permitted to use that analysis to help it selected its “most likely” length for the lease.

There doesn’t seem to be a specific question related to Paragraph 6.41 so I’m going to make comments here. According to this paragraph, the Boards have tentatively decided that the lessee’s intentions and past practices would not be considered when determining the lease term. I’m having a hard time seeing how this statement is consistent with the examples included in the PV-Leases document. As a case in point, where would the probabilities in Example 5 come from if not derived from lessee specific experience? The entity is described as a mature business with experience in expanding to new locations. If the Boards decide to exclude lessee-specific expectations regarding renewals, I’m guessing that most leases will be capitalized at a value based on the minimum lease. In other words, we will end up with a PVMLP just like have

3 Of course, over the lease term, any approach will have equality between total depreciation expense plus total interest expense and total cash flows for rental payments. So, one might consider this mortgage-method depreciation simply a variation of other accounting methods that could be used to recognize lease obligations and right-to-use assets.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 10

under current standards, with minor differences mostly limited to contingent rentals and guarantees of residual value. Is that what the Boards really want? Of course, it is probably what is going to happen anyway since the lessee’s bias will be to minimize the lease obligation whenever possible.

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 recognised 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.

Periodic reassessment on the basis of new facts or circumstances is a reasonable approach for lease accounting (particularly if the retrospective and prospective methods of implementing the change are prohibited). As stated elsewhere, I believe that the reassessment should always be at the original discount rate. For some situations like minor changes in expected cash flows for a guarantee of residual value, the reassessment would not be particularly relevant for financial statement users, particularly in the early years of the lease when substantial uncertainty exists about future values of used assets. Accordingly, revisions should be avoided unless have a substantial affect. In fact, I discovered that leases with contingent rentals are going to be troublesome – there is no way that I can see that one could avoid adjustments to at least the lease obligation for even minor differences between expected and actual contingent rentals. In fact, changing projections for all future contingent rentals to match the actual amount incurred for the most recent period would not be any more difficult than leaving future rentals at the originally expected amount. However, the Boards could keep the process a bit simpler if the right-to-use asset is not revised each time a contingent rent payment differs from the expected amount. (Please see my Appendix C for a complete example with additional comments). If the right-of-use asset is not adjusted, the total cash flows over the lease term would be equal to the total depreciation expense plus total interest expense plus total gains or losses recognized over the lease term. Given the frequent ups and downs that might be expected for contingent rentals based on sales, it is likely that the gains and losses will cancel out over the lease term.

I’d like to suggest the Boards consider permitting the use of my “retroactive catch-up method” for dealing with situations where the expected lease term or payments under the lease term change from the original estimate. In arriving at my “new” method, I first spent a good bit of time on Examples 6 through 8 trying to understand the intended accounting impact. In addition, I played around with variations of Example 3 that had both increased and decreased lease terms. My recommended method is a slight variation of the catch-up method but has certain advantages. With my catch-up method, the original present value of expected lease payments (PVELP) liability amortization and right-to-use asset depreciation schedules are converted to the revised PVELP liability amortization and right-to-use depreciation schedules at the date when it becomes apparent that the lease term or total cash flows will be substantially different than the original estimate (see my Appendix B for an example). The main difference in my approach is that interest expense is adjusted so that, by the end of the actual lease term, the total interest expense and total depreciation expense recognized will be equal to what would have

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 11

been recognized had the actual lease term and actual payments been known at inception. Thus my method is “retroactive” in that is the “if only we had known” approach to a change in accounting estimate.

This alternative approach is consistent with accounting standards regarding a change in accounting estimate. The initial value of the right-to-use asset is an estimate based on the expectations regarding payments to be made under the terms of the lease. When the estimate changes, it does not mean that the right-to-use asset has increased or decreased in “value.” Rather, it means that our original estimate of the value was incorrect. Therefore, we make changes to the current and future periods to correct the erroneous original estimate. As discussed in my response to Question 7, “hange in accounting estimate” language should be used in the final standard. Much of the language in the PV-Leases document seems to imply that the right-to-use asset suddenly became more or less valuable as projected payments change. This language is flawed in my opinion since the option to renew or purchase the asset existed when the lease was signed. The original measurement did not find “truth” and neither does the re-measurement. We are merely revising an estimate; therefore, the accounting should be consistent with existing guidance on changes in accounting estimates.

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.

After doing lots of examples, I am forced to agree. A purchase option, like a renewal option, is either exercised or not. Therefore it should be included in the minimum lease payments when it is more likely than not to occur. However, there may still be room for guidance regarding the inclusion of a bargain purchase option. However, a bargain purchase option should no longer “trump” a bargain renewal option (as it does under current US GAAP). For example, the renewal option might be $5 per month for a year and the purchase option might be $100. If the purchase option were a bargain, current rules would have the lease term always end at the date the bargain purchase option becomes available even though it would be cheaper to renew for a year and more logical is only a year of useful life remained.

Chapter 7: Contingent rentals and residual value guarantees Contingent rentals  

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?

I agree. In reaching this conclusion, I carefully considered variations in Example 9 including both the proposed FASB and IASB approaches to initial and subsequent measurement. My initial reaction was a preference for current GAAP which basically ignores most contingent rentals as of the inception of the lease. However, I can see that abuses would arise if leases were structured to have a higher percentage of contingent rentals as compared to fixed rental payments. So I believe we do need to include an estimate of contingent rental payments in the computation of the initial value for the obligation to make lease payments and the right-of-use asset. The initial estimate could be based on the current level of sales or usage – but that

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 12

wouldn’t always be available. So an estimated “most likely” amount should be included in the computation of PVELP. I think that either a “best estimate” or a “weighted probability expected amount” would be acceptable. I don’t think the weighted probability approach should be required but it also should not be precluded.

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.

I think either approach should be permitted. If reasonable probabilities are available for a range of outcomes (more than mere guesses to implement an accounting requirement!) then the lessee should be able to use the expected value technique to estimate the most likely contingent rentals. However, the method should not be required. Note that a symmetrical probability distribution will produce the middle number anyway – something I accidentally discovered in making up an example for an asset retirement obligation!

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.

This seems consistent with current GAAP and therefore it would be okay with me. However, one could estimate regular increases in price indices and that could be used to forecast an increasing series of payments. Conceivably, that could give rise to a more accurate initial estimate of the value of the right-to-use asset. The same cannot be said for contingent rentals based on interest rates like LIBOR. These change frequently with economic conditions and move both up and down. To keep it simple, therefore, I think it might be wise to always use the “current index” to determine the initial value of the PVELP (right-to-use asset and obligation). Please note that an index-based estimate of future contingent rents will be just as subject to error as any other type of estimated contingent rents such as those based on sales or usage. Accordingly, one can expect “every period” adjustments to the lease obligation, even when the projected future amounts have not changed. This is another argument for the FASB rather than the IASB approach discussed as described in Paragraphs 7.31 and 7.32. See example in my Appendix C which more fully demonstrates the complications and also suggests an “even easier” alternative.

19. The boards tentatively decided to require remeasurement 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.

Contingent rentals (in many cases like the example in my Appendix C) will almost never be exactly the amount predicted at inception. This raises a number of severe complications for the subsequent accounting for leases with contingent rentals. I suppose that one could simply have

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 13

a gain/loss account for contingent rentals that differ from the expected amount (with no adjustment to either the liability or the asset). However, I believe the Boards are leaning towards revision in at least the lease obligation. As far as I can tell, revisions in the lease obligation will be required with every payment that differs from the originally expected amount (that means adjustments with essentially every payment!) In addition, differences in the past may lead to different expectations about future contingent rentals and therefore cause additional revisions in the estimated liability because of changes in future expected payments. I would like to see it made plain that changes to the right-to-use asset should only be triggered by major differences in projected contingent rentals. Otherwise, the accounting will be too complex – even though the added complexity will not make the financial statements much more meaningful to users. Instead of changes to just the liability account, the Boards could consider simply accounting for insignificant differences between expected and actual contingent rentals via a gain or loss account on the income statement. Please see the end of my Appendix C example for an illustration.

20. The boards discussed two possible approaches to recognising all changes in the lessee’s obligation to pay rentals arising from changes in estimated contingent rental payments: (a) recognise any change in the liability in profit or loss (b) recognise 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.

After testing out both approaches on variations of Example 9, I have a strong preference for the FASB approach (a). This approach was relatively easy to implement with a simple modification to the lease amortization schedule. In contrast, it took me quite awhile to get something working to illustrate the IASB approach (b). In my example, I have differences between actual and expected (without changing future amounts) and also a change in future amounts triggered by a second year of differences between expected and actual contingent payments. For this analysis, I used the catch-up method, as I understand it. Depreciation was simple straight-line, no salvage value. However, the IASB approach (b) has to adjust depreciation expense each time the right–to-use asset is adjusted. Therefore, this second approach is more complicated and time consuming. (It was even harder when I tried to apply my alternate catch-up method.) The conclusion I reached based on my examples: many adjustments will be relatively immaterial and of little interest or benefit to financial statement users. From my multiple hours of fiddling with the two approaches, my preference for (a) is exceedingly strong! In fact, I’d like to see something even simpler that could be used for immaterial differences between estimate and actual. Certainly, major changes in estimates need to be recognized, probably in both the obligation and the right-to-use asset accounts. Please see my Appendix C example and discussion.

Residual value guarantees  

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?

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 14

I think these two items could easily be approached in the same way: for initial measurement, use the most likely amount to be paid (with the weighed probability approach neither required nor precluded) and for subsequent measurement, using approach (a) in Question 20 to adjust the lease obligation but not the right-to-use asset. I see no reason for the residual value guarantee to be separated from the rest of the lease contract, particularly if separation triggers accounting for the guarantee as a derivative (shudder!). I created an Example 9-RV (similar to Example 9 in the PV-Leases document but with a residual value guarantee and no contingent rentals) to test out the two approaches for handling changes in estimated residual value guarantees. The process was much easier than the one for contingent rentals because it is less likely to require frequent revisions. Determining the estimated difference between the residual value of the leased asset and the guaranteed amount can be calculated using the weighted probability approach, if reasonable probabilities are available. It isn’t that complicated! The important complications would result from frequent adjustments to the right-to-use asset and depreciation expense if the IASB approach (b) in Question 20 becomes required.

With respect to having a different treatment for changes in lease term versus changes in estimates of originally uncertain dollar amounts (contingent rents and residual value guarantees), it is true that both changes logically affect the original estimate of the initial value of the right-to-use asset and therefore the lease obligation. The justification for the different approach is that the cash flow changes are determined by uncertainty of dollar amounts for contingent rentals and residual value guarantees but the cash flow changes for changes in the lease term are related to future decisions as to whether options will be exercised. In addition, changes in expected lease term should be relatively infrequent, especially as compared to the differences between actual and expected contingent rentals that may occur with every single payment! I would not be opposed to handling changes in projected guarantees of residual value in the same way we would use for changes in lease term – it would be perfectly logical and the present value of cash flows to be paid in the distant future would rarely be material enough to trigger adjustments. However, the frequency of changes that are inherent in accounting for contingent rentals argues for an exception to the “adjust every period” rule. Therefore I strongly support differential treatment for at least contingent rentals.

Chapter 8: Presentation  

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?

I believe that lease obligations (as accounted for per the PV-Leases document) are substantially different from most financial liabilities and therefore need to be separately presented in the financial statements. First, financial liabilities generally specify fixed payments on known dates. In the case of leases, some portion of the payments may be contingent on sales, usage or various indices. In addition, we will be using “most likely” lease terms rather than contractually known payment dates. If financial liabilities have guarantees equivalent to residual value guarantees or something equivalent to purchase options, those elements are generally separated out as derivatives (which I wouldn’t want for leases!). If the lease

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 15

obligations are not separately displayed on the face of the financial statements, the amount should be disclosed in the notes to the financial statements along with the related carrying amount of right-to-use assets. As mentioned earlier (see Question 9), for purposes of disclosure, fair values could be readily computed at with a “Level 3” approach if that information were deemed essential to financial statement users. However, I’m personally of the opinion that the value would be pretty soft and therefore not very meaningful.

In addition, I’m opposed to commingling interest on leases with other interest expense – particularly if the prospective or retrospective methods are permitted for implementing re-measurement of lease obligations and right-to-use assets when expectations about cash flows change. As shown in my Appendix A, these methods would severely distort the annual relationship between interest and financial liabilities since the rates may be excessively high or low (even negative).4 Since many ratios use interest expense in computing debt coverage, the financial statement user should have the choice to include or exclude leases from the analysis.

Currently, we have schedules listing the rentals due over the next five years (at least in US GAAP). I would like to see this schedule maintained and expanded to clarify which payments are fixed and which are estimates of contingent rentals. It might look something like this:

Projected payments 

under leases

Minimum fixed rentals under 

existing contracts

Planned payments under unexercised 

renewal and purchase options

Estimated contingent rentals and residual value 

guarantees2012 655                     625                        ‐                           30                           2013 655                     625                        ‐                           30                           2014 675                     625                        20                             30                           2015 575                     525                        20                             30                           2016 575                     525                        20                             30                           

2017‐2021 2,875                  125                        2,600                       150                         Thereafter 1,510                  ‐                         1,500                       10                           

7,520                  3,050                     4,160                       310                         

Less interest 3,290                 Lease obligation 4,230                 

4 The catch-up method described in the PV-Leases document would also result in greatly increased or decreased amounts for interest expense in the periods following an adjustment. Even my proposed retroactive catch-up method would potentially distort interest expense although only in the period when an adjustment is made. See the example in my Appendix B.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 16

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

If there were a feasible way to distinguish between what we now call operating and finance leases, I would be amenable to recognizing right-to-use assets related to what we currently call operating leases as intangible assets with the right-to-use assets related to finance leases being classified with the relevant category of plant, property or equipment. However, it appears that the Boards are reluctant to complicate the standards by attempting to delineate a difference. Therefore, my preference would be the display of right-to-use assets in the statement of financial position (balance sheet) in the category to which the leased asset belongs. The rationale that makes most sense to me is that leasing is an alternative to purchasing the underlying asset. Capitalizing all leases is a way to demonstrate the equivalence of leasing and purchasing (with a loan).

Chapter 9: Other lessee issues  

24. Are there any lessee issues not described in this discussion paper that should be addressed in this project? Please describe those issues.

I have several thoughts about “what else” should be included in the new standard. First, is there a need to specify treatment for investment tax credits (ITC)? That portion of current US GAAP has become pretty obscure since there are fewer of these credits available now that when FASB Statement No. 13 was issued. Also, as I recall, the ITC had more of an effect on classification than on the accounting for leases.

Second, should there be some guidance on the maximum amount of the right-to-use asset? I don’t think the amount (at least at the inception of the lease) should exceed the fair value of the underlying asset if it can be reasonably determined. However, a PVELP in excess of fair value at inception may be unlikely since the lessee will be biased toward using the highest possible incremental borrowing rate and assuming the shortest possible lease term.

Third, the Boards would be wise to take advantage of the “tried and true” guidance from existing standards. For example, it would be well to mention existing guidance on renewal penalties to aid folks in knowing what to include or exclude from the PVELP: penalties should be excluded if the lease term is deemed to be long enough to avoid them but included if so short that the penalty would need to be paid. What about a guarantee of lessor’s debt? Should that not be an indication that the lease term will cover at least the period of the guarantee? Specialized nature of the asset –wouldn’t that suggest that the lessee would exercise renewal options through the maximum period (up to the useful life of the asset)? Likewise, projected below-market purchase or renewal options would suggest the purchase or extension of the lease term. See my Appendix D for an outline of potential guidelines based on current standards.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 17

Here are some other thoughts regarding issues that were discussed in the PV-Leases document.

Sale-leaseback. While the Boards did not specifically ask for advice regarding sale-leaseback situations, I took Example 10 and tried to imagine what the option (a) in Para. 9.12 would look like and I’m completely stumped. Both the physical asset and the right-to-use asset would appear on the books and both would presumably be depreciated. Upon sale, the cash would be received and charged to a liability (rather than sale) and cash would be paid out in accordance with terms of the lease contract, presumably resulting in interest expense. But at what point would the physical asset be removed from the books? Evenly over the years of the lease? Would the gross profit also be recognized evenly over the lease? Without an example, I’m very unsure as to exactly what this option means! In my opinion, sale-leaseback situations are very rarely arms’ length transactions and therefore the amounts paid may be quite different from market prices (as discussed in Para. 9.11). I would recommend a simple solution: treat all sale-leaseback situations as sales with the gain or loss on sale spread evenly over the lease term. This treatment should discourage transactions structured merely to obtain off-balance sheet financing.

Initial direct costs incurred by lessee. I believe that the most sensible treatment would be to include these costs as part of the right-to-use asset (i.e., add to the PVELP). Leases are not business combinations so the analogy to consolidation accounting (immediate expense recognition) is less compelling than that of treatment as acquisition costs associated with other long-lived assets like buildings and equipment. In those cases, initial direct cost are currently capitalized.

Chapter 10: Lessor accounting  

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.

Yes. It is difficult to see how the right to receive a (relatively certain) set of payments over a specific period of time differs from a financial asset just because it is the “loan” of tangible assets rather than a loan of money. Arguably, the accounting should be symmetrical – if it is a liability for the lessee, it would be an asset for the lessor.

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.

Upon first reading, I was fairly indifferent between the two approaches. The first is more familiar because it is what is called for under current standards for finance leases. However, the latter appears to be consistent with the recent discussion paper on revenue recognition. As the Boards are attempting to rationalize and standardize accounting for revenue, it would be nice to be as consistent as possible across various types of transactions.

Disadvantages of Approach a. Paragraph 10.16 implies that revenue would be immediately recognized since all leases would become “sales” of the underlying asset deemed transferred to

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 18

the lessee. This just seems wrong to me and it would certainly be a major departure from current accounting standards. Apparently, there would be revenue to recognize immediately to offset the relinquishment of any right to use the asset during the lease term AND there would be interest revenue recognized from the lease receivable??? That just seems like double counting to me – but maybe I’ve misinterpreted something.

Disadvantages of Approach b. I think I would have a harder time explaining the second approach to students. They are already horrified when we do examples where both lessor and lessee end up with the same asset on their books. Students really complain that it is “just not right” that both parties should be depreciating the same asset. Of course, the lessor legally owns the leased asset and has only given up the right to its use over the term of the lease. This is clearly a performance obligation that could be booked (especially if the leased asset stays on the lessor’s books). If the asset will be returned, it makes a good bit of sense to keep it on the balance sheet. This approach does have the unfortunate result of essentially doubling the assets and lessors won’t like having another liability on the books . However, this makes the revenue recognition parallel to that we will (?) be using for warranty on products: revenue recognized over the passage of time.

Advantages of Approach b. One possible advantage to the “new right and obligation” approach is that it might reduce the incentive for lessors to book the highest possible PVELP, particularly for leases where a profit on sale is recognized. Since lessors will not wish to have large liabilities, they may naturally make more conservative projections of the lease term and be less likely to include services among the lease payments. One case that I vaguely recall from years back had to do with photocopier leases. The lessor was a manufacturer (Xerox I think) that was able to inflate its sales for awhile by “selling” package deals that included paper and toner along with the equipment. Of course, that was a violation of proper accounting and eventually had to be corrected. But the example does illustrate one of the perverse incentives that might be reduced by changing to a new concept for lessor accounting.

After careful consideration, I came up with what I believe would be a practical hybrid approach that uses general guidelines to distinguish between leased assets that are effectively transferred to the lessee and those that are not. For the former, accounting would be similar to the current treatment for finance leases while the latter would use approach (b). This approach is described in my Appendix E and includes examples. I hope the Boards find it useful!

27. Should the boards explore when it would be appropriate for a lessor to recognise income at the inception of the lease? Please explain your reasons.

Yes. There are clearly situations where a lease is simply a way for a manufacturer or dealer to make a sale that would otherwise go to a competitor. In other words, it is a way to offer financing to assure the sale. However, this would be a rare rather than a common situation given that what were formerly operating leases will now be capitalized by lessees (and presumably lessors). I like the notion presented in Para. 10.28 but I concur that some specialized guidance for real estate would be wise. In addition, short-term leases of one year or less might be scoped out (for lessors only?) and accounted for as revenue as time passes and

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 19

rents are collected – similar to the approach in the PV-Leases Example 2 on page 25. See also the “style b” approach in the third example in Appendix E.

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

If legitimate market values are available (level 1 or 2 inputs), there is no reason that leases could not be carried at fair value. However, once we drop to level 3 in the fair value hierarchy, I can’t see much reason to make a distinction just because the lease is “held as an investment.” Perhaps simply letting all lessors have the option of accounting for leases at fair value would be the easiest approach. Insurance companies and college endowments would possibly want to take advantage of a fair value option but I expect it would be more trouble than it is worth for most other for-profit and not-for-profit entities. With respect to current disclosures under IAS 40, it seems to me that merely updating the existing discount rate to match current economic conditions and recalculating the present value of remaining lease payments and projected residual value would give a “fair value” figure that could be disclosed along with carrying value – assuming there is no better way to arrive at a fair value for the majority of leased assets. However, I profess no particular knowledge regarding how these fair values are currently being estimated for the disclosure under IAS 40.

29. Are there any lessor accounting issues not described in this discussion paper that the boards should consider? Please describe those issues.

Subleases are an interesting issue that will arise if lessee standards are promulgated before lessor standards. That is probably an argument for implementation of all of the new lease standards at the same point in time. To me, merely excluding the head lease from the scope of the new standard does not seem to be a viable alternative. If lessor standards cannot be developed in time for the release of lessee standards, interim guidance for subleases only would be the best approach (in my opinion).

To the list of “other lessor considerations” on page 82, I would add unguaranteed residual values. This will become a much more important issue under new standards if they apply finance lease accounting to almost all leases, i.e., approach (a) from Question 26. Projecting residual values is more art than science. Perhaps disclosure of residual values among other fair value disclosures would be helpful but that implies separating out this component of the lease. Valuing most lease arrangements would rarely rise above level 3 in the fair value hierarchy of inputs. However, if we go with approach (b) from Question 26, the obligation could be measured essentially the same way being discussed for the lessee with only one major exception: any guaranteed residual value should be included at the full amount. This approach has the nice benefit of excluding all unguaranteed residual values from the measurement of the lease receivable and the “relinquishment of right-to-use” liability account. Instead, any residual

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 20

value would be automatically on the books as part of the carrying value of the underlying asset.5

The interest rate that lessors should use will also be an important topic. For real estate leases, the residual value could be projected to be nearly the same or even higher than the fair value of the leased asset at inception. This would give a very high implicit interest rate and therefore potentially distort interest revenue (and interest expense if communicated to lessee – see comments under Question 6). In addition, my experiments with proposed lessor accounting revealed the fact that the implicit rate can be so high that it would exceed the cash inflow from rent payments and thus result in “negative reductions” to the principal balance in the receivable account – a rather nonsensical result! So perhaps lessors should be using the rate they would charge the borrower for a loan that had the leased asset as collateral. Thus, they would take into account both the risk level inherent in the arrangements and the credit standing of the lessee. This would be a mirror image of the lessee’s incremental borrowing rate – the lessor’s lessee-specific lending rate. Since the implicit rate is the better rate for situations comparable to those currently considered finance leases, maybe the rule could be that lessors would use the lending rate (instead of the implicit rate) only for leases that do not effectively transfer the leased asset to the lessee.

In any future lessor standard, I would also like to see a close parallel between lessee and lessor guidance as to expected lease terms and what amounts should be included in the PVELP. Obviously, the lessor and the lessee may make different assumptions but the guidance should be very similar. Some differences would be natural and important. First, lessees include estimated future cash flows related to residual value guarantees but the lessor gets the full amount back (in either cash or physical assets). Therefore, the lessor’s receivable and PVELP should include the full value of any guarantee of residual value. This would be true for both lessee and third-party guarantees. Second, the treatment of unguaranteed residual values should depend on whether or not the asset is considered to be effectively transferred to the lessee. Under approach (a) in Question 26, the lease receivable would need to include any unguaranteed residual value but under approach (b), the receivable should not include unguaranteed residual values. These issues have been addressed in my proposed lessor accounting scheme which is described in my Appendix E.

Cooking the Books under the Proposed Guidelines 

Given the proposed lessee accounting guidelines, I tried to imagine how people will attempt to structure leases in an effort to minimize the lease obligation. Financial engineering will now be focused on keeping lease terms short (and thereby minimizing projected cash flows). Leases will continue to avoid any bargain renewal options, automatic title transfers, or

5 The more I thought about the issue of unguaranteed residual values, the more I liked approach (b) in Question 26, particularly for situations in which the physical asset is not effectively transferred to the lessee. See my Appendix E.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 21

bargain purchase options that would result in longer lease terms. Unless forced to include expected contingent rentals, leases would be structured to include contingent rents in preference to fixed rents. If short-term leases are scoped out of the standards, leases will be written with lease terms just less than the cutoff with multiple renewal options of the same length and at the same (or higher) rent. Since leases structured in this fashion are not very “safe” from the lessor perspective, there will undoubtedly be a continuing market place for third party guarantees of residual value. Lessors may also increase their desired return rates to compensate for the additional risk. From the lessee’s perspective, this would reduce the economic rationality of the lease arrangement. Existing gimmicks like having the lessee guarantee the lessor’s debt for a period that goes beyond the basic lease term will remain popular unless prohibited.

Once the lease is signed, the lessee will probably attempt to justify the highest possible incremental borrowing rate as well as make conservative estimates of contingent rentals and residual value guarantees. Unless purchase options are obvious bargains, the lessee will assume the leased asset will be returned to the lessee at lease end. Unless renewal options are obvious bargains, renewals will be deemed unlikely.

I decided to explore the improvement the proposed standard would bring to current accounting practices if lessees continue to structure leases to minimize adverse impacts on financial statements. The example in my Appendix F (as well as some other situations I considered) leads me to make the following “worst case” predictions:

• Reported liabilities will tend to be much lower than would be expected under an honest appraisal of the lease terms. At worst case, the liability booked will be for the present value of the payments in the next year. The right-to-use asset will be too low at inception and much too high at the end of the lease (of course book value will be zero by then). The good news is that, over the life of the lease, interest expense will be the same (as long as we don’t attempt something like the prospective or retrospective methods) and the total depreciation expense recognized plus total interest expense recognized will still equal the total cash flows. For the year-to-year renewal scenario explored in Appendix E, interest expense plus depreciation expense equals the rent payment each year – just as it does in the method illustrated in Example 2 on page 25 of the PV-Leases. So maybe it would be okay, after all, to let lessee’s use that method for short leases – it would be a lot easier and no information content would be lost. However, given these findings, I suggest expanding the minimum disclosure illustrated in my answer to Question 22. For further discussion and an example of an expanded footnote disclousre, please see Appendix F.

Summary and Conclusion 

For the most part, I believe that the proposed standards will be workable and will provide an improvement for users of financial statements. However, I do have some concerns. In this section, I will try to summarize what I believe are my most important suggestions for the Boards.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 22

First, the language regarding the reassessment of right-to-use assets should be couched in terms of a change in accounting estimate rather than a change in the value of the right-to-use asset. Please refer to comments under Questions 7 and 14.

Second, my alternative catch-up method should be considered because it is much more logical than the catch-up method described in the PV-Leases document once we start thinking of subsequent re-measurement as changes in the accounting estimate that gave us the initial value for the right-to-use asset. Please see Questions 11 and 14 plus the illustration in my Appendix B. With my retroactive catch-up method, interest expense as well as depreciation expense should always end up equal to the present value of the actual payments under the actual lease term as of the inception of the lease. However, I don’t think this method should be required since it would make the IASB approach to handling contingent rentals even harder.

Third, it is important to use a catch-up method based on the original discount rate (see Question 10) rather than using a continually changing incremental borrowing rate. The Boards could require disclosure of the estimated fair value of right-to-use assets since it could readily be determined by, in essence, replacing the original discount rate with the current incremental borrowing rate in the lease obligation amortization schedule. However, please don’t require all the extra adjustments to be booked since making changes to both asset and liability accounts is very complicated, particularly for my version of the catch-up method.

My fourth point is a pitch for “let’s keep it simple.” Small gains and losses (for contingent rentals and residual value guarantees) taken directly to the profit and loss statement should generally balance out over the course of the lease and preparers would save a good deal of effort that would be required to continually update the value of the right-to-use asset. Even better, it would be nice to avoid adjustments to the liability account for minor differences between expected and actual. The illustration in Appendix C suggests little benefit for financials statement users from frequent minor adjustments. I’d really like to see the Boards permit the “even easier method” illustrated at the end of Appendix C. See also comments under Questions 14, 19, 20 and 21.

Fifth, the prospective and retrospective methods of handling changes in expected lease term or cash flows should be prohibited because they carry the risk of severe distortion of interest expense. As described in my Appendix A, one can get nonsensical negative interest rates and even nonsensical negative amounts for total interest expense. See also comments under Questions 7 and 11.

Sixth, consider having lessees use the lower of their incremental borrowing rate or the interest rate implicit in the lease. I can live with using the incremental borrowing rate but I think the “lower of” rule would be superior and no more burdensome than current standards, See comments under Question 6.

Finally, I hope my proposed lessor accounting guidelines will be useful to the Boards. While Appendix E is not in “official standards language,” it should be sufficient to at least identify most issues.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 23

I am available to discuss or clarify any of these points if the FASB board or staff members feel that would be helpful.

Sincerely,

Teresa P. Gordon Teresa P. Gordon, CPA, Ph.D. Professor of Accounting University of Idaho 208-885-8960 tgordon@uidaho.edu

P.S. I’d like to apologize to the Boards for all the typos I’m sure I missed. I am running behind because I thought the due date was July 19 until two days ago. As I proofed this letter, I also realized that I was somewhat repetitive – with better time allocation, I could have been more concise. My page count is getting close to half the length of the PV-Leases. Sorry! My excuses also include the fact that I had a computer crash today which particularly affected the Excel files I’d been working with – and I was already having version control problems! Despite the rush to finish up, I think I’ve managed to cover everything I wanted to discuss. I’ll send the Excel files for possible staff use – assuming typos make the examples incorrect (I’ve already caught a few). In addition, it is very possible that I made some erroneous assumptions in working through the various examples. In either case, someone might find it useful to be able to see formulas and computations. However, the most important examples have been included as appendices to this letter. [If anyone else wants the Excel files, they can e-mail me at tgordon@uidaho.edu.]

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 24

Appendix A Comparison of Techniques for Implementing

the Re-measurement of Lease Obligations and Assets

Table A-1: Impact on Financial Statements of Revision Methods Considered by FASB & IASB

Catch-up method Prospective method Retrospective method Complexity of computations and technology needed

Moderate (3 step)

Can be done with time-value of money tables but easier with Excel functions or financial calculator

Low (2 steps)

Requires computation of interest rate so best done with technology

High (4 steps)

Requires computation of interest rate so best done with technology

Impact on depreciation expense over lease term (if lease term increases)

Highest

Total depreciation expense equals the higher PVELP computed for the revised lease term and cash flows

Lowest

Equals the original estimate of PVELP (amount recognized at inception)

In between

Equal to neither the original nor revised PVELP

Impact on depreciation expense over lease term (if lease term decreases)

Lowest

Total depreciation expense equals neither the amount from the original nor the revised PVELP table

Highest

Equals the original estimate of PVELP (amount recognized at inception)

In between

Equal to neither the original nor revised PVELP

Impact on interest expense over lease term (if lease term increases)

Lowest

In between amounts that would have been recognized under either amortization table used from inception of lease

Highest

A lot higher than would have resulted had the original interest rate been applied to a PVELP based on increased lease term and cash flows. Ties to neither amortization table.

High

Higher than would have resulted had the original interest rate been applied to a PVELP based on increased lease term and cash flows. Ties to neither amortization table.

Impact on interest expense over lease term (if lease term decreases)

High

In between amounts that would have been recognized under either amortization table used from inception of lease

Lowest

Interest rate becomes a large negative number and total interest expense may also be negative (nonsensical)

Low

Interest rate becomes (small) negative number. Total interest expense ties to neither amortization table

PVELP = present value of expected lease payments

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 25

Appendix A, Table 2 Instructions for the Revision Methods Considered by FASB & IASB

Catch-up method Prospective method Retrospective method To calculate the adjustment needed to lease obligation and right-to-use asset

1. Determine what the PVELP would have been using the new lease term and cash flows and original discount rate

2. Determine balance due at change date had the new amortization table been used from the beginning [Excel function CUMPRINC can be used or simply create the “as it would have been” amortization table using new PVELP and original discount rate]

3. Difference between old and new balances at date of change is the adjustment needed

1. Take the liability balance at date of change and find the interest rate that will set that amount equal to the remaining cash flows under the new assumptions. [Excel function RATE works but may require an entry in the “guess” field since the interest rates may be very high]

2. Use the new rate to record future amounts of interest expense and reduction in balance due. No adjustment is made to the right-to-use asset nor to the obligation to make lease payments amortization table

Note that it is impossible to compute new rate if current balance is zero.

1. Find interest rate that sets the original PVELP equal to the cash flows under the new assumptions

2. Use the new rate to determine what the balance on the amortization table would have been had the new rate and original PVELP been used [This can be done with Excel function CUMPRINC to find remaining principal payments unless the interest rate is negative]

3. Difference between the balance due determined in Step 2 and the balance due per original amortization table is the adjustment needed.

4. After the adjustment is made to the amortization table, apply new interest rate to determine future interest expense and reductions in principal

Computational pitfalls – particularly when expected lease term decreases rather than increases

None noted May require a negative interest rate causing Excel or calculator functions to fail. Try putting in a negative interest rate in the “guess” field in the RATE function. Of course, negative interest expense makes no real world sense.

As with prospective method, interest rate may be negative which can cause Excel or calculator functions to fail. Also seems to create numerous small rounding errors from the multiple present value computations required.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 26

Appendix B Alternate Catch­up Method (Retroactive Catch­up Method) Example 

This example is a variation of Example 3 on page 30 of the PV-Leases. I wanted to see what happens if the original lease term was expected to be 7 years but, as of end of year 3, the lessee decides not to exercise the two year renewal option. I also did journal entries for prospective, retrospective and catch-up methods for Example 3 but this one is a little shorter and will serve to show the differences in what I believe to be the Boards’ version of the catch-up method and what I believe to be a better catch-up method. Here is a summary table for the catch-up method as I understand it.

 Period   Payment   Interest   Principal 

 Adj for Non‐

renewal   Balance  Rate used 

0 182,223  1 35,000     14,578     20,422     161,801   8%2 35,000     12,944     22,056     139,745   8%3 35,000     11,180     23,820     53,510     62,414     8%4 35,000     4,993       30,007     32,407     8%5 35,000     2,593       32,407     ‐           0               8%6 0               8%7 0               8%

175,000   46,287     128,713  

Depreciation Schedule, straight-line with no salvage value:

 Period  Expected 

Life  Depr 

Expense  Right of Use 

Asset Acc'd Depr

Asset Book Value

0 7                182,223        182,223   1 26,032      26,032 156,191   2 26,032      52,064 130,159   3 104,127    26,032      (53,510)         78,096 104,127   4 2                52,064      ‐                 130,159 52,064     5 52,064      ‐                 182,223 ‐           

182,223    128,713       

The next page shows journal entries for the two catch-up methods.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 27

Appendix B, continued

Entries a, b1 to b3, and c1 to c3 the same for all methods a  Upon signing the lease  Debit   Credit    Right‐to‐use asset    182,223         Lease obligation       182,223         b  Record interest expense, first 3 years   b1  Interest expense  14,578   Lease obligation  20,422      Cash     35,000  b2  Interest expense  12,944   Lease obligation  22,056      Cash     35,000  b3  Interest expense  11,180   Lease obligation  23,820      Cash     35,000         c  Record depreciation expense, first 3 years c1‐3  Depreciation expense  26,032      Acc'd depreciation    26,032  d  Entry for regular catch‐up method   Lease obligation  53,510      Right‐to‐use asset    53,510  d  Entry for alternate catch‐up method   Lease obligation  53,510      Interest expense    11,032      Right‐to‐use asset (plug)    42,478 

d  Depreciation expense  5,751   Accumulated depreciation    5,751 The balance in lease obligation prior to the adjustment is 115,924 but the present value of only two more payments of 35,000 each is just 62,414 (using original interest rate of 8%). The lease obligation in both catch-up methods should be 62,414 after the adjustment. However, the alternate method also adjust interest expense so that, by the end of the lease term, the total interest expense will be the 35,255 that would have been recorded had we known at inception that the lease would not be renewed. In addition, depreciation expense is adjusted so that total depreciation will equal the PVELP of the revised payments now that the lease term is five years instead of seven.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 28

Appendix B, continued

After the adjustment, the journal entries are essentially the same except that depreciation expense is what it would have been had we originally known that the PVELP would equal CU 139,745 over five years instead of CU 182,223 over seven years.

Regular Catch‐up Method

Alternate Catch‐up Method

debit credit debit   creditb4  Interest expense   4,993   4,993  

Lease obligation   30,007   30,007   Cash    35,000   35,000 

b5  Interest expense   2,593   2,593  Lease obligation   32,407   32,407  

 Cash    35,000   35,000 

c4‐7  Depreciation expense   52,064   27,949  Acc'd depreciation   52,064   27,949 

The advantage of the alternate approach is clearer from the T-accounts (next page) which show that the Right-to-use asset equals accumulated depreciation = total depreciation expense = the “corrected” estimate of 139,545. In addition, interest expense is the “if we had only known” figure rather than something in between. In other words, it is exactly 8% interest on an initial value of CU 139,545.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 29

Appendix B, continued

T‐accounts for Regular CATCH‐UP  Method

dr cr dr cr dr cr dr cr dr cra 182,223   a 182,223  

c1 26,032            b1 20,422     c1 26,032     b1 14,578    c2 26,032            b2 22,056     c2 26,032     b2 12,944    c3 26,032            b3 23,820     c3 26,032     b3 11,180    

d2 53,510     d2 53,510    c4 52,064            b4 30,007     c4 52,064     b4 4,993      c5 52,064            b5 32,407     c5 52,064     b5 2,593      

ending 128,713   182,223          0               182,223   46,287    

T‐accounts for Retroactive Catchup method

dr cr dr cr dr cr dr cr dr cra 182,223   a 182,223  

c1 26,032            b1 20,422     c1 26,032     b1 14,578    c2 26,032            b2 22,056     c2 26,032     b2 12,944    c3 26,032            b3 23,820     c3 26,032     b3 11,180    

42,478     d3 ‐                   5,751               d3 53,510     ‐           5,751       11,032     c4 27,949            b4 30,007     c4 27,949     b4 4,993      c5 27,949            b5 32,407     c5 27,949     b5 2,593      

ending 139,745   139,745          139,745   35,255    

Right to use asset Accumulated Depreciation Lease obligation Depreciation expense Interest Expense

Right to use asset Accumulated Depreciation Lease obligation Depreciation expense Interest Expense

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 30

Appendix C Examples to Illustrate Proposed Accounting for  

Changes in Contingent Rentals  (Based on Example 9, page 54 in PV­Leases) 

To work Example 9, I shortened the lease term to 3 years (instead of 5) but used the same assumption for incremental borrowing rate (10%) and payments. In this case, under the FASB approach, the most likely contingent rental amount is CU 200 for a total rent payment of CU 700. Under the IASB approach, the weighted probability amount for contingent rentals is CU 235 giving a total rent payment of CU 735.

Expected Amortization Table ‐ FASB Expected Amortization Table ‐ IASB

 Period 

Total expected payment  Interest 

 Principal   Balance  Period

Total expected payment Interest Principal Balance

0 1,741     0 1,828      1 700           174        526        1,215     1 735 183           552            1,276      2 700           121        579        636        2 735 128           607            668          3 700           64           636        0             3 735 67             668            0              

2,100       359        1,741     2,205        377           1,828       

Additional assumptions used to illustrate approach toward subsequent measurements:

For both examples:

YearActual Sales

Contingent rent @ 1% At end of year:

Revised projection

Contingent Rent

Revised Projection

Contingent Rent

1 15,000     150                Future sales level is now  20,000          200 24,000         240             2 21,000     210                Future sales level is now  22,500          225 21,750         218             3 23,000     230               

For FASB Example For IASB Example

FASB Approach (adjustment to P&L rather than to right­to­use asset) 

Summary table showing adjustments and actual payments

 Period  Fixed 

Payment Contingent payment

Total payment  Interest   Principal 

 Adjust‐ment   Balance 

 Rate used 

‐          1,741          1             500               150               650                174             476             50          1,215           10%2             500               210               710                121             589             (33)         659               10%3             500               230               730                66               664             (5)           ‐               10%

1,500            590               2,090             361             1,729          12         

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 31

Appendix C, continued

FASB approach journal entries:  debit   credit 

At inception of lease: Right‐to‐use Asset  1,741 Lease obligation  1,741  [Original balance is based on i=10%, n=3, pmt=CU 700, fv=0, type=ordinary annuity]

Record payment: Debit  Credit Debit  Credit Debit  CreditLease obligation 476        589        664       Interest expense 174        121        66          Cash 650        710        730       Adjust balance:Gain/Loss on contingent rentals 50           33           5            Lease obligation 50           33           5            Record depreciation:Depreciation expense 580        580        580       Acc'd depreciation 580        580        580       

1,280     1,280     1,323     1,323     1,315     1,315    

Depreciation expense = $1,741 divided by 3 year lease term

At end of year 1 At end of year 2 At end of year 3

Notes on computation of adjustments: Year 1 – The present value of the actual Year 1 rent of 650 and the projected 700 rent for Years 2 and 3 is CU

1,695 with a balance due of CU 1,215 as of end of Year 1 [n=2, i=10%, pmt=700, fv=0, type=0]. Given the actual reduction in principal of 476 (from entry above), the current balance in lease obligation is CU 1,265 [1,741 - 476]. The difference between these balances is the source of the CU 50 downward adjustment and just happens (?) to equal the difference between expected and actual contingent rent.

Year 2 – The present value of the actual rents for the first two years (650 and 710) plus the projected third year rent of 725 is 1,722 with a remaining balance of 659 as of end of Year 3. Lease obligation on the books is 626 [1,741,- 476 -50 – 589]. CU 33is the upward adjustment needed for the lease obligation..

Year 3 – the CU 5 entry simply zeros out the remaining balance in the lease obligation account after payment of the actual rent of CU 730.

IASB Approach (adjustments to both the liability and to the right­of­use asset) 

IASB approach journal entries:    debit    credit  At inception of lease:   Right‐to‐use Asset  1,828       Lease obligation    1,828   [Original balance is based on i=10%, n=3, pmt=CU 735, fv=0, type=ordinary annuity

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 32

Appendix C (continued) – IASB Journal Entries

At end of year 1:   debit  credit Lease obligation  467    Interest expense  183       Cash    650  

Note that CU 183 is the interest expense from the original table but the debit to lease obligation is a plug figure to balance the entry to the actual rent paid. 

     Lease obligation  76    Right‐to‐use asset    76 

This amount can be computed by creating a NEW amortization table which has the actual contingent rent for Year 1 plus the new CU 740 projected payments for years 2 and 3. The PVELP for this series of payments is CU 1,758 with a balance due at end of year 1 of 1,284. [The balance due is also the present value of 2 ordinary rents of 740 at 10%.]  The balance in lease obligation after the 467 debit above is 1,361.  Therefore, the adjustment is the difference or 76 to catch‐up the lease obligation to the balance on the new table. (Note that rounding errors are extremely common after doing so many present value computations which explains why I don’t have 77 as the journal entry amount).The amended amortization table looks like this: 

 Period 

 Fixed Payment 

Contingent payment

Total payment  Interest   Principal 

 Adjust‐ment   Balance 

 Rate used 

‐      1,828          1         500            150               650            183           467             76             1,284           10%2         500            240               740            128           612             673               10%3         500            240               740            67             673             (0)                  10%

1,500         630               2,130         378           1,752            

Depreciation expense  584       Accumulated depreciation    584  

The revised balance in the right‐to‐use asset is 1,828 ‐ 76 = 1,751. There are three years remaining. Therefore, depreciation expense is 1,751 divided by 3. Note that this is NOT the revised PVELP divided by 3 which would be CU 586 per year for 3 years. 

 At end of year 2:   debit  credit Lease obligation  582    Interest expense  128       Cash    710  

Note that 128 is the interest expense from the amended table prepared at end of year 1 but the debit to lease obligation is a plug figure to balance the entry to the actual rent paid. 

        

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 33

Appendix C (continued) – IASB Journal Entries

End of Year 2 journal entries, continued

  Debit  Credit Lease obligation  50     Right‐to‐use asset    50  

This amount can be computed by creating a ANOTHER amortization table which has the actual contingent rent for Years 1 and 2 plus the new CU 717.50 projected payments for Year 3. The PVELP for this series of payments is CU 1,717.  The ending balance at end of Year 2 on this new table is CU 652 which is 50 different from the CU 703 currently in the lease obligation account [1,828 – 467 – 76  ‐582]. We add the adjustment to the on‐going table to get the following as of the end of Year 2: {I know there is a rounding error but I’m tired of trying to fudge the numbers!} 

 Period  Fixed 

Payment Contingent payment

Total payment  Interest   Principal 

 Adjust‐ment   Balance 

 Rate used 

‐          1,827.84     1             500.00         150.00         650.00          182.78       467.22       76.32       1,284.30      10%2             500.00         210.00         710.00          128.43       581.57       50.45       652.27         10%3             500.00         217.50         717.50          65.23          652.27       ‐               10%

TRUE 1,500.00      577.50         2,077.50       376.44       1,701.06          Depreciation expense  559       Accumulated depreciation    559  

The revised balance in the right‐to‐use asset is 1,751 ‐ 50 = 1,701. There are two years remaining. The new book value of the right‐to‐use asset = CU 1,701 less Year 1 depreciation of 584 = 1,117.  Therefore, depreciation expense is CU 559.  Note that this is NOT the most recent PVELP divided by 3 which would be CU 572 per year for 3 years. 

 At end of year 3:   debit  credit Lease obligation  665   Interest expense  65      Cash    710  

Note that 65 is the interest expense from the amended table prepared at end of year 1 but the debit to lease obligation is a plug figure to balance the entry to the actual rent paid. 

 Right‐to‐use asset   13    Lease obligation    13  

This time the entry is easy – merely what it takes to zero out the amended amortization table after putting in actual instead of expected contingent rental.  Alternatively, think about it as getting rid of any remaining balance in the lease obligation account.  

 

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 34

Appendix C (continued) – IASB Journal Entries

End of Year 3, continued

Depreciation expense  571       Accumulated depreciation    571  

One could get fancy here and compute depreciation expense as shown for the first two years.  But the easier way is to simply recognize enough to make accumulated depreciation equal the new amount in the right‐to‐use asset account.  The new balance is 1,701 + 13 = CU 1,714.  Accumulated depreciation already booked is 584 + 559 = 1,143.  So, third year depreciation is the difference of CU 571 [1,714 – 1,143].  

Final amortization table showing adjustments and actual payments

 Period  Fixed 

Payment Contingent payment

Total payment  Interest   Principal 

 Adjust‐ment   Balance 

‐          1,828          1             500               150               650                183             467             76          1,284          2             500               210               710                128             582             50          652              3             500               230               730                65               665             (13)         ‐              

1,500            590               2,090             376             1,714          114         

Comments regarding FASB­IASB differences: 

The FASB approach seemed easier to me, possibility because I was also trying to do the retroactive catch-up approach to adjust depreciation and interest expense – very complicated. the only real advantage to the FASB approach is getting rid of the complications of continuous revisions of depreciation expense as the right-of-use asset account is adjusted under the IASB approach. If I had also tried to implement changes in incremental borrowing rate (which IASB wants), the complexity would really get challenging!

On the other hand, there were no examples of adjustments and maybe the folks at FASB and IASB had something simpler in mind than what I came up with. I would really hate to try to do all these changes with either the prospective or the retrospective methods described in Chapter 5. I’ve worked out a similar example for changes in projected required cash outflow under a guarantee of residual value. It is in Excel and I won’t take time to type it up since the “findings” are about the same.

Even though I prefer the FASB’s tentative conclusion to the IASB’s tentative conclusion, it would be better to make things even simpler if the differences between uncertain expected dollar amounts and actual dollar amounts are relatively small. On the next page, I’ve taken the same examples charged differences between actual and expected directly to the P&L statement with no adjustments to the obligation to make lease payments. It is MUCH simpler! For a least these examples, I can’t see that financial statement users would benefit from the more complicated approaches. Obviously, a trend that indicates significant differences between expected and actual amounts should trigger adjustments to at least the lease obligation.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 35

Appendix C, continued

The “Even Easier” Possibility 

This approach would make no adjustments to lease obligation and right-to-use assets for small differences between expected and actual contingent rentals (or projected payment under a residual value guarantee)

For the FASB example:

Record payment: Debit  Credit Debit  Credit Debit  CreditLease obligation 526        579        636       Gain/Loss on contingent rentals 50             10           28          Interest expense 174        121        66          Cash 650           710        730       

Record depreciation:Depreciation expense* 580        580        580       Acc'd depreciation 580           580        580       

1,280     1,280       1,290     1,290     1,310     1,310    

*Depreciation expense = CU 1,741 divided by 3 year lease term

For the IASB example:

Record payment: Debit  Credit Debit  Credit Debit  CreditLease obligation 552        607        668       Gain/Loss on contingent rentals 85             25 5            Interest expense 183        128        67          Cash 650           710        730       Record depreciation:Depreciation expense* 609        609        609       Acc'd depreciation 609           609        609       

1,344     1,344       1,344     1,344     1,344     1,344    

*Depreciation expense =CU 1,828 divided by 3 year lease term

Summary ‐ over the lease term:FASB 

ExampleIASB 

ExampleInterest expense 361 378Depreciation expense 1741 1827Gain/loss on contingent rentals (12) (115)

2,090     2,090      

Actual payments under lease 2,090     2,090      

At end of year 1 At end of year 2 At end of year 3

At end of year 1 At end of year 2 At end of year 3

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 36

Appendix D – Some Tentative Guidelines for Lessees 

THE LEASE TERM:

Includes renewal periods covered by bargain renewal options when there is a penalty large enough to assure renewal when extension of lease term is at option of lessor during which the lessee guarantees the lessor's debt related to the property during which there is a loan from lessee to the lessor during other renewal periods that are considered to be likely*

*Exercise of renewal options should be considered likely if: the cost of relocating of the business using the leased assets is significant the lessee has made significant leasehold improvements that would be lost if the lease is

not extended alternate productive capacity does not currently exist and substantial revenues would be

lost if the lease is not extended significant costs would be incurred to return the asset to the lessor

EXPECTED LEASE PAYMENTS:

Include fixed rentals and most-likely projected amount for contingent rentals during the expected term of the lease

Exclude executory costs paid by lessor (maintenance, property taxes, or insurance)

Include all rental payments up to date of a purchase option that is expected to be exercised

Include the amount of any purchase option that is expected to be exercised

Include renewal penalties not large enough to assure continuation of lease but exclude renewal penalties that are large enough to assure continuation of lease

Include rents during renewal periods during which there is/(are): renewal options expected to be exercised a nonrenewal penalty large enough to assure continuation of lease any guarantee by lessee of lessor’s debt related to leased property an outstanding loan from lessee to the lessor

Include most-likely amount to be paid under a guarantee of residual value

Include any other payments (other than those for services) that will be made to lessor under the terms of the lease during the expected lease term

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 37

Appendix E – A Proposal for Lessor Accounting 

This is a hybrid approach that would not require guidelines to distinguish between operating and finance leases (although it is close). The guidelines precede the description of the appropriate lessor accounting.

Indications that the lessor has effectively transferred the leased asset to the lessee:

There is a bargain purchase option that the lessee is expected to pay

There is an automatic title transfer to the lessee

There is a guarantee of substantially all of the expected residual value of the asset (by lessee or a third party)

The lease term (including periods covered by bargain renewal option or assured by nonrenewal penalties or the like) represents most of the asset’s remaining useful life

The lessor will recover the acquisition price through the minimum expected lease payments

The lessor is not a dealer or manufacturer and does not generally carry assets of this type in plant, property and equipment

The lessor is a dealer or manufacturer whose business operations includes substantial sales of new and used assets of the same type covered by the lease

The leased asset was designed or modified to meet the specific needs of the lessee and cannot readily be leased to other parties without large expenditures

If real estate is a major part of the leased assets, the asset has not been effectively transferred to the lessee unless there is a bargain purchase option or automatic title transfer

Indications that the lessor has not effectively transferred the leased asset to the lessee:

The leased asset will be returned to lessor at the end of the lease (no bargain purchase option and no automatic title transfer)

The original lease term (including periods covered by bargain renewal option or assured by nonrenewal penalties or the like) represents only a small portion of the asset’s remaining useful life

The residual value is substantial in comparison with the fair value at inception of the lease and is not guaranteed by the lessee or a third party

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 38

Appendix E, continued

A substantial portion of the lessor’s operating activities are devoted to the management and leasing of similar assets (both new and used) but the lessor is not a dealer or manufacturer of similar assets

Any modification of the leased asset to suit specific lessee requirements does not require substantial initial expenditures (in comparison with initial fair value) and the lessor will not incur substantial costs to modify the asset for another lessee at the end of the lease term

The leased asset is primarily real estate (land and/or buildings) and the lease does not include a bargain purchase option or automatic transfer of title to the lessee

The lessor did not acquire the asset on behalf of the lessee for the sole purpose of earning a return equivalent to interest revenue on the acquisition cost

The lessor does not ordinarily manufacturer or sell assets similar to those covered by the lease

[Guidelines for determining the lease term would be essentially identical to the ones listed for lessees in Appendix D. Guidelines for what cash flows to include in the estimate of PVELP would be also be similar to those used by lessees (as shown in Appendix D) with a few differences. The main difference would be for amounts to consider as “cash flows” when there is a lessee or third-party guarantee of residual value. For unguaranteed residual values, there would also be guidance on the inclusion or exclusion in the lease receivable (as distinct from the PVELP) when the asset will be returned to the lessor: the unguaranteed residual value would be included only if the leased asset met the guidelines for removal from the lessor’s balance sheet.]

 

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 39

Appendix E, continued

Accounting by Lessors 

Effective transfer of leased asset

The lessor should remove the leased asset(s) from its books if the asset(s) has been effectively transferred to the lessee (see guidelines above). In this case, the physical assets are replaced by a receivable measured at the present value of the expected rental payments plus any guaranteed residual value and unguaranteed residual value that is expected to exist at the end of the expected lease term.

Generally, the only source of revenue from the lease arrangement will be interest revenue. However, in the case of a dealer or manufacturer that normally sells assets of the type leased, a sale would be recognized at the inception of the lease and measured at the present value of the expected lease payments, excluding any unguaranteed residual value. Cost of goods sold is increased by an amount equal to the reduction in inventory less the present value of any unguaranteed residual value. Any initial direct costs are expensed immediately. The lease payment receivable is recorded at the present value of the likely lease payments over the expected lease term plus the present value of any unguaranteed residual value. Interest revenue is recognized over the lease term using the effective interest method and the interest rate implicit in the lease.

When no sale is recognized at the inception of the lease, the lease payment receivable is recognized at the fair value of the leased asset (generally the acquisition cost) plus any other initial direct costs incurred. This initial value is amortized over the lease term using the effective interest method. The discount rate is the interest rate implicit in the lease after considering all likely cash inflows from lessee and any residual value.

Any subsequent re-measurement triggered by substantial changes in expected lease term, rental payments or residual values should be calculated using the original discount rate and the catch-up method. The increase or decrease impacts the receivable and creates a gain or loss on the profit and loss statement.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 40

Appendix E, continued: Accounting by Lessors

No effective transfer of leased asset.

If the lessor has not effectively transferred the leased asset(s) to the lessee (see guidelines above), the physical asset(s) is not removed from the books and the lessor will continue to record depreciation expense over the useful life of the asset(s). The lessor shall record both a receivable and a performance obligation related to the lease. The receivable is measured at the present value of the expected payments under the lease including the full amount of any guaranteed residual value. The receivable shall not include any unguaranteed amounts. The discount rate is the rate at which the lessor would be willing to lend money to the lessee with the leased asset(s) as collateral. The liability is measured at the same amount and is amortized over the lease term by any reasonable amortization method (straight-line method, mortgage-method, etc.) The lease payments receivable is amortized using the effective interest method.

Subsequent re-measurements should be undertaken when expected lease payments differ substantially from original estimate due to changes in expected lease term, contingent rentals, purchase options and the like. Any increase or decrease is calculated using the original discount rate and the catch-up method. An adjustment is made to both the lease receivable and the obligation to permit the lessee to use the leased asset. For minor changes such as small differences between expected and actual contingent rent, the lessor may elect to adjust the lease receivable through a gain or loss on the profit and loss statement (as opposed to an adjustment to the receivable and performance obligation).

Examples of Lessor Accounting 

I have includes an example for each of the possibilities under my proposed scheme for lessor accounting. Examples 12 and 13 in the PV-Leases had no “facts” so I have created them. In each of the three examples presented, the initial value of the asset is approximately CU 190,000 the fixed rental payment is CU 35,000 for the first five years, and the implicit rate is around 8%. In other words, I took the figures given in PV-Leases Example 3 and tried to imagine how and why they would be acceptable to a lessor.

 

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 41

Appendix E, continued

Example 12 (page 78 in PV­Leases) 

Assumptions: Acquisition cost of asset = CU 190,108 (includes CU 108 initial direct costs) Useful life of asset = 10 years Implicit interest rate is approximately 8% Lease term = 5 years with option to renew for another 5 years. There is a nonrenewal penalty of CU 74,000 if the lease term is not extended Fixed lease payment = CU 35,000 for the first 5 years, and CU 18,500 during the renewal period Residual values are essentially unknown to the financial institution but should be sufficient to cover costs of disposal if the asset is returned at end of 5 or 10 years Nonrenewal is considered to be more likely than renewal so the PVELP is CU 190,108. Since the minimum lease payments are sufficient to recoup almost the full purchase price, this lease would qualify for removal from lessor’s balance sheet.

For the lessee, this would be considered a capital lease under current US GAAP since the PVMLP exceeds 90% of fair value (unless the incremental borrowing rate is more than about 13% and whether or not the renewal option is considered a bargain). It would be a direct finance lease for the lessor assuming no important uncertainties exist with respect to collectability or cost.

Under current accounting standards for direct finance leases, the initial balance in the receivable would be the purchase price plus any other initial direct costs. If a realistic residual value were to be included in the receivable, the implicit rate would drop considerably below the desired rate of return used to compute the required payments. Accordingly, for this preliminary version, I omitted inclusion of a residual value.

Lease 12a - Amortization Schedule for Expected Lease Payments

 Period   Payment   Interest   Principal   Adjustment*   Balance ‐       190,108       1           35,000        15,209        19,791        170,317       2           35,000        13,625        21,375        148,942       3           35,000        11,915        23,085        ‐                     125,857       4           35,000        10,069        24,931        100,926       5           35,000        8,074          26,926        74,000               0                   

175,000      58,892        116,108      74,000               546,042       

*Nonrenewal penalty plus residual value of returned asset

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 42

Appendix E, continued

Selected journal entries for Example 12

debit creditUpon transfer of right of use to lessee:Lease receivable 190,108       Equipment acquired for lease 190,108       

End of year 1Cash 35,000         Interest revenue 15,209         Lease receivable 19,791         

At end of year 5 (assuming no renewal)Cash 109,000       Interest revenue 8,074           Lease receivable 100,926       

Equipment held for disposal  at fair valueGain on returned asset at fair value

Comments on Lease 12: If a financial institution is concerned with recouping the acquisition cost and earning a fair rate of interest given current market conditions and the perceived risk inherent in the arrangement, it could choose to ignore residual values when determining the necessary rentals. If I had included a realistic residual value at end of the fifth year (CU 92,000 from Example 13) in Example 12, the implicit rate that would set the cash flows equal to acquisition cost would be a very healthy 16.588%. After doing these two variations, I considered whether it would be better to record a HIGHER initial lease receivable (based on the 8% rate that had been used to determine the 35,000 rents and the 74,000 penalty). The present value of the expected payments plus the present value of the residual value = 252,722. Using this approach would mean that the lessor would recognize a 62,614 gain at inception of the lease – and that doesn’t seem right. Better to record gain when the residual value becomes measurable! But the best way would be to include an estimate of the residual value and adjust the implicit rate. In other words, current GAAP works well and we should retain most of the guidance for direct finance leases for situations where a financial institution acquires an asset on behalf of a lessee with no intention of keeping the asset.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 43

Appendix E, continued

Example 13 (page 78 in the PV­Leases) 

Assumptions: Usual selling price of asset = CU 190,000 Cost to acquire or produce the asset = CU 160,000 Useful life of asset = 10 years Implicit interest rate is approximately 8% Lease term = 5 years with option to renew for another 5 years. There is no nonrenewal penalty If renewal option is exercised, title will pass to lessee at end of Year 10 Fixed lease payment = CU 35,000 for the first 5 years, and CU 18,500 during the renewal period Residual value at end of five years = CU 92,000 Residual value at end of seven years = CU 38,000 The renewal option is a bargain and there is a title transfer so the expected lease term is 10 years. Therefore, PVELP = CU 190,016

Without the title transfer provision, this would be an operating lease for the lessee under current US GAAP unless the renewal option was considered a bargain.

Since this lessor normally earns a profit from manufacturing or selling assets of this nature, any other initial direct costs of entering into the lease would be expensed in the year of sale and the asset would be considered to be effectively transferred to the lessee. Other guidelines that confirm effective transfer include: lease term = useful life, title transfers and fair value is recovered through lease payments.

Lease 13 - Amortization Schedule for Expected Lease Payments  Period   Payment   Interest   Principal   Balance   Rate used 

0 190,016  1 35,000            15,201              19,799        170,218   8.000%2 35,000            13,617              21,383        148,835   8.000%3 35,000            11,907              23,093        125,742   8.000%4 35,000            10,059              24,941        100,801   8.000%5 35,000            8,064                26,936        73,865     8.000%6 18,500            5,909                12,591        61,274     8.000%7 18,500            4,902                13,598        47,676     8.000%8 18,500            3,814                14,686        32,990     8.000%9 18,500            2,639                15,861        17,130     8.000%10 18,500            1,370                17,130        (0)              8.000%

TRUE 267,500          77,484              190,016    

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 44

Appendix E, continued

Selected journal entries for Example 13

debit creditUpon transfer of right of use to lessee:Cost of goods sold 160,000       Lease receivable 190,016       Inventory 160,000       Sales 190,016       

End of Year 1:Cash 35,000         Interest revenue 15,201         Lease receivable 19,799         

End of Year 6:Cash 18,500         Interest revenue 5,909           Lease receivable 12,591         

End of Year 10:Cash 18,500         Interest revenue 1,370           Lease receivable 17,130         

Leased asset is not returned

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 45

Appendix E, continued

Lessor Side of Example 3 (page 30 in the PV­Leases) 

Assumptions: Cost to acquire asset = CU 280,000 ( 100,000 land & 180,000 building) Accumulated depreciation to date = CU 90,000 Book value at inception of lease = CU 190,000 Useful life of asset at acquisition = 20 years, remaining useful life = 10 years Rate at which lessor would lend money to lessee with asset as collateral = 8% Lease term = 5 years with option to renew for another 2 years There is no nonrenewal penalty There is no bargain purchase option or title transfer Fixed lease payment = CU 35,000 for the all years This is the going rate for this type of real estate. Lessor is a “price taker” Expected value at end of five years = CU 235,000 Expected value at end of seven years = CU 217,000 Expected values assume land increases 4% per year over20 years and then I added book value of building less 10,000 for renovation or destruction Using this same crude technique, the fair value at inception would be about CU 228,000 The expected lease term is 5 years since there is no reason for the lessor to expect the lessee to exercise the renewal option The lessor’s estimated implicit rate is nearly 16% for a five year term and close to 15% for the seven year term but the lessee would not be able to estimate this rate and would be using an incremental borrowing rate of 12% The lessor’s lending rate to this lessee is also 12%

For both the lessee and the lessor, this would be an operating lease under both US GAAP and IFRS [No title transfer, no bargain purchase option, lease term = 50% of remaining useful life, PVMLP < 90% of estimate fair value, nature of asset is not specialized]

Under my proposed guidelines, there is nothing to indicate that the asset as been effectively transferred to the lessee. Therefore, the leased asset is NOT removed from the lessor’s balance sheet. The lessor would continue to depreciate the building at CU 9,000 per year (CU 180,000 acquisition cost divided by 20 year expected useful life). 6

6 A finance-lease approach could be applied to these facts. Since the real estate would have to be removed from the books, a large gain would have to be recognized at the inception of the lease. In addition, the lease receivable would have to include the large unguaranteed residual value and the implicit rate would be very high. Furthermore, interest revenue would exceed the cash payments each period giving rise to “negative reductions” to principal. Therefore, I’ve not bothered to type up my findings for this approach!

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 46

Appendix E, continued

A lease payments receivable and a performance obligation (to permit lessee’s exclusive use of the asset) will be recognized and amortized over the lease term. The obligation is measured in the essentially the same way that would be used by the lessee to measure its comparable right-to-use asset. If we use the estimated implicit rate, PVELP = 115,139. If we use the lessor’s lessee-specific lending rate, the PVELP = 126,167. If given a choice, the lessor would probably prefer the lower value but all of the fair values in this example are very crude estimates and it would be simpler to use the lending rate, as I have done in the following amortization table.

Lease 3 – Lessor’s Amortization Schedule for Expected Lease Payments

 Period   Payment   Interest   Principal   Balance  Rate used 

0 126,167  1 35,000            15,140              19,860        106,307   12%2 35,000            12,757              22,243        84,064     12%3 35,000            10,088              24,912        59,152     12%4 35,000            7,098                27,902        31,250     12%5 35,000            3,750                31,250        0               12%

175,000          48,833              126,167    

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 47

Appendix E, continued

Lease 3 – Lessor Journal Entries (Style A for Revenue Recognition) Upon transfer of equipment to lessee:Lease Payments Receivable 126,167       Performance obligation 126,167       

End of first year:Depreciation expense 9,000           Acc'd depreciation 9,000           

Cash 35,000         Interest revenue 15,140         Lease payments receivable 19,860         

Performance obligation 25,233         Rent revenue 25,233         

Using straight line amortization

Total rent revenue 126,167       Total interest revenue 48,833         

Total cash received 175,000       Less depreciation expense 45,000         

Gross profit on lease 130,000       

The impact of straight-line amortization would be decreasing revenues over the lease term (40,373 for first year and 28,983 for fifth year).

Style B Recognition of Revenue 

It would be quite simple and easy to use a mortgage-method amortization approach for the performance obligation since the same interest rate would apply (whether implicit or lessee-specific lending rate). In other words, the amortization table for the lease payments receivable provides the “depreciation” expense in the “principal” column which totals to the initial value of the performance obligation. In essence, interest revenue and interest expense would cancel out leaving the rent equal to the fixed cash flow. I’ve denoted this as “Style B” and its constant revenue stream would be attractive to most lessors!

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 48

Appendix E, continued

Example 3 – Lessor Journal Entries (Style B for Revenue Recognition) End of first year: Debit CreditDepreciation expense 9,000           Acc'd depreciation 9,000           

Cash 35,000         Interest revenue 15,140         Lease payments receivable 19,860         

Performance obligation 19,860         Interest expense (?) 15,140         Rent revenue 35,000         

Using mortgage‐method amortization

Total rent revenue 175,000       Total interest revenue ‐               

Total cash received 175,000       Less depreciation expense 45,000         

Gross profit on lease 130,000       

Since interest revenue and interest “expense” cancel out, the entry devolves to:

Debit CreditCash 35,000         

Rent revenue 35,000         Performance obligation 19,860         

Lease payments receivable 19,860         

Comments on Lessor Side of Example 3 

For the lessee side (see Question 12), I recommended that the mortgage-method for depreciation of the right-to-use asset be permitted only if interest expense was properly labeled. For the lessee, there is a monetary obligation that closely parallels other loans that secure the use of long-lived assets. The lessor situation is different – the performance obligation is not a financial liability. Therefore, inclusion of interest expense for this nonmonetary “debt” could lead to distortions in interest expense that could be misleading as financial statement users try to compute debt coverage ratios or the like. Therefore, I’m leaning toward recommending the “summary” entry under Style B that recognizes neither interest revenue nor interest expense for all leases in which the underlying asset is not considered effectively transferred to the lessee.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 49

Appendix F  Worst Case Implementation of Proposed Standards 

An Example 

This example is a variation of Example 3 on page on page 30 of the PV-Leases but the initial lease term is one year and there are six sequential one-year renewal options. In other words, the lease can be extended to seven years but the lessee only makes a year-to-year commitment. Thus, it is a “worst-case” scenario for implementation of the proposed standards.

The lease begins in July 1 with the initial payment due June 30 of the following year. The lessee’s fiscal year ends December 31. During the audit period, the lessee claims uncertainty as to whether the first renewal option will be exercised. In June of the following year, the lessee notifies lessor of intention to renew the lease for one more year. Here are the resulting entries:

     Debit    Credit  July 1, Year 0 at inception of lease:   Right‐to‐use Asset  32,407       Lease obligation    32,407   [Original balance is based on i=8%, n=1, pmt=35,000, fv=0, type=ordinary annuity Dec 31, Year 0 (end of fiscal year): Interest expense  1,296  1,296    Interest payable     Depreciation expense  16,204    Accumulated depreciation    16,204 

Accrue interest expense and depreciation expense.   Interest expense is 32,407 * 8% * 6/12 = 1,296; Depreciation expense is CU 32,407 divided by 1 year lease term * 6/12 = 16,204 

     June, Year 1 Lease obligation  32,407    Right‐to‐use asset    32,407 

Lessee informs lessor of intention to renew lease which requires an adjustment. This journal entry uses the catch‐up method described in the PV‐Leases. The balance in the lease obligation account on June 30 will be zero and it should be 32,407 (i=8%, n=1, pmt=35,000, fv=0, type=0).  

June 30, Year 1 Lease obligation  32,407 Interest payable  1,296 Interest expense  1,297    Cash     35,000 

Lessee makes the payment for the first year. Balance in lease obligation remains at 32,407. Balance in right‐to‐use asset is 32,407‐16,204 =16,203 + 32,407 adjustment = 48,610 with remaining useful life of 1.5 years as of beginning of Year 1

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 50

Appendix F, continued

Dec 31, Year 1 (end of fiscal year): Interest expense  1,296    Interest payable    1,296 Depreciation expense  32,407    Accumulated depreciation    32,407 

Accrue interest expense and depreciation expense.   Interest expense is 32,407 * 8% * 6/12 = 1,296; Depreciation expense is CU 48,610 divided by 1.5 remaining lease term as of Jan 1 or  CU 48,610 divided by 1.5  

If the lessee continues to renew the lease through the maximum 7 year term, here is what the amortization schedule and the depreciation schedule will look like – using the catch-up method:

 Period   Payment   Interest   Principal  Adj for Renewal   Balance 

 Rate used 

0 32,407    1 35,000     2,593       32,407     (32,407)    32,407     8%2 35,000     2,593       32,407     (32,407)    32,407     8%3 35,000     2,593       32,407     (32,407)    32,407     8%4 35,000     2,593       32,407     (32,407)    32,407     8%5 35,000     2,593       32,407     (32,407)    32,407     8%6 35,000     2,593       32,407     (32,407)    32,407     8%7 35,000     2,593       32,407     0               8%

245,000   62,777     62,777    

 Period  Depr 

Expense Acc'd Depr

 Adj asset 

Right‐to‐use Asset

 Book value of Asset 

on P&L (depr + int)

0 32,407     32,407    1 32,407     32,407 32,407    64,815     32,407     35,000    2 32,407     64,815 32,407    97,222     32,407     35,000    3 32,407     97,222 32,407    129,630   32,407     35,000    4 32,407     129,630 32,407    162,037   32,407     35,000    5 32,407     162,037 32,407    194,444   32,407     35,000    6 32,407     194,444 32,407    226,852   32,407     35,000    7 32,407     226,852 ‐          226,852   ‐           35,000    

226,852   245,000  

Impact 

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 51

Appendix F, continued

Comments on Year­by­Year Renewal Example 

Let’s compare the year-by-year lease renewal to the same lease with an expected lease term of seven years. Here is the amortization schedule we would have prepared and the resulting depreciation expense:

 Period   Payment   Interest   Principal   Balance   Depr  Impact on P&L 

0 182,223  1 35,000     14,578     20,422     161,801   26,032     40,610    2 35,000     12,944     22,056     139,745   26,032     38,976    3 35,000     11,180     23,820     115,924   26,032     37,211    4 35,000     9,274       25,726     90,198     26,032     35,306    5 35,000     7,216       27,784     62,414     26,032     33,248    6 35,000     4,993       30,007     32,407     26,032     31,025    7 35,000     2,593       32,407     0               26,032     28,624    

245,000   62,777     182,223   182,223   245,000  

Note that total interest expense is the same CU 62,477 on both amortization schedules and, in both cases, total cash outflows equal total interest expense plus total depreciation expense. One big difference, however, is that there is a constant “hit” of CU 35,000 on the P&L if we did the year-to-year renewals instead of the decreasing stream of expenses that would have otherwise occurred. In addition, the right-to-use asset continues to increase in the year-to-year renewal example and ends up at CU 226,852 instead of the CU 182,223 we would have recorded “if we had only known.” If we think of the initial CU 32,407 value for the right-to-use asset as an estimate, then the errors have accumulated to CU 44,629 over the course of the lease. That is nearly a quarter higher than it “should have been.” However, the most striking difference that I see is the hugely different balances for the lease payment obligation. The error is 82% of the correct amount at inception, 77% at the end of the second year, 48% at the end of the fifth year and zero only at the end of the sixth and seventh years.

The use of the retroactive catch-up method described in my Appendix B would correct the error in the final balance of the right-to-use asset but would be exceedingly tedious to do given the very frequent revisions in lease term. While complex, I can’t see that it would necessarily be a deterrent to structuring leases in this way. In contrast, the prospective is essentially unworkable because the ending balance at the date of each renewal is zero. As far as I can tell, the retrospective method ends up using the original interest rate anytime there is only one year of the revised lease term remaining when the change in estimate is made – at least for the increasing lease term situation. In this particular case, the retrospective method turns out to the same as the catch-up method shown above.

1680-100 Comment Letter from T. Gordon July 16, 2009 Page 52

Appendix F, continued

This exploration of the “worst case” scenario for structuring leases strongly suggests that there needs to be a required disclosure regarding all available extensions in lease terms in something like the format below. The weighted average historical incremental borrowing rate as well as the incremental borrowing rate at the end of the fiscal year should also be disclosed. This would permit financial statements users to estimate the fair value of all right-to-use assets and lease obligations for future rent payments. I’ve computed the liability that would exist if all current leases were extended the maximum possible length – another useul disclosure. It would not be hard to estimate the fair value of the lease obligation by substituting the current incremental borrowing rate instead of the weighted average historic rate.

Suggested Footnote Disclosure to Help Ameliorate Problems Caused by Structuring Leases For the Purpose of Minimizing Reported Liability for Lease Payments 

Projected payments 

under leases

Minimum fixed rentals under 

existing contracts

Planned payments under unexercised 

renewal and purchase options

Estimated contingent rentals and residual value 

guarantees

Additional cash flows under existing leases extended to 

maximum length2012 655                     625                        ‐                           30                            30                           2013 655                     625                        ‐                           30                            30                           2014 675                     625                        20                             30                            30                           2015 575                     525                        20                             30                            ‐                          2016 575                     525                        20                             30                            ‐                          

2017‐2021 2,875                  125                        2,600                       150                          100                         Thereafter 1,510                  ‐                         1,500                       10                            60                           

7,520                  3,050                     4,160                       310                          250                         

Less interest 3,245                 Lease obligation 4,275                 

The weighted average incremental borrowing rate is 10% and the current incremental borrowing rate is 9%. If existing leases were extended through the maximum possible period, the liability would be 4,411 with a fair value estimated at 4,633.

(From the Microsoft Word version, you should be able to double-click on the table and move around to see how relatively easy a schedule like this could be prepared.)