Banks Obtain Some Relief with Revised Exposure Draft Addressing Leases

By Baker Newman Noyes September 2, 2013

Earlier this year, the Federal Accounting Standards Board and International Accounting Standards Board jointly issued a revised Exposure Draft (ED) on leases which attempts to address the criticisms of the 2010 exposure draft.

One of the criticisms of the 2010 exposure draft was that income statements would have reflected a pattern of front-loaded expenses for all leases (similar to today’s capital leases).  Banks that have significant real estate leases would have been hit hard by this proposed change.  Real estate leases tend to have longer terms and the longer the average lease term, the greater the impact of front loading the lease costs.  When the front-loading of expense was coupled with the decrease in capital that arose from recording a right-to-use asset and liability, banks developed great concern with the potential impact on their capital ratios.

Under the revised ED, a right-to-use asset and liability still will be recorded; however, expense recognition will depend on the nature of the underlying asset and whether the lessee acquires or consumes more than an insignificant portion of the asset.  The revised ED includes a “dual model” whereby leases either will be Type A or Type B.  If the lessee is expected to consume more than an insignificant portion of the asset over the lease term, it is a Type A lease; if less, it is a Type B lease.

As a practical expedient, the revised ED contains a presumption that leases of real property (i.e., land and/or buildings) are Type B leases, and leases of assets other than real property (i.e., equipment) are Type A leases. Overcoming this presumption requires consideration of the significance of (a) the lease term compared to the underlying asset’s economic life and (b) the present value of the lease payments compared to the fair value of the underlying asset. For example, if the underlying asset is real property, the lease is a Type B lease unless (a) the lease term exists for the major part of the underlying asset’s remaining economic life or (b) the present value of the lease payments accounts for substantially all of the underlying asset’s fair value.

For Type A leases, lessees will recognize lease costs using an accelerated method that separately recognizes amortization expense and interest expense.  For Type B leases, lessees will recognize lease costs using a straight-line method.

Presumably, in light of the practical expedient, most banks’ branch leases (or land leases for branch sites) will be Type B and therefore straight-line expensing is appropriate rather than front-loading.  However, grossing up of the right-to-use asset and related liability will have a negative effect on capital ratios.

An effective date has not yet been established, but we recommend that banks begin analyzing their leases now, particularly those leases involving branches, to determine the effect on capital ratios, especially in light of the new Basel III capital requirements. Editor’s Note: Yes, we published an article on this topic in our July issue of the BNN Briefing, but thought it was worth repeating with a slant on how it affects banks. To view the original article please click here.

If you would like to discuss these matters further, please contact your BNN advisor at 1.800.244.7444.