Implementation issues in applying new guarantor accounting to leases

ELT, Aug 2003

In the absence of clear guidance, lessors must discuss and consider how to implement FIN 45.

From a business perspective, leases represent a powerful tool to optimally allocate the risks and rewards incident to asset ownership. On the closing date, the parties to a leasing transaction strike a bargain where each participant believes that it has accepted risks commensurate with the rewards received. Accountants have struggled over the best way to portray the economic bargain given the contingent nature of certain important contractual provisions, notably those involving guarantees and indemnities, and have increasingly come to believe that the current risk and rewards model (FAS 13 or IAS 17 accounting) may not be effective in providing the desired transparency.

With the collapse of Enron partially attributable to its guarantees of certain off-balance-sheet financing arrangements, the Financial Accounting Standards Board (FASB) responded with new interpretative guidance intended to increase the transparency of retained risks, FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45). From a broader perspective, this new interpretative guidance evidences a continuing commitment on FASB's behalf to fair value accounting as the best means of revealing the risk elements inherent in an economic bargain.

While FIN 45 has a clearly stated objective of improving the financial reporting to help users assess the amounts, timing, and uncertainty of the guarantor's prospective cash flows, it provides limited implementation guidance for preparers and their auditors in achieving the stated objective. Without such guidance, as illustrated below, significant differences in views about the scope of FIN 45 and the recognition and measurement of covered guarantees and indemnities may emerge.

Further, it appears that FASB has no current plans to support the implementation process by providing follow-on guidance and analysis in the interest of improving the financial reporting community's understanding of theory and practice. Accordingly, preparers and auditors will face significant uncertainty in achieving the stated objective of FIN 45 and in minimizing the risk of second-guessing, particularly for public companies subject to Sarbanes-Oxley (the new regulatory regime mandating, among other requirements, principal executive and financial officer certifications and expanded disclosures of off-balance sheet arrangements).

This article intends to facilitate discussions about implementation issues facing preparers and their auditors in identifying guarantees within the scope of FIN 45 and, once identified, in recognizing and measuring those guarantees. It does not constitute accounting advice. Preparers should consult with their auditors on FIN 45 implementation issues.

Key Implementation Issues

In applying FIN 45, lessees and lessors generally have had to address the following implementation issues:

Scope. Which contracts (or contractual provisions) come within the scope of FIN 45?

Initial Measurement. What valuation technique(s) should be used in measuring the fair value of a covered guarantee or indemnity?

Subsequent Measurement. Which accounting method(s) should be used in the subsequent measurement of initially recognized amounts?

Interplay with FAS 13. Does FIN 45 affect lease classification? What effect, if any, does FIN 45 have on the accounting for leases?

The sections below provide a summary of the author's current understanding of various views on these key implementation issues.

Grandfathered Contracts

FIN 45 provides that the initial recognition and measurement provisions shall be applied on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. In other words, FIN 45 effectively grandfathered existing contracts.

FIN 45 does not state when a guarantee should be considered issued or modified. Clearly, if the parties to an existing lease agree to change the terms and conditions of a guarantee or indemnity in an existing lease, then the changed provision would likely lose its grandfathered status. Similarly, if the parties agree to change the provisions of an existing lease in such a way that it creates a "new lease" under FAS 13 (e.g., by extending the lease term), all of the provisions in the new agreement would also likely come within the scope of FIN 45. However, in all other circumstances, the correct interpretation of "issued or modified" may not be so clear-cut.

The following is a list of changes that may or may not cause a grandfathered lease contract to come within the scope of FIN 45:

A change to the provisions of the existing lease that does not trigger a "new lease" and does not involve any changes to the existing guarantees or indemnities that would otherwise come within the scope of FIN 45.

A change in the parties to the lease, e.g. sale or transfer of the existing lease from one lessor to another lessor or a lessee substitution (which may involve lessee consent) or the acquisition of a lease in connection with a business combination.