A New Standard
Understanding the FASB/IASB Lease-accounting Project
Tony Gabinetti
In 2010, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued a joint proposal for revising lease-accounting standards. The proposed changes are expected to have a significant impact on companies engaged in substantial leasing activities. The proposal effectively eliminates off-balance-sheet or operating lease accounting for most leases.
The joint proposal would establish an accounting model that would require that assets and liabilities under leases be recognized in the statement of financial position. This differs from the current GAAP accounting model that classifies leases into capital leases (records and asset and liability) and operating leases (does not recognize an asset and liability).
While many of the problems associated with existing lease accounting relate to the treatment of operating leases by the lessee, keeping the current lease accounting by the lessor would be inconsistent with the proposed lessee accounting.
Measuring Assets and Liabilities
The proposal utilizes a ‘right-of-use’ model that would apply to all leases, including those currently classified as operating leases. This model is similar to the current model for capital leases. Both lessees and lessors would be required to record an asset and corresponding liability on their balance sheets.
The lessee would record an asset representing the present value of its right to use the leased asset during the lease term, and record a liability representing the present value of its lease payments. Subsequently, the lessee would measure the asset at amortized cost, and record amortization expense using the ‘effective interest rate method,’ under which lease payments are allocated between principal and interest over the lease term.
A lessor would initially record an asset representing the present value of its right to receive lease payments and recognize revenue over the lease term. Under the initial-exposure draft, the lessor also would select one of two accounting models:
1. Performance obligation. A lessor that continues to be exposed to ‘significant risks or benefits’ associated with the leased asset would use this model. It would recognize a liability (its obligation to allow the lessee to continue using the lease asset) as well as the underlying asset; or
2. Derecognition. A lessor that doesn’t retain such exposure would use this model. It would derecognize its rights to the leased asset as the asset is transferred to the lessee. And the lessor would continue to recognize a residual asset (its rights to the leased asset at the end of the term).
According to recent news, the board appears to have settled on one accounting approach for lessors: the lessors would derecognize the leased asset and record both a lease receivable and a residual asset for the portion retained by the lessor.
The proposal prescribes simplified accounting methods for certain short-term leases and also provides an exception for ‘simple capital leases’ — those entered into before the ‘transition date’ that are classified as capital leases under existing standards but include no options, contingent rents, termination penalties, or residual-value guarantees. Leases that fall within this exception can be accounted for under existing standards for capital leases.
Determining the Lease Term
One challenge for both lessors and lessees under the proposed standards will be determining the lease term. The original proposal called for measurement of assets and liabilities based on the longest lease term that’s ‘more likely than not’ to occur, taking into account all options to renew or terminate.
However, the FASB and IASB tentatively decided to adjust this threshold. Under the boards’ revised definition, the lease term would include the non-cancellable term, plus any extension options if there’s a significant economic incentive for the lessee to extend the lease. The boards also determined that the parties should reassess the lease term only if a significant change alters the lessee’s incentives to extend or terminate the lease.
Assessing the Impact
If your company has a significant number of operating leases, assess the proposed standards’ potential impact as soon as possible. The need to value, track, and report lease-related assets and liabilities may require you to modify or upgrade certain systems, procedures, and controls.
Also, because the new standards would rely heavily on estimates and judgments, they significantly expand financial statement disclosure requirements for leasing activities. The proposal also may have an impact on key measures of financial performance, such as EBITDA, and on financial ratios and other benchmarks used in loan covenants, compensation agreements, and certain contracts. The reason for this is that, under current standards, rent payments under an operating lease are treated as ordinary operating expenses. Under the proposed standards, rent would be replaced with a combination of interest and amortization expense.
Accounting for Services
One difficulty under the new standards being proposed is the need to account separately for distinct service components of a lease.
This isn’t an issue under current standards for operating leases because the lease and service components (such as agreements to provide maintenance or repairs) are treated in basically the same way. But under the proposal, the lease component would be recorded on the balance sheet while the service component would not. Allocating between payments for use of the leased asset and payments for services can be challenging. In future leases, your company may want to ensure that any services to be provided are charged separately.
The FASB and IASB are revising their original proposal and are expected to re-expose the standards for additional comment in the first quarter of 2012. Many believe that the new standards will take effect in 2015.
Tony Gabinetti, CPA, is a senior audit manager at Meyers Brothers Kalicka, P.C. in Holyoke; (413) 536-8510; [email protected]
